Indexology^® Blog

Similar to the Venn diagram in which the overlapping section of circles is the focus, the S&P U.S. High Quality Preferred Stock Index is designed to measure preferred securities that are constituents of both the fixed-rate and investment-grade preferred stock indices.

Exhibit 1: S&P U.S. Preferred Stock Indices Hierarchy

The weight of cumulative preferred stocks is set at 75%, while the weight of the non-cumulative category is set at 25%, subject to issuer limit.  Within each category, securities are equally weighted.  To reduce concentration risk, the maximum weight of each issuer is capped at 22.5% at each quarterly rebalancing.

As of June 17, 2016, the S&P U.S. High Quality Preferred Stock Index had returned 1.40% YTD, while the broader .  The high-quality index includes investment-grade constituents only, whereas 44% of the broader preferred index includes speculative-grade stocks and another 14% is not rated.  Similar to corporate bonds, preferred stocks are sensitive to changes in interest rates, however, also similar to equity, preferred stocks exhibit more volatility than most fixed income asset classes.

Along with portfolio diversification, preferred stocks can enhance overall yield.  Current yields, as of June 17, 2016, are almost three times higher than those of equities.

Exhibit 2: Multi-Asset Yield Comparison

According to Graham Day, the Senior Vice President at Elkhorn, “investment grade and cumulative preferreds have historically provided lower drawdowns compared with the broader preferred market.”[1]

Exhibit 3: Historic Drawdown Table

[1]   Bill Conboy, May 24, 2016, “Elkhorn Launches the First High Quality Preferred ETF (BATS: EPRF).”

The S&P Canada Aggregate Bond Index offers an investable way to participate in a broad index that is designed to measure the performance of the Canadian market.  The index is made up of the following fixed income product groups (see Exhibit 1).

Exhibit 1: S&P Canada Aggregate Bond Index and its Subindices

The S&P Canada Aggregate Bond Index has returned 1.11% for the month and 3.16% YTD as of June 13, 2016.  This benchmark index is a market-cap-weighted aggregation of the individual components, of which sovereign bonds (federal bonds) have returned 2.47%, provincial & Municipal bonds have returned 3.68%, investment-grade corporate bonds have returned 3.04%, and collateralized bonds have returned 1.25%, as of June 13, 2016.  The heavier-weighted sector of the overall index are provincials & municipals (47%) and sovereigns (29%).

Exhibit 2: Sector Weights

Source: S&P Dow Jones Indices LLC.  Data as of June 13, 2016.  Chart is provided for illustrative purposes.

Diving deeper into the makeup of the index, the 47% weight held by provincials & municipals consists of issuers such as the ones displayed in Exhibit 3.

Exhibit 3: Issuers Within the S&P Canada Provincial & Municipal Bond Index

The S&P Canada Investment Grade Corporate Bond Index contains 607 bonds and has a yield-to-worst of 2.2%.  It is an investment-grade index, with 40% of its bonds residing in the ‘BBB’ rated category from a conservative ratings approach that takes the lowest of Standard & Poor’s Ratings Services, Moody’s, and Fitch.  As a reflection of the Canadian market, the financials sector holds 63% weight in the index.

The collateralized sector of the market accounts for a small percentage of the index, less than 1%.  The S&P Canada Collateralized Bond Index contains 15 bonds with a market value of CAD 10 billion that meet the qualifications.

As of June 10, 2016, there is USD 10.6 trillion in negative yielding assets throughout the world—that’s more than 15% of global GDP. The increase in assets with sub-zero yields is evident when looking at the S&P Global Developed Sovereign Bond Index. On a market value basis, sovereign bonds with negative yields now account for 51% of the index (up from 27% at year-end 2015).

