Indexology^® Blog

The last few weeks have been challenging for business the world over. People working from home and aggressive social distancing have led to business contraction and the expectation of rising default. On March 19, 2020, an S&P report expected that the U.S. trailing 12-month speculative-grade corporate default rate would rise to 10% within the next 12 months, from 3.1% in December 2019.

In this blog, we aim to highlight how the S&P U.S. High Yield Low Volatility Corporate Bond Index,[1] by reducing volatility, has delivered better risk-adjusted returns in recent market turmoil.

Option-Adjusted Spreads (OAS): Screaming Market Volatility

In 2020, high yield credit spreads traded stable at the tight end up until the first half of February, reflecting persistent yield chasing (see Exhibit 1). However, since then, global risk assets, driven by COVID-19 concerns, have sold off sharply. From Jan. 17, 2020, to March 23, 2020, the OAS for the S&P U.S. High Yield Corporate Bond Index widened by 719 bps from trough to peak, along with a 33% decline for the S&P 500^® during the same time period.

S&P U.S. High Yield Low Volatility Corporate Bond Index: Lower Volatility, Better Long-Term Risk-Adjