Indexology^® Blog

In anticipation of the Federal Reserve’s policy meeting starting Wednesday that may raise the federal funds target rate, here’s what you need to know about how the decision impacts commodities.

Historically rising interest rates are positive for commodities for two main reasons.  One is the return on collateral increases, pushing up the total return. The other reason is that producers may be disincentivized to produce and store as carrying costs increase.  This is fundamentally based on the futures relationship to the spot market.  In order for the market clear, the convenience yield must equal the opportunity cost, which is expressed in the formal relationship between buying the futures price today for delivery at time T and buying the commodity at the spot price today and storing it until time T.  The futures prices can be expressed in terms of the spot price, interest rate, cost of storage and convenience yield, through the central equation of the “theory of storage”.

This is not just theoretical but is supported by the data.  On average in rising rate periods, the S&P GSCI Total Return index has gained 43.5% more than the spot index that has gained on average 31.3%, showing that rising rates can drive carrying costs higher, making it less beneficial to hold inventory.

The impact benefits some commodities more than others, and the ones that gain most tend to be the more economically sensitive energy and industrial metals.  For example, rising rates help oil more than gold.  In rising rate periods, (WTI) Crude oil gains on average 49.0% and Brent crude gains nearly double that up 90.0%. What’s even more interesting is that the term structures become backwardated, again as producers are disincentivized to produce and store amid higher interest rates since it is more expensive. The impact can be observed in the added return from the positive roll yield.  Brent on average adds an additional 22.9% and (WTI) Crude oil gains an additional 16.8%.  If rates rise, it can possibly be the catalyst to get U.S. inventories down, which is the key factor in the oil rebound.

Gold on the other hand only gains on average 27.7% in rising rate periods but remains in contango, losing 2.8% since it is so supplied, relatively cheap and easy to store.

Another indicator the market is watching is the monthly consumer price index (CPI,) scheduled to be published early Wednesday by the Bureau of Labor Statistics.  Oil is the most sensitive commodity to inflation since energy is the most volatile component of CPI.  Historically going back to 1971, the inflation beta of the S&P GSCI is 3.4 which means for a 1% increase in inflation, it results in a 3.4% increase in return of the S&P GSCI during the period from 1971–2017.  However, when the time period is shortened to start in 1987, the inflation beta jumps substantially to 13.8.  This is since 1987 is the year oil was added into the index.  The impact is also observed by comparing the inflation beta between the S&P GSCI and Dow Jones Commodity Index (DJCI.) The inflation beta since 2000, which is when data for DJCI is available, the inflation beta of DJCI is 12.3 versus 16.5 for S&P GSCI.  This is since energy is only 1/3 of the equally weighted DJCI versus about 65% in energy in the world production weighted S&P GSCI.

Not only is energy attractive from it’s inflation protection but many traders love it for its volatility.  However some market participants prefer the lower volatility of gold and the safety it may provide in this environment of a weak financial sector, uncertain economic growth and political unrest.  A mistake though is to assume gold will provide inflation protection because it doesn’t do a great job in that role.  Since the launch of the S&P GSCI index in 1991, the excess return of copper over inflation is 5.1% versus gold of 3.5%, and the inflation beta or sensitivity to inflation is far higher for copper at 9.2 versus just 3.5 for gold.  An investor can get almost triple the inflation protection from copper than gold.  Oil still is far better with an inflation beta of 16.5 and excess return over inflation of 5.6%.

Last, if the fed decides not to raise rates, the dollar may fall significantly.  In that case, every commodity may benefit, but again, the falling dollar doesn’t impact every commodity equally and the more economically sensitive copper and oil fare better than gold.  On average for every 1% the dollar falls, copper gains on average 5.3%, Brent crude gains 4.5%, (WTI) Crude oil gains 4.3% and gold just 3.5%. What is interesting though is that when the dollar rises, gold actually rises on average, gaining 33 basis points for every 1% the dollar rises.  A rising dollar also doesn’t hurt oil and copper as much as the falling dollar helps. For every 1% dollar rise, copper drops just 99 basis points and oil falls 1.8%.

