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Defensiveness of the Credit Strength Strategy in U.S. Corporate Bonds

The Case for Positive Earnings Criteria in International Small-Cap Benchmarks

July 2019 Commodities Performance Highlights – A Nickel for Your Thoughts

Channeling Maverick and the Maestro: The Fed Cut Rates because “We Were Inverted”

Cboe S&P 500 Buffer Protect Indexes: First Outcome Period Recap

Defensiveness of the Credit Strength Strategy in U.S. Corporate Bonds

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Hong Xie

Senior Director, Global Research & Design

S&P Dow Jones Indices

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Our fundamental credit strength strategy uses credit ratios to screen out issuers with risky credit profiles and construct corporate bond portfolios with strong credit quality (for a detailed methodology, please see our previous blog). Our research shows that a credit strength strategy can potentially reduce return volatility and improve drawdowns. Our goal in this blog is to further highlight that a credit strength strategy can offer downside protection and sector diversification.

Exhibit 1 illustrates the defensiveness of the credit strength strategy. Both investment-grade and high-yield credit strength portfolios tend to outperform (underperform) the broad market when the credit market falls (rises). This observation is consistent with the reduction in return volatility and drawdown we find in our research (volatility and drawdown are reduced by 12%/16% and 25%/30% for investment grade/high yield, respectively).[1]

As a bottom-up fundamental credit approach, our credit strength strategy emphasizes issuer selection and weighs issuers equally, thereby reducing the overconcentration of financial issuers in the portfolio. A traditional corporate bond index weighs constituents by bond size, meaning an issuer’s weight is dictated by the amount of debt the issuer has outstanding. Therefore, a market-value-weighted corporate bond index tends to have its weight disproportionately concentrated in issuers from the Financials sector, as illustrated by the S&P U.S. Investment Grade Corporate Bond Index (see Exhibit 2).

Weighting issuers equally is one way to avoid overconcentration in issuers or sectors with the most debt, and this strategy is consistent with the goal of constructing a portfolio with better credit fundamentals. Exhibit 2 compares the Financials sector weights in our hypothetical credit strength portfolios versus traditional corporate bond indices.

The diversification effect is noticeable in both investment-grade and high-yield bonds, and it is particularly pronounced in investment-grade bonds, where the average allocation to Financials in the credit strength strategy is nearly half of the broad investment-grade corporate bond index (20% versus 40%).

Defensive portfolios with diversified sector allocation may potentially be able to offer lower return volatilities. A properly constructed credit strength portfolio can offer effective credit exposure for long-term corporate bond investors, while improving risk-adjusted returns and mitigating credit risk.

[1] For more details, please see our previous blog: https://www.indexologyblog.com/2019/07/10/using-credit-ratios-to-build-defensive-corporate-bond-portfolios/

The posts on this blog are opinions, not advice. Please read our Disclaimers.

The Case for Positive Earnings Criteria in International Small-Cap Benchmarks

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Phillip Brzenk

Senior Director, Strategy Indices

S&P Dow Jones Indices

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We recently published a research paper, “Building Better International Small-Cap Benchmarks,” offering a comprehensive look at the recently launched S&P Global SmallCap Select Index Series. These indices are designed to measure the performance of small-cap companies with positive earnings.

Why incorporate positive earnings criteria into small-cap benchmarks? The initial foundation stems from two prior studies[1],[2]; the first study showed that the quality factor was one of the primary drivers of the return differential between two prominent small-cap benchmarks in the U.S. The second study found that the variability of the size effect mainly stemmed from the volatile performance of low-quality, or junk, small-cap firms. Additionally, the authors found that when junk or low quality is controlled for, the size premium becomes more robust in nature and can be found across industries, time periods, and 23 different markets.

Based on evidence found in the two papers, we investigated whether quality has earned a similar premium in international S&P DJI small-cap universes. To test the effectiveness of positive earnings, Exhibit 1 shows the average one-month excess return of positive earnings companies to negative earnings companies for each country in the S&P Global BMI universe.[3]

On average, profitable companies outperformed unprofitable companies in over 80% of the countries in the S&P Global BMI universe. In addition, we did not observe any geographical region bias, which leads us to conclude that excess returns being earned by profitable small-cap securities is potentially a global phenomenon. This is a key point in showing the robustness of this strategy, as the criteria shows consistent results across markets and regions.

