Indexology^® Blog

 Climate change talks dominated sustainability discussion in 2015 as COP21 approached
As we approached COP21 in Paris this year, the core of sustainability discussion was increasingly centered on climate change, which has received a consensus priority status as both the most important and the most pressing subject. The Montreal Carbon Pledge that was adopted in September 2014, whereby signatories agree to measure and publicly disclose the carbon footprint of investment portfolios annually, has reached $10 trillion of assets by the time of COP21, and the Portfolio Decarbonization Coalition whereby members will drive GHG emissions reductions on the ground by decarbonizing their portfolios has accumulated $600 billion. The Mercer report “Investing in the time of Climate Change” presented a very solid and quantified investment case, with Coal and Oil industries being the biggest losers under various climate scenarios and Renewable Energy being the only winner.

The impact of COP21 and beyond
COP21 brought a ray of hope to those who have been keen to minimize the carbon-related risks.  Supported by the initiatives of public climate leaders, particularly the President of France, Francois Hollande, 195 nations’ delegations have been able to reach a legally binding and universal agreement targeting to get the climate change constrained within 2 degrees beyond the pre-industrial level and aiming to explore the possibility of 1.5 degrees.  The agreement sets a coordination framework for individual governments, government and supranational agencies and NGOs in road mapping and implementing a transition to low carbon economy. This will require approximately $1 trillion dollars to be invested annually in low-carbon technologies and continued technological innovations, shift of funds from developed countries to developing countries.  Part of the solution is in activating long-term and low cost financial solutions for public and private sector. Low carbon indices are clearly important part of this toolkit, as it helps the industry measure the performance of the low carbon market.

The ‘belly’ of the municipal bond curve or the 5 – 10 year maturity range has done well this year, almost as well as the longer maturity range.   Returns for non-callable investment grade municipal bonds tracked in the 5, 7 and 9 year range all have demonstrated good returns in this low rate environment.

The S&P AMT-Free Municipal Series 2024 Index shows non-callable municipal bonds maturing in 2024 have an average yield of 2.16% and have returned 3.5% year-to-date.   This range has outperformed the composite S&P National AMT-Free Municipal Bond Index and has nearly kept pace with longer bonds tracked in the S&P Municipal Bond 20+ Year Index.

Table 1: Select Municipal Bond Indices Yields and Returns:

It has been over nine years since the Fed raised interest rates, but today, the Fed raised rates just as expected. While the Fed actions have been well telegraphed, and interest rates are probably the least of worries for commodities, there is one measure that might be worrisome.

Although since 1991, rising rates seem not to have been a decisive factor in equity performance, and have clearly not been a negative force (as shown in the chart below from this paper,) there is more uncertainty about the stock market today than tomorrow. 

One indicator of extreme market stress can be seen when the price of futures contract on the CBOE Volatility Index® (VIX) with a nearby expiration is more expensive than one later dated. This condition is called backwardation (it sounds like a bad diagnosis and usually is) but it is relatively rare, happening in only 17% of days since Mar. 29, 2004.

The futures contracts are now reflecting this condition for five days straight. This has happened a number of times before but one of the interesting things about today is that the market seems not only uncertain but downright jittery. It looks a bit like in 2007, soon after the Fed starting raising rates, when the market felt noticeable fear by the measured backwardation. It’s not the fear alone but the persistence. Just a few months ago, from Aug. 20 – Oct. 7, the Chinese stock market crash sent chills through the market. Backwardation appeared again from Nov. 13 – 16 with one of the biggest weekly stock market drops in months that crashed the S&P 500’s 200-day moving average, a bearish signal for many investors. Again, ahead of the Fed decision – which should not have been surprising – backwardation appeared and is present. The chart below shows the history of VIX backwardation with the S&P 500 index levels. The green triangles represent when the Fed raised rates in 2006 and when they started quantitative easing in 2008.

While the interest rates alone have not influenced stock prices, the unprecedented quantitative easing started a vicious cycle of risk-on/risk-off (RORO) that was the result of a binary outcome for risky assets – either the easing works OR it doesn’t. Since commodities are a risky asset, they are a class where the returns are noticeably impacted by fear before the financial crisis and after, when quantitative easing began. Pre-crisis, there was no relationship between a high VIX and commodities, but the relationship turned negative post-crisis.