Given the sensitivity difference, oil may better positioned than gold in the face of rising rates, the chance of a weaker dollar, and with concern about inflation.

So far, the municipal bond market has seen only a modest reaction to the recent negative credit watch being placed on the ratings of several bond insurers.

Month to date as of June 12, 2017, the S&P Municipal Bond Insured Index tracking over $148billion in par value of insured bonds has performed in sync with the overall market.  The insured bond index has an average yield that is higher than the broader S&P Municipal Bond Investment Grade Index which tracks over $1.5trillion in par value.  As an additional validation, the insured bond market performance as compared to larger more liquid bonds in the S&P National AMT-Free Municipal Index also seems to be at a parity, at least so far in June.

Year to date the higher yielding bonds in the S&P Municipal Bond Insured Index have contributed to outperformance verses the rest of the investment grade market place.

Table: Select municipal bond indices, their yields and returns:

For more information on S&P’s bond indices including methodologies and time series information please go to SPDJI.com.

Please also join me on LinkedIn

Leveraged loans (also called senior loans or bank loans) typically pay a two-part coupon—a market-driven base rate (30-90 day LIBOR) plus a contractual credit spread.  As shown in Exhibit 1, the weighted average credit spread of U.S. leveraged loans, as measured by the S&P/LSTA Leveraged Loan 100 Index, has fallen steadily and now sits at about one-half of where levels were just 16 months ago.

Against a backdrop of anticipated rising interest rates, demand for the senior secured floating-rate asset class has created an environment that has benefitted issuers of bank loans.  Given the high demand and relatively limited supply of new loan issuances, issuers have been able to renegotiate their credit terms (i.e., reduce the credit spread on the outstanding loan).  This has been done through two processes: refinancing and repricing.

As shown in Exhibits 2 and 3, volumes of both refinancing and repricing have skyrocketed in 2017.  Generally speaking, loan repricings involve issuers reaching out to market participants via an arranger to lower the interest rate on an existing facility, with no other changes to the loan agreement.  Refinancings, however, involve a new loan structure (i.e., new term, new agreements, etc.), which replaces the existing facility.  The existing loan that is refinanced is repaid at par, which could result in a further hit to yield if the loan was trading above par (as of May 31, 2017, approximately 60% of the S&P/LSTA Leveraged Loan 100 Index was bid at par or higher).

Exhibit 4 shows a sample of some of the larger facilities that have repriced in 2017.  As of May 31, 2017, over 300 facilities have repriced.  The repricing impact has ranged from 25 to 350 bps, with an average of 70 bps.

Despite the negative impact this activity has had on yields, there are several potential positives to take away from the current state of senior loans.  With the new, lower interest rates, most issuers have improved their fundamentals (i.e., stronger interest coverage ratios) and those issuers that have refinanced have extended their terms out with better financing rates.  Therefore, in addition to being secured and senior in the capital structure, many bank loans may now have improved credit profiles.

In addition, credit spreads are only one part of a bank loan’s coupon.  The second part, and perhaps the most appealing aspect, is the floating component, which is typically based on LIBOR.  As shown in Exhibit 5, three-month LIBOR currently sits at 1.22%, up 22 bps YTD as of May 31, 2017, and over 50 bps since June 2016.  Additionally, based on Fed Fund futures, the likelihood of a June 2017 rate hike currently stands at over 95%.

Finally, compared with high-yield corporate bonds, senior loans offer lower duration risk, given the floating-rate nature.  Rates on loans typically reset every 90 days, implying a duration of 0.25 versus a current effective duration of 4.18 on the S&P U.S High Yield Corporate Bond Index.  So, in addition to having lower default rates and higher recovery rates than high-yield corporate bonds, senior loans offer significantly higher yield-per-unit of duration.  Furthermore, as shown in Exhibit 6, option-adjusted spreads in ‘BB’/‘B’ corporate bonds have tightened to levels not seen since 2014.

To learn more about the senior loan market and hear why loans may be an effective asset class for income and diversification, please join us on Tuesday June 20, 2017, for our webinar: Will the FOMC Continue to Fuel Interest in Senior Loans?