Exhibit 2 shows that applying a positive earnings criteria to small-cap benchmarks has been an effective tool in attaining outperformance across multiple universes. For example, the S&P SmallCap Select Indices outperformed their S&P Global BMI counterparts across all regions, and the performance differential was particularly prominent in emerging markets.

As a result, incorporating a positive earnings screen can potentially be a useful way to boost returns across a number of markets, globally. To find out more about our recently launched S&P Global Small Cap Select Index Series, see the latest research paper.

[1] Brzenk, P. and A. Soe (2015). “A Tale of Two Benchmarks: Five Years Later.” S&P Dow Jones Indices.

[2] Asness, C., A. Frazzini, R. Israel, T. Moskowitz, and L. Pedersen (2018). “Size matters, if you control your junk.” Journal of Financial Economics. 129: 479-509.

[3] We limited the countries to those that had been in S&P Global BMI for the entire testing period. One-month returns are total returns (inclusive of dividends) in local currency.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

July 2019 Commodities Performance Highlights – A Nickel for Your Thoughts

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Fiona Boal

Head of Commodities and Real Assets

S&P Dow Jones Indices

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Commodities markets hit the summer doldrums in July. The S&P GSCI was down 0.2% for the month and 13.1% YTD. The Dow Jones Commodity Index (DJCI) was down 0.8% in July and up 6.1% YTD, reflecting its lower energy weighting. Impressive rallies in nickel and silver markets were pitched against a slump in agriculture prices, leaving the broad commodities indices little changed over the month.

The S&P GSCI Petroleum ended the month up 0.7%. Oil prices have remained relatively stable despite a serious escalation of geopolitical tensions in the Middle East, which may speak to a global economy that is weakening at a notable pace. It is also likely that U.S. production is now acting as a firewall against the geopolitical risks apparent in the global economy.

The S&P GSCI Industrial Metals ended the month up marginally, with most metals displaying bland monthly and YTD performance. However, there has been one notable exception; the S&P GSCI Nickel was the big outperformer in July, up 14.4% on the back of a widening global market deficit and the ongoing contraction in visible inventories. Nickel inventories at the London Metal Exchange are the lowest since January 2013, having fallen by 30% since the beginning of 2019. Little progress at the Sino-U.S. trade talks at the end of July and the Chinese Purchasing Managers’ Index suggesting another month of contraction in manufacturing activity present significant head winds for industrial metals into the end of the year.

After the U.S. Fed cut rates as expected amidst a revival of global central bank easing, gold’s performance cooled slightly into the end of the month. According to the World Gold Council, global gold demand rose 8% in the first half of the year driven by central bank buying and a flurry of funds into gold-based exchange-traded products. The S&P GSCI Silver spiked 7.1% higher in July, with some speculators betting silver will catch up to gold’s double-digit YTD performance.

It was a poor month for agricultural commodities, with the S&P GSCI Agriculture falling 5.5%. Grain market participants remain wary regarding the exact size and condition of the U.S. crop after heavy rain caused unprecedented planting delays in spring. Many are waiting for the USDA to issue updates on how much corn and soybeans were planted in a report to be issued by the USDA next month. There were conflicting reports over the month regarding the purchase of U.S. soybeans by Chinese crushers, but with little official progress in the trade talks between China and the U.S. the return of this major export market seems some way off .The S&P GSCI Coffee fell 8.8% in July. A frost scare in Brazil early in the month sent prices to 2019 highs, but prices subsequently fell as crop damage appeared minimal.

The so-called Chinese protein gap and falling feed prices offered some support to U.S. livestock markets in July. The S&P GSCI Livestock rallied 3.1% for the month. China, the world’s largest pork producer and consumer, has reported more than 140 outbreaks of African swine fever since the first case was reported in August 2018. Despite a 63% tariff on U.S. pork, China is still buying U.S. pork, though not at pre-trade war levels.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Channeling Maverick and the Maestro: The Fed Cut Rates because “We Were Inverted”

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Brian Luke

Global Head of Fixed Income Indices

S&P Dow Jones Indices

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One of the classic scenes from the original Top Gun movie recounts the exchange Maverick (Tom Cruise) had with a MiG-28. Maverick corrects Charlie’s (Kelly McGillis) intelligence report on the Russian fighter jet with his eyewitness account. When she asks how he saw a MiG-28 perform a 4G dive from above, he responds: “Because I was inverted.” Goose (Anthony Edwards) interrupts Mav that it was “we,” not “I.”

