Indexology^® Blog

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.

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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 .

Recently, the S&P BSE SENSEX closed above 30,000 (and 31,000 as of 26^th May 2017) for the first time, recording a lifetime high in its 31 years of live history.  Immediately, print and online media were flooded with news articles discussing various milestones of the S&P BSE SENSEX.

There were columns explaining how market participant wealth grew over the past 30 years, comparing different asset classes (equity, fixed income, gold, etc.), with the S&P BSE SENSEX being used as proxy for equities.  What amazed me is that almost all of them used the price return (PR) version of the S&P BSE SENSEX, completely missing out on the cash dividend component.  The version of the S&P BSE SENSEX that is tracked on television or in newspapers is the price return index, which is designed to measure only the capital appreciation (price change) of its constituents.  Like all S&P BSE indices, the S&P BSE SENSEX also has a total return version that measures not just returns from price change, but also returns earned due to cash dividends and their reinvestment, called the S&P BSE SENSEX Total Return (TR).  The cash dividends earned are assumed to be reinvested in the index as of dividend ex-date.

The TR version of S&P BSE SENSEX starts from 19^th Aug 1996. The first TR value is exactly same as PR value i.e. 3,281.49 as of 19^th Aug 1996. The S&P BSE SENSEX index close value of PR and TR versions as of 26^th May 2017 (first time when S&P BSE SENSEX closed above 31,000) is 31,028.21 and 43,778.32 respectively. This shows power of compounding of reinvestment of dividends.

Exhibit 1: S&P BSE SENSEX and S&P BSE SENSEX 50 Index Performance 

Source: Asia Index Pvt. Ltd.  Data from May 29, 2007, to May 26, 2017.  Index performance based on price and total return in INR.  Past performance is no guarantee of future results.  Charts are provided for illustrative purposes and reflect hypothetical historical performance.  The S&P BSE SENSEX and S&P BSE SENSEX 50 were launched on Jan 2, 1986, and Dec 6, 2016, respectively.

Source: Asia Index Pvt. Ltd.  Data from May 29, 2007, to May 26, 2017.  Index performance based on price and total return in INR.  Past performance is no guarantee of future results.  Table is provided for illustrative purposes and reflects hypothetical historical performance.  The S&P BSE SENSEX and S&P BSE SENSEX 50 were launched on Jan 2, 1986, and Dec 6, 2016, respectively.

Why Is It Important to Take Note of the TR Index?

Equity investments generally generate returns from two sources—capital appreciation (or price changes) and cash dividends.  In order to have a fair, apples-to-apples comparison, it is important to compare the portfolio returns with the TR version of the index.  For instance, if an investor with a single-stock portfolio compares the returns earned from the portfolio with the returns from the S&P BSE SENSEX (PR), it would be an unfair comparison.  Apart from capital appreciation, the portfolio returns include cash dividends earned.

Source: S&P Dow Jones Indices LLC.  Table is provided for illustrative purposes.

In Exhibit 3, we can see that if we compare stock A’s total return of 12% with the index’s price return of 10%, we would falsely assume that stock A outperformed the index; however, when the same is compared with the index’s total return of 13%, we realize that stock A underperformed.

As TR includes not just PR, but also cash dividends, the TR index will be always be higher than the PR index, because cash dividends can’t be negative.

To conclude, it is absolutely fine to track the PR index on a daily basis.  However, it may be a good idea to use the TR index when one has to measure or compare the returns or performance of asset(s) and scheme(s) with an index, as it is the TR version that would more closely represent what a market participant would take home.

To learn more about TR index calculation, check out Index Basics: Calculating an Index’s Total Return.