Brazilian equity market experienced a significant pullback during the month of May due to political concerns.  The correction amounted to being the worst one-day drop since Dec. 30, 2009.  On May 18, 2017 alone, S&P Brazil BMI dropped 8.85%.  On the same day, the S&P/BOVESPA Low Volatility Index posted -5.72%, over 300 bps less than the underlying market-cap-weighted index.

The lower losses posted by low risk indices are not surprising.  It is well established that low volatility strategies deliver higher risk-adjusted returns than the broad-based, market-cap-weighted benchmark over a long-term investment horizon.  Low volatility strategies tend to go down less than the market, thereby offering downside protection while providing a degree of upside participation in an up market.  The efficacy of the strategy has been demonstrated not only in developed markets,[1] but also in Brazil.

Brazilian market participants concerned about equity market volatility can express their views through low volatility strategies.  The S&P/BOVESPA Low Volatility Index, launched on April 30, 2015, is designed to track the performance of the top quartile of securities in the Brazilian equity market that have the lowest volatility.

Exhibit 1 and Exhibit 2 highlight the performance of the S&P/BOVESPA Low Volatility Index compared to the underlying market during the month of May.  While the underlying broad market posted -3.74% (TR), the low volatility strategy experienced positive returns of 1.04%, delivering nearly 480 bps of excess returns.

The behavior of the S&P/BOVESPA Low Volatility Index compared with the underlying benchmark is not exclusive to just May 2017; we have similarly observed lower drawdowns than the market through time.  Exhibit 3 shows the three worst drawdowns during the index history, from Dec. 30, 2009 to May 31, 2017.  In all three cases, the low risk strategy posted lower losses than the market.

Because they experience lower drawdowns than the underlying market, low volatility strategies generally have less to make up for on the upside.  Therefore, over a long-term investment horizon, low volatility strategies tend to deliver higher returns than the benchmark.  We observe the same effect in Brazil, with the S&P/BOVESPA Low Volatility Index outperforming the benchmark (see Exhibit 4).

[1]   http://spindices.com/documents/research/research-is-the-low-volatility-anomaly-universal.pdf

The bond markets are certainly not “Lost in Space”¹. There is good rationale as to why the bond markets are in the position they are today; compressed spreads are the result of low rates coupled with strong demand out pacing supply for yield assets.   However, the homogenization of the US corporate bond markets is worrisome and should begin to raise some eyebrows in the junk bond markets.  What am I worried about? Credit spreads widening.

Chart 1: The S&P 500 BB High Yield Corporate Bond Index spread to the S&P 500 Investment Grade Corporate Bond Index:

Some rationale behind the angst:

• Elevated risk vs. potential reward
• Size of market. The S&P U.S. High Yield Corporate Bond Index has grown in market value from $715billion in December 2006 to over $1.5trillion in June 2017.
• More than half of that index, by market value, is comprised of consumer discretionary, energy, telecom and materials related issuers.
• Weakness in consumer discretionary. The drumbeat of bad news in the retail consumer discretionary markets: stores closing, companies closing, downsizing or reorganizing. The S&P U. S. High Yield Consumer Discretionary Bond Index tracks over $304billion in market value.
• Oil. The S&P U.S. High Yield Energy Corporate Bond Index tracks over $233billion in market value of bonds from the energy sector.
• Competition in telecommunications. The S&P U.S. High Yield Telecommunication Corporate Bond Index tracks over $132billion in market value.
• Materials. The S&P U.S. High Yield Materials Corporate Bond Index tracks over $142billion.

Chart 2: Select indices and their yields over time:

The past is not prologue and no one has ever seen this type of market before. Monitoring the spread risk in the high yield sectors seems prudent at this juncture.

¹Lost in Space was a 1960’s sci-fi television series of the Robinson family traveling through space. The protagonist son, Will, was protected by a robot who would warn him of pending danger by waiving its arms and saying “Danger, Will Robinson”.

For more information on S&P’s bond indices including methodologies and time series information please go to SPDJI.com.

Please also join me on LinkedIn .