Indexology^® Blog

As with the weather for the northern hemisphere, the U.S. high-yield market seems to be making a comeback.  The 0.54% return in February for the S&P U.S. Issued High Yield Corporate Bond Index appears to be the green shoot of return for high-yield bonds.  March 2016 followed the prior month’s gain with a blossom of its own.  The index returned 4.5% for the month, which was the largest monthly return since October 2011’s return of 5.07%.  Year-to-date, the index returned 3.36%, which is refreshing to high-yield investors, who, before this month, had not seen a positive year-to-date return since November 2015.

The S&P 500 High Yield Corporate Bond Index performance behaved similarly returning 3.43% for March, which was the index’s largest return since a 3.86% return in October, 2011.

High yield option-adjusted spreads (OAS) for the year have double peaked, reaching highs of 907 and 883 bps on Jan. 20, 2016, and Feb. 11, 2016, respectively.  Since then, the OAS spread has tightened by 180 bps, giving bankers a window of opportunity to work with issuers in providing more debt to the market before any possible additional rate increase by Fed.  According to IFRMarkets, 57% of Q1 2016 high-yield issuance was sold in March, and at USD 6.3 billion, with the last week of March being the busiest for 2016.  Next week, an additional USD 3-5 billion more is expected.  Notable new issues for the week were included the following.

• T Mobile USA, Inc., with USD 1 billion of an eight-year maturity and a coupon of 6%.
• Western Digital Corp., with USD3.35 billion of an eight-year maturity and a coupon of 10.5%.
• HD Supply Inc., with USD 1 billion of an eight-year maturity and a coupon of 5.75%.
• BPCE S.A., with USD 750 million of a six-year maturity and a coupon of 8.25%.Exhibit 2: OAS History for the S&P U.S. Issued High Yield Corporate Bond Index
  

  

   

In part 2 of this blog series, we will look at the effect the 25%+ increase in new membership related to the Affordable Health Care Act (ACA) has had on costs.  From the time of the initial drafting of the ACA rules, there was concern that the new enrollees in the individual insurance market would increase overall costs.  Since many of these enrollees were expected to have pre-existing health conditions, overall costs could go up as utilization increases.  However, the key question that needs to be studied is whether the average cost per person has increased, and if so by how much?

Looking at Exhibit 1, we can clearly see that the average cost on a Per Member Per Month (PMPM) basis has increased significantly.  When the ACA was under development in 2009-2010, the average PMPM cost was just above USD 160 per person for an individual policy.  However at the same time, the average member covered by an employer-based plan, either large group or self insured, cost just above USD 260, or USD 100 more a month.  Since the introduction of the ACA, and in particular since 2013, we have seen a drastic increase in the PMPM costs for an individual to over USD 360 a month, while employer-based plans are still just below USD 360 a month.

Why the difference?  The key component in the legislation is the requirement that plans are no longer allowed to decline coverage for pre-existing conditions nor charge more for patients with pre-existing conditions.  This means that the once healthy population of members in the individual pool will now have to help cover the costs for more enrollees that are not as healthy.  However, employer coverage pools have always had a predictable sampling of unhealthy individuals.  Further, employer group medical insurance has not discriminated between the healthy and non-healthy, since they provide coverage to everybody.  Now that individual medical policies are required to provide coverage regardless of a person’s health status, it would be expected that PMPM costs should rise to a similar level as the employer coverage, as shown in Exhibit 1.  The key question is, are the ACA rules strong enough to entice the majority of the healthy population to maintain or add coverage in the individual market?  If not, then will average costs continue to rise above, and could individual policies face a “death spiral” rendering them unaffordable?  Keep watching this space as we continue to monitor healthcare costs moving forward.

In the first half of March, the S&P GSCI Total Return had added 9.6% and staged its biggest comeback ever, gaining 18.8% from its bottom on Jan. 20, 2016. Unfortunately, the index gave up 4.3% since March 17, 2016, losing about half its March gain. Despite the loss, the index posted its first positive monthly gain of 4.9% (data ending Mar. 30, 2016) since Oct. 2015. March’s commodity return is historically big and is the biggest March since March 2006, when the index gained 5.1%.

All 14 commodities in the Agriculture (8) and Energy (6) sectors in the S&P GSCI TR gained in March. This has not happened since July 2012. In fact, all commodities inside the agriculture sector have never been positive together in any historical March.