Fed Chairman Jerome Powell could have responded the same way when asked why he cut rates today. The treasury yield curve was inverted for the first time since the dark days of 2007. This is cause for alarm as the previous three recessions occurred after the 10-year U.S. Treasury Note yield fell below the three-month yield, as is the case today.

By cutting rates, the Fed is hoping to be ahead of the curve to stave off another recession. History has shown precedent for this. Looking at the S&P U.S. Treasury Current 10-Year Index yield minus the S&P U.S. Treasury Current 2-Year Index yield, the curve inverted the previous two recessions, but it hasn’t fallen below zero in the current cycle, unlike the 10-year/3-month curve.

Then there’s the Maestro. It was former Fed Chair Alan Greenspan’s deft use of the overnight rate during the previous longest bull market in history that gave him the nickname “Maestro” (not less brave than Maverick’s move, by the way). In 1994, Greenspan cut rates despite the strong equity market performance. The S&P 500® climbed 88% from the October 1990 lows and it rallied another 42% before the Fed would tighten monetary policy again. With a bull market long in the tooth and a similar political landscape (an incumbent gearing up for his reelection campaign), Jerome Powell is taking a page out of the Maestro’s songbook by cutting before the yield curve inverts.

History has shown that maintaining exposure to equities during an easing cycle can still be profitable despite substantial prior gains. Throughout the 1990s, Greenspan cut rates a total of 23 times. The S&P 500 responded positively each time, averaging a 16% annual return following each cut. However, his same approach did not work as well in the 2000s after the yield curve inverted and the bull market ended.

It remains unclear whether the Fed is channeling the Maverick move by pushing the limits or Alan Greenspan’s “Maestro” of the 1990s with sustained economic success. Market participants can only wait to see what the consequences of the Fed’s moves might be. For now, investors will have to follow the bond market for clues on the next Fed move.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Cboe S&P 500 Buffer Protect Indexes: First Outcome Period Recap

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Matt Kaufman

Principal and Senior Director, Head of Distribution and Product Development

Milliman Financial Risk Management LLC

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On June 28, 2019 the July Series of the Cboe S&P 500 Buffer Protect Indexes completed their first one-year outcome period (6/28/18 – 6/28/19). The Cboe S&P 500 Buffer Protect Indexes are designed to afford investors defined exposures to the S&P 500 Price Index, where the downside buffer levels, upside growth potential, and outcome period are all pre-determined. The approach taken by the Buffer Protect Indexes is analogous to certain equity-linked strategies used in structured products and indexed annuities—industries with more than $1 trillion in assets in the U.S. alone.

In short, the Buffer Protect Indexes performed as they were designed, exhibiting the same positive return as the S&P 500 Price Index over the outcome period, with approximately half the beta and a significantly lower maximum drawdown. The table and chart below depict the historical performance of two Cboe S&P 500 Buffer Protect Indexes:

  • Cboe S&P 500 15% Buffer Protect Index – July Series: Designed to provide access to the price return of the S&P 500, to a cap, with a built-in buffer of 15%, over an outcome period of one year.
  • Cboe S&P 500 30% (-5% to -35%) Buffer Protect Index – July Series: Designed to provide access to the price return of the S&P 500, to a cap, with a built-in buffer of 30% (beginning at -5%), over an outcome period of one year.

Did the Indexes Deliver a Defined Outcome?

Yes. The Indexes seek to match positive returns of the S&P 500 Index, to a cap, in up markets and in down markets, buffer investors against losses of 15% or 30% (-5% to -35%) over the outcome period. The S&P 500 was positive at the end of the outcome period, and the Buffer Protect Indexes matched the price returns of the S&P 500. Additionally, as a result of the downside buffers and upside caps, the Indexes experienced significantly less volatility and drawdowns than the S&P 500 along the way (while matching the return of the S&P 500 at the conclusion of the outcome period).

Implications

The investment community has been widely tracking the Cboe S&P 500 Buffer Protect Indexes, and the completion of their inaugural one-year outcome period was an important milestone in the adoption of “defined outcome” based investment strategies. This could add to financial advisors’ toolkit as they manage varied risk tolerance levels and investment objectives.

The posts on this blog are opinions, not advice. Please read our Disclaimers.