There are a number of global factors that contribute to negative bond yields, however it’s worth clarifying that there is a difference between negative yields and negative rates. Central banks set policy rates to control economic growth, and economies require low levels of inflation to grow.  Central banks attempt to ensure adequate inflation while protecting against high inflationary conditions and avoiding deflationary conditions.  As such, the Bank of Japan first cut its benchmark interest rate below zero to -0.1% in January 2016.  The rate cut was an attempt to counteract the effect of falling oil prices and to help achieve its target inflation goal of 2%.  In November, central banks in Europe imposed negative rates on commercial banks in an effort to encourage banks to lend and prompt businesses and savers to spend and invest.  Furthermore, Sweden’s policy rate is currently -0.5%, and Switzerland cut its rate to -0.75%.

Alternatively, many yields on sovereign debt have turned negative due to a concern over a lack of economic growth. Yields have turned negative in Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Sweden, and Switzerland.  Since the financial crisis, sub-zero yields have occurred sporadically, however they have typically appeared during times of market stress and predominantly in short-dated, highly liquid assets.  It seems that this is no longer the case, as negative yields have now spread to intermediate maturities throughout European and Japanese sovereign bonds.  The current yield on a 20-year Swiss government bond is -0.08%.

The negative yield environment is reflective of a principal preservation mentality, in which market participants are more concerned with “return of capital” than “return on capital.” However, it’s worth noting that current yields assume that bonds will be held to maturity; some market participants may believe they will be able to sell the bonds for more than they paid (i.e., yields will fall even more).

The municipal bond market is a huge and diverse segment of the bond markets.  Part of the ‘lore’ of the muni bond market has been that the summer months of the year create a natural increase in demand for municipal bonds.  It turns out there is a basis behind this ‘lore’.

Using the broadest municipal bond index at S&P (and I believe in the muni market place), the S&P Municipal Bond Index and examining the concentration of debt maturing in each month gives us a  visual of a ‘lunar’ like affect on the municipal bond market.

Some statistics describing the characteristics of the S&P Municipal Bond Index (as of June 10, 2016):

• Tracks over 91,000 bond issues
• Represents over $1.72 trillion in market value and $1.62 in par value
• Average coupon is 4.52% (par weighted)
• Average monthly interest implied is $6.2 billion (based on par value * coupon/12)  but that is simply an average that does not take into account the ‘lunar’ cycle for municipals.

The ‘Lunar’ municipal cycle:  By par value,  41.7% of the par value of debt matures in the months of June, July and August.  Meaning their semi-annual coupons are paid in December, January, February, June, July and August. This creates a wave of coupon cash flow coupled with a concentration of  bonds maturing in June, July and August that helps foster reinvestment demand for municipal bonds in the summer months.

Table 1: Monthly maturity distribution of bonds in the S&P Municipal Bond Index:

A key to understanding the impact of such a cycle is determining how much of that coupon and maturing bond cash flow is reinvested in the municipal bond market and how much is used to generate an income stream for it’s bondholders.

Another perspective is how much debt is retiring or maturing each year in the next few years.  Other bond markets, like the high yield corporate and senior loan markets often have high concentrations of debt maturing in specific years in the near future – often referred to as a ‘maturity cliff’.

Table 2: Maturity distribution by par value of the S&P Municipal Bond Index:

The recent oil price rally has pushed the energy sector upward in both the equity and bond markets. In the second quarter so far, the S&P 500 Energy Index (equity) has returned over 9.1% in total return and the S&P 500 Energy Corporate Bond Index has returned over 7.3%.  Meanwhile, the broader indices have seen more modest returns: the S&P 500 Bond Index (the debt of the S&P 500 companies) has returned 2.61% and the S&P 500 (TR) has returned 2.21%.

Table 1: Select indices and their quarter-to-date returns:

Yields of bonds in the S&P 500 Energy Corporate Bond Index have tumbled as bond prices have rallied.  At the end of March the average yield of bonds in the index was a 5.17%  and ended June 10th at a 3.95% –  a 122 basis point drop.  The average yields of bonds in the S&P 500 Bond Index have also fallen but only by 25 basis points during this time frame, helped in part by the inclusion of the energy bond sector.

Chart 1: Select indices and their yields (Yield to Worst):