March 2016 has also been a historically big month for the energy sector and some of the constituents inside it, in addition to coffee and sugar. For example, coffee gained 10.4% in March, it was the best March since March 2002 and the second best March since 1981, and the best month since July 2014.

The central bank of England has said that the European Union referendum in June 2016 is the most significant near-term domestic risk to the country’s financial stability.  Because of its separate currency, Britain is one of the countries that could disassociate itself most easily from the EU.  It is a long time until June, and the question lingers: is this another Scotland situation with a heavy amount of press, but in which case, like Scotland, the U.K. will stay just where it is?

The “Brexit,” as it is being called, could have varying consequences, depending on the terms of a departure agreement.  Such terms would be negotiated after the vote.  To try and predict the outcome is sheer madness, as they say.  The decision will rely upon prevailing economics, future outlook, crowd sentimentality, and many other factors.

What can be observed from S&P Dow Jones Indices is the following.

• K. corporate bonds reached their widest spread for the year on Feb. 17, 2016, as the S&P U.K. Investment Grade Corporate Bond Index reached an option-adjusted spread of 218 bps (see Exhibit 1).
• K. corporate bonds had been tightening in spread ahead of the March 10, 2016, European rate cut.
• Since the EU rate cut, all U.K. corporate spreads have been tighter, with the S&P U.K. A Investment Grade Corporate Bond Index performing the best, at 32 bps lower.
• The S&P U.K. Investment Grade Corporate Bond Index has returned 50 bps more in total return than the S&P Eurozone Investment Grade Corporate Bond Index (2.6% versus 2.1%, respectively).
• AAA U.K. investment-grade corporate bonds have returned 5.31% YTD. However, as discussions continue on the possible outcome of the “Brexit,” investors have moved back into risk, and the BBB corporates have returned 2.63% for the month, as of March 28, 2016 (see Exhibit 2).

Exhibit 1: Option-Adjusted Spread History–U.K. Investment-Grade Corporate Bond Indices

As assets tracking factor indices grow, so does the attention paid to evaluating and promoting these so-called “smart beta” funds.  Even the nomenclature attracts attention.  Professor William Sharpe, famous among other things for introducing the concept of beta to academic finance, has said that the term “smart beta” makes him “definitionally sick,” and lesser lights than he have also voiced reservations about the terminology.  Recently one of the financial community’s best journalists opined that smart beta may be less smart than many of its practitioners allow.

How should an investor evaluate a “smart beta” strategy?  One fair way is to evaluate it against the claims its advocates make, which requires that those claims be made explicit.  A factor index provides exposure to stocks with certain common characteristics.  Are those characteristics desirable in themselves, or desirable only because they are a means to a different end?  What, in other words, is the telos of a smart beta index?  This question puts a certain burden on both manager and investor, as clarity, already a moral virtue, becomes a practical necessity.

For example: suppose an investor is sold a value-driven “smart beta” ETF.  Its managers say (truthfully) that it will hold only stocks with above-average yields and below-average PE ratios.  The investor buys the fund and, several years later, finds that his “smart” ETF has underperformed the dumb old cap-weighted index from which its constituents were drawn.  But the ETF’s stocks were cheap when they were bought and they remain cheap.  Ought the investor to be aggrieved?  And if so, with whom — with himself, or with his ETF manager?

Of course, in our simple example, the investor may not have been fully clear, not even with himself, about his underlying assumptions.  He may have told himself that he bought the ETF in question because he wanted to own undervalued stocks, and this may even be true, as far as it goes.  But it may not go far enough.  Perhaps the fuller truth is that he wanted to own undervalued stocks as a means of outperforming a cap-weighted benchmark.  And smart beta’s failure to outperform, in this case, is as irksome as would be the underperformance of an active manager (although perhaps less painful in view of smart beta’s presumably-lower fees).

The investor, in other words, needs to understand his own motivation.  Does he want factor exposure in itself, or because it is a means to a different end?  An investor who undertakes factor exposure as a means of outperforming should be aware that, just as no active manager outperforms all the time, neither does any factor index.  The investor should strive to understand the conditions that will make for a factor’s success.  Equally, he should strive to understand his own goals and motivations.