Indexology^® Blog

A trend that has been catching attention is purchases of U.S. municipal bonds by foreign investors.  A terrific summary was recently published by VanEck’s Michael Cohick and that can be found by clicking here.

As that research points out, the Federal Reserve data on foreign investor holdings has jumped to end 2016 at $106 billion.  That data can be found on page 125 of the Federal Reserve Statistical Release March 9th 2017.

Some factors that could be making U.S. municipal bonds attractive to foreign investors include:

• A strong U.S. dollar or perspectives of a strong for longer U.S. dollar.
• U.S. municipal bonds, whether tax-free or taxable, offer incremental yield relative to the negative or near zero yield environments seen in the Eurozone and Japan.
• The relatively high quality of investment grade municipal bonds to other asset classes such as U.S. corporate bonds and in some cases sovereign bonds.
• The low historical default rate of investment grade municipal bonds.
• Shorter duration than U.S. investment grade corporate bonds.  For example, investment grade municipal bonds tracked in the S&P National AMT-Free Municipal Bond Index have more than a two year shorter duration than those tracked in the S&P 500/MarketAxess Investment Grade Corporate Bond Index. Note: both indices designed to reflect more liquid segments of the markets.
• Relatively lower volatility of U.S. municipal bonds as compared to U.S. corporate bonds.
• Due to these factors, U.S. municipal bonds can also be a diversifying asset class.

Liquidity: Due to the large number of U.S. municipal bond issuers and the sheer number of municipal bonds outstanding the depth of liquidity for U.S. municipal bonds has been a factor impacting the market for decades. The lower depth of liquidity for U.S. municipal bonds helps keep yields higher as a liquidity “premium” is demanded by the market in return for this risk. The advent and growth of diversified municipal bond Exchange Traded Funds (ETF’s) could be helping to provide access to and liquidity for municipal bonds. The Federal Reserve Statistical Release shows assets in municipal bond ETF’s have grown from $15.1 billion at year end 2014 to $24.7 billion at year end 2016.

Table:  Select bond indices, their yields and year-to-date returns:

Which of the figures below belong together?

It’s obvious, even if analogies aren’t your strong suit, that A is like C and B is like D.  A and C are not like B and D.

The economic relevance of this simple visual exercise is this: At its March 2017 meeting, the Federal Open Market Committee voted to raise the federal funds rate, the second increase since 2008’s financial crisis. The Fed’s dot plots forecast more increases this year, and of course rising short term rates place pressure on the longer end of the yield curve as well.

Rising interest rates and their impact on equity markets have been a going concern for several years. Intuitively, many investors think that rising interest rates should be bad for the stock market. But recent history has shown that that’s not necessarily the case. From 1991 through 2016, there have been 129 months when the 10-Year Treasury Yield rose. Of these, the S&P 500 gained in 94 of the months and declined in 35—i.e. in a rising rate environment, the market was twice as likely to do well as badly. The common belief that there is an inverse relationship between interest rates and equity market performance is no longer a sure thing.  By extension, the question of rising rates’ impact on factor indices also arises.

This brings us back to our problem in analogies; here’s the same graph we looked at earlier, properly labeled:

For certain strategies that are explicitly risk attenuators or risk amplifiers, the direction of the equity market has much more impact on their relative performance than does the direction of the bond market. For example, the S&P 500 Low Volatility Index tends to outperform in bad markets while lagging in good markets; the S&P 500 High Beta Index (a risk amplifier) exhibits the opposite pattern of returns. As the chart above shows, the average return spreads of Low Volatility were positive in the months when the S&P 500 was down and negative in the months when the S&P 500 was up—and vice versa for High Beta. This dependency on the broader equity market is consistent regardless of the direction of the bond market.

Buy-write strategies, also known as covered calls, are a staple offering for income-seeking market participants who sell, or “write,” call options against shares of assets they already own in order to generate income from the option premium.  However, the option seller forfeits the upside potential of the asset and is obligated to sell the asset to the buyer of the option if it is exercised.

Since 2002, CBOE has launched a suite of buy-write indices that covers all major U.S. equity benchmarks.  Exhibit 1 shows the buy-write indices based on the S&P 500.

The BXM is considered the benchmark index for buy-write strategies.  It writes standard monthly at-the-money (ATM) call options based on the S&P 500 and holds the options to maturity before they are cash settled.  All dividend and option premiums are fully reinvested in the index.

According to the roll data published by CBOE, between March 17, 2006, and Dec. 16, 2016, the short call position went in-the-money (ITM) and was exercised in 85 out of 130 months (65.38%).  This implies that any gain from the S&P 500 was offset by the short call cash settlement in almost two out of three months, and that in the other months, the S&P 500 decreased or was unchanged.  Based on this data, the growth in the BXM mainly came from the reinvestment of the stock dividend and the call option premium.

Taking the monthly roll data published by CBOE, we tested several distribution plans based on the BXM (see Exhibit 2).  Assuming we invested USD 100 in the BXM on March 17, 2006, on Dec. 16, 2016, we would end up with USD 165.57 if all dividends and premiums were reinvested, but only USD 11.47 if all dividends and premiums were immediately distributed every month.  With an annual distribution of 4.5%, we would end up with USD 102.13, almost at par with the initial portfolio value.  Although the option premium seemed high at 1.84% per month, distributing 1% monthly (or 12% annually) would have reduced the portfolio value by one-half in these 130 months.

The BXY is another popular buy-write index, which writes 2% out-of-the-money (OTM) call options based on the S&P 500 every month.  It allows the equity to grow up to 2% between monthly rolls but takes in a lower call premium as a tradeoff.