The RORO environment meant investors either felt they were, or were not getting paid for taking the risk to invest in risky assets. This drove up the correlation of commodities with stocks to unprecedented levels, just over 0.7. By 2013, the Fed started to taper and the correlation fell back to zero, and stayed below its average of 0.26 until Aug., 2015, precisely when VIX backwardation appeared. In just slightly more than one month, the correlation doubled from 0.22 (Aug. 20, 2015) to 0.44 (Sep. 28, 2015). Since then, it has increased slightly more to 0.46, its highest level in over two years, since Aug. 20, 2013.

The one thing to worry about is the combination of higher than average VIX backwardation with high risky-asset (stock/commodity) correlation. This only happened three times before now. Once in the financial crisis, once in 2011 just following the debt ceiling crisis and U.S. downgrade, and for a very short time in the 2010 flash crash. This is illustrated in the chart below where the S&P 500 represents stocks and the S&P GSCI represents commodities.

The S&P U.S. Issued High Yield Corporate Bond Index has just over USD1 trillion of par amount outstanding while its total return is down 3.11% for the month and down 4.51% YTD.  The energy and materials sectors have been the sore spot for the high yield market, given the anxiety over credit quality, as current low prices in oil and commodities, along with a Fed increase in rates, may be a cause for concern for future earnings and the cost of capital.  The return of the S&P U.S. Issued High Yield Corporate Bond Index ex energy and materials sectors would be less affected, returning -2.14% for the month and -0.05% YTD.

The growth of the high yield market since the 2008 financial crisis has been significant; the par amount outstanding of the S&P U.S. Issued High Yield Corporate Bond Index increased by 65% from Dec. 31, 2008, to Dec. 15,^, 2015.  As shown in Exhibit 1, the growth in issuance within the energy and materials sectors has been significant as well. At its highest in September 2014, the energy sector reached USD 207 billion and has since dropped to USD 122 billion.  Materials was as low as USD 33 billion in March 2009 before peaking at USD 102 billion in December 2014, and it was at USD 81 billion par outstanding as of Dec. 16, 2015.

Exhibit 1: Energy & Materials Sector Growth

Source: S&P Dow Jones Indices LLC., Data as of Dec. 15, 2015. Past performance is no guarantee of future results.  Chart is provided for illustrative purposes and contains hypothetical historical performance.

As the liquidity of recent markets have been tested by the impact of low energy prices a look at index design and results may be valuable.  Focusing on investment grade corporate  bonds we can see dramatic differences in depth of liquidity as a result of index design.

For investment grade corporate bonds two indices tracking these markets have very different liquidity profiles. Let’s compare the liquidity data of the bonds in the S&P 500 Investment Grade Corporate Bond Index to the broader S&P U.S. Issued Investment Grade Bond Index.  The S&P 500 Investment Grade Corporate Bond Index  provides a view of the performance of corporate bonds issued by the blue chip companies in the iconic S&P 500 Index,  other index inclusion criteria including par amount minimums are the same as the broader corporate bond index.

Results:

• More of the bonds in the index are trading each month: During the six month period of June through November 2015 bonds in the S&P 500 Investment Grade Corporate Bond Index had a higher percentage of trading each month: approximately 95% of the bonds in this index traded each month vs. 89% of the bonds in the S&P U.S. Issued Investment Grade Bond Index. Please refer to Table 1 below for the data.
• Fewer bonds but significant representation of the bonds trading: The S&P 500 Investment Grade Corporate Bond Index has fewer bonds than the broader index but the average trade volume of bonds in the index as measured by the number of trades, market value of trades and total market value of trades represent a high percentage of the trading volume of the broader index. Please refer to Table 2 below for the data.

Table 1: Trade Volume: Average Par Value Traded, % of Constituents Traded

Table 2: Trade Volume:  Market & Par Value Traded

The data illustrates that tracking the larger entities such as the blue chip companies in the S&P 500 Index results in significantly better liquidity characteristics for the underlying bonds than broader benchmarks.