Indexology^® Blog

According to the S&P China Corporate Bond Index, the market value of Chinese corporate bonds was approximately CNY 26.4 trillion and represented 36% of the overall China bond market as of May 5, 2016.  It is a robust expansion compared with the mere 6.7% exposure in 2007 (see Exhibit 1).

The yield-to-maturity of the S&P China Corporate Bond Index came down 170 bps to 3.66% in 2015. This spread tightening in 2015 was largely due to improved liquidity, particularly with the correction in A-shares in the first half of 2015.

However, this trend is reversing as fundamentals start to weigh in.  Defaults and concern about the deteriorating credit quality of Chinese corporates captured plenty of global headline news.  Investors raised concern about state-owned-enterprises, particularly those in the industries affected by overcapacity, as government support can no longer be assumed. The yield-to-maturity of the S&P China Corporate Bond Index widened 18bps to 3.84% year-to-date, while its total return climbed 0.49% in the same period.

Across sector-level indices, industrials took the biggest hit with recent defaults in the steel, mining, and cement sectors.  The option-adjusted spread of the S&P China Industrials Bond Index was the highest; it widened 50 bps to 155 bps over the three-month period ending May, 2016 (see Exhibit 2).

Exhibit 1: Market Value of the S&P China Corporate Bond Index and the S&P China Government Bond Index

Exhibit 2: Option Adjusted Spread of the S&P China Corporate Bond Index and its Subindices

Yields of Canadian corporate investment-grade and high-yield bonds have been trending lower (up in price) since the beginning of March 2016.  Year-to-date, the S&P Canada Investment Grade Corporate Bond Index returned 1.59% while the S&P Canada High Yield Corporate Bond Index returned 4.54% as of April 30, 2016.

The beginning of April saw yield increase by 9 bps for investment grades and 58 bps for high yield from April 7-19, 2016, as measured by the S&P Canada Investment Grade Corporate Bond Index and the S&P Canada High Yield Corporate Bond Index.  In spite of the one-week increase in yields, the indices rallied after April 19, 2016, going into the end of the month.  Investment-grade bonds moved tighter by only 4 bps, but high yield stepped it up by tightening 32 bps.  In the end, the April index returns were 0.55% for investment grade and 2.16% for high yield.

The performance by industry sectors shows that all sectors had positive returns for the month.  Energy, which is a significant weight in both investment grade (7.7%) and high yield (25.7%), has recently been a notable contributor after past months of negative headlines.  Up until April 25, 2016, investment-grade financials had returned -0.06% for the month, but performance during the last week of the month pushed the large sector (63.8%) up for a return of 0.14% in April.  High-yield consumer discretionary, which accounts for 48.6% of the index, and returned 0.80% for April; this sector contains issuers such as Golf Town Canada, Mattamy Group, Quebecor Media, Brookfield, and AutoCanada, Inc.

The Dow Jones Commodity Index and S&P GSCI total return indices gained 9.1% and 10.1%, respectively, in April. For the S&P GSCI, it was the best month in a year, and the second best April ever in history since 1970, only after last year’s April, when it gained 11.1%. Further, the S&P GSCI is up 15.5% since Feb 29, 2016, making this the first consecutive positive two months in two years, since Mar-Apr 2014, but marks the biggest consecutive two months in almost seven years since May-Jun 2009 when it gained 20.4%.

There has never been an April with this many positive commodities, posting 20 of 24 winners (coffee, Kansas wheat, live cattle and feeder cattle lost.) Only six months in history have had more positive commodities and April 2016 had the most winners since Feb. 2014, when 22 commodities were positive.

It is not surprising to see the S&P GSCI deliver strong returns in April given that historically on average it is the best month. However, it is concerning that only four commodities (copper, gold, cotton and lean hogs – and the lowest count since November’s Nightmare) are in backwardation, a condition that generally reflects a shortage.  There have been 24 months with better returns than in Apr. 2016, but the backwardation count this low concurrently with the high returns hasn’t happened since 1974, when there were only six commodities in the index. What it means is the supply/demand fundamentals may not be in place to support this commodity rally and that it may be driven more by the falling dollar.

Preferred stock is a hybrid security that has characteristics of both stocks and bonds.  In the capital structure, preferred shares are subordinate to bank loans and senior corporate bonds, but they are senior to common stock.  If a company had to file for bankruptcy and the assets of the company were liquidated, preferred shareholders would get paid after bond holders and before common stock holders.  This leads to higher recovery rates than common stock, while at the same time offering much lower default rates compared to high-yield bonds.

In low interest rate environments with narrow credit spreads, preferred stocks behave similarly to bonds.  In periods of high volatility, they behave more closely to stocks.  Exhibit 1 shows the performance of the S&P U.S. Preferred Stock Index compared to both the S&P US Issued BBB Investment Grade Corporate Bond Index and the S&P US Issued BB High Yield Corporate Bond Index.

Unlike common stock, most preferred dividends are cumulative, meaning dividend payments accrue even if not paid when scheduled.  If a firm suspends paying dividends, it must pay preferred shareholders in full before paying any dividends to common shareholders.

The energy sector has had a significant effect on preferred stocks.  The impact of depressed oil prices is easily visible by comparing the performance of the S&P International Preferred Stock Index to that of the S&P U.S. Preferred Stock Index.  Exhibit 2 shows the dramatic effect that exposure to the energy sector has had on preferred stocks.  The S&P International Preferred Stock Index has over 20% exposure to companies in the energy sector; meanwhile, the S&P U.S. Preferred Stock Index has no exposure.  As a result, the U.S. index has significantly outperformed its international counterpart.  Since August 2014, the S&P U.S. Preferred Stock Index was up 10.0%, while the S&P International Preferred Stock Index was down -27.5% as of March 2016.

Now, there has been a long bull market where stocks have outperformed commodities for eight consecutive years, ending in 2015. It’s a record. If markets behaved just as they have in the past, then some investors might say it’s time to switch asset classes. However, the high correlation between risky assets experienced recently like during the recession of 2001-2003 and the global financial crisis in 2007-2009 has caused many investors to reconsider allocating by traditional asset classes defined by security type like stocks, bonds and real estate or commodities.

Instead, many investors are moving towards new techniques that define asset classes by their similarities in risk type.  For example, a risk-based allocation may use risk-buckets defined by growth, income, inflation and liquidity.  In the analysis of which assets protect against various risks, commodities, and in particular oil, float to the top of the inflation protection list.

Following the last time equities outperformed commodities for nearly as long from 1980-86, seven consecutive years, U.S. CPI year-over-year rose from 1.1% in Dec 1986 to 6.3% in Nov 1990, and commodities, as measured by the S&P GSCI Total Return index, returned almost 300% through that period.

The inflation sensitivity is high for commodities with an inflation beta near 15 for world production weighted indices (near 70% in energy) and closer to 10 for equally weighted indices with about 1/3 weighted in energy. This makes sense given it is the same food and energy in the indices that is in the CPI and that energy is the most volatile component so the more energy, the higher the inflation protection. Notice the big jump after 1987 – that came from adding energy into the index.

The need for inflation protection and diversification has created high demand for investment in oil. Especially since many emerging markets or newer ones to commodities feel more comfortable with a single commodity rather than the basket. For example, last August, the first ETF (exchange traded fund) on oil was launched in all of greater China out of Taiwan and now has over $300 million.

This is important since now their investors can benefit from the inflation protection and diversification provided by oil. The correlation to oil of many stock markets is only moderate at best.

Now is an exciting time for investors to gain this diversification and inflation protection in Hong Kong too.  On April 29, 2016, the very first ETF (exchange traded fund) on commodity futures will be listed in Hong Kong. Using monthly year-over-year data since 1987, the S&P GSCI Crude Oil has an inflation beta of 13.8 while the S&P 500 and Hang Seng Index only have inflation betas of 1.5 and 5.8, respectively. Also, the excess return of oil over the Hong Kong CPI is 7.2%, which is about the same as the excess return of their stock market but almost double the excess return from the S&P 500.

The oil can also offer some downside protection. For example, since 1987, on average when the HSI was negative in a month, it fell 5.6% but during those months, crude oil was basically flat, only dropping 0.2% and that’s not much worse than gold, the one considered the safe haven. Also, oil protects in many famous stock market drops like the Persian Gulf War and Black Monday.

Not only does this mark a new era of investment alternatives from traditional assets like stocks and bonds for investors to use in order to protect against portfolio risks but as investors allocate to commodities in local Asian markets, the futures growth may help standardize the quality of energy and food to make prices less volatile and their environment cleaner.