To illustrate the impact of the moneyness of options on distribution of cash flows, we ran a similar test on the BXY (see Exhibit 3).  For the same time period, USD 100 invested in the BXY grew into USD 197.86 and USD 44.86 if all dividends and premiums were distributed immediately.  The portfolio ended up almost at par (USD 103.93) if the index distributed 6% annually.

Exhibits 4 and 5 show that the option premiums collected from BXM were much higher than from BXY.

These tests illustrate the trade-off of a typical buy-write strategy: ATM option premiums are usually larger than the OTM option premiums, but selling ATM options forgoes all the upside of the stock market.  The equity position has no upside but the potential cost of options being exercised.  For income-seeking market participants, picking a proper buy-write portfolio to meet a specific distribution goal has to take both the equity growth and the call premium into consideration.

November 9, 2016, was the day when the world witnessed two big unexpected events—one was Mr. Donald Trump winning the U.S. presidential election, and the second was the Indian Prime Minister Mr. Narendra Modi announcing that 500 and 1,000 rupee notes would no longer be considered legal tenders.  Both of these events were expected to affect India in a big way.

On November 8, 2016, Mr. Narendra Modi came on national television and announced that at the stroke of midnight, 500 and 1,000 rupee notes would no longer be legal tenders.  These notes constituted 86% of the total currency in circulation.  This announcement was by far the boldest economic decision taken in recent years.  The rationale for this unexpected decision was to remove counterfeit currency notes from the system, end the parallel black market economy, and digitize the Indian economy.

The old notes were proposed to be replaced with new 500 and 2,000 rupee notes.  The deadline to deposit or change old notes was December 30, 2016 (50 days after the announcement).  There were restrictions imposed on withdrawal, as it would take some time to release the new currency notes into the system.  Millions of people rushed to banks and ATMs to deposit old notes and collect new ones, which were unfortunately in shortage.  The unregulated cash economy had suddenly come to a standstill.

Demonetization was the topic of discussion across the length and breadth of India.  While many supported this bold move, there were others who criticized it.  Many people felt that it was a landmark decision that would have enormous benefits in the long run, while some argued that it was a decision that only caused inconvenience to the people, especially the poor.

We will analyze the effect of demonetization on the four leading S&P BSE Indices, the S&P BSE SENSEX, S&P BSE LargeCap, S&P BSE MidCap, and S&P BSE SmallCap.

Source: S&P Dow Jones Indices LLC.  Data from November 8, 2016 to March 14, 2017.  Table is provided for illustrative purposes.  Past performance is no guarantee of future results.

In Exhibit 1, we can see that all four indices have given a positive return.  The returns of the S&P BSE SENSEX and S&P BSE LargeCap were higher than those of the S&P BSE MidCap and S&P BSE SmallCap post demonetization.

Exhibit 2: Index Total Returns

Source: S&P Dow Jones Indices LLC.  Data from November 8, 2016 to March 14, 2017.  Chart is provided for illustrative purposes.  Past performance is no guarantee of future results.

From Exhibit 2, we can see that after the demonetization announcement, all four indices fell for about two weeks due to uncertainty in the economy.  This was followed by a stable period of two weeks, during which markets even recovered.  Nearing the cut-off date for depositing old notes (December 30, 2016), the markets again fell as there was uncertainty about the future due to the shortage of new currency in circulation.  The S&P BSE MidCap and S&P BSE SmallCap fell more compared with the S&P BSE SENSEX and S&P BSE LargeCap, as the demonetization had a greater effect on smaller companies. Since January 1, 2017, the markets have been bullish and have continued the upward trend.

Considering the upward movement in all four indices post demonetization, as well as the recent state election results (especially that of Uttar Pradesh, where the Narendra Modi Government obtained majority), we can conclude that the demonetization decision has been backed by most people and it has generally had a positive impact on capital markets in India.

Chinese authorities will allow market participants to buy onshore bonds through transactions carried out in Hong Kong, which will further broaden foreign access to China’s onshore bond market. While no additional details have been provided, a “bond connect” scheme that provides cross-border cash bond trading is anticipated by market participants.

Despite currency volatilities, China bonds offer better yields and diversification benefits. However, foreign investors are concerned with the potential credit risk.  Besides the non-parallel rating systems between local and the international standards, the implicit government guarantees prevented bond defaults, which had made it difficult to analyze the true underlying credit risk.

However, following the first bond default in 2014, the number of bond defaults has been accelerating, including those of state-owned enterprises. According to WIND data, over 60 bonds defaulted in 2016, with the affected sectors including land development, mining, steel-iron, and oil & gas.  The biggest default in 2016 was from China City Construction, a Chinese construction and development firm, with a collective defaulted amount of CNY 8.55 billion.  In the first two months of 2017, bond defaults amounted to CNY 4.1 billion from Dongbei Special Steel, Dalian Machine Tool, and Inner Mongolia Berun.

From 2014 to February 2017, China recorded a total of CNY 58 billion of bond defaults, which is equivalent to 0.11% of the current overall market value, as tracked by the S&P China Bond Index. The top two industries that had the highest default amounts were mining/diversified and landing development/real estate, reflecting the sharp slowdown in Chinese manufacturing and construction.

The defaults are perceived to be healthy for the long-term development of China’s onshore bond market. In the search for higher-quality corporate bonds, we adopted a two-tier screening approach in our index design and launched the S&P China High Quality Corporate Bond 3-7 Year Index. As per the index methodology, issuers must first be investment-grade rated by at least one of the international rating agencies, and then securities must be rated ‘AAA’ by at least one of the local Chinese rating agencies.

Exhibit 1: China Corporate Bond Defaults by Company Industry (Total Par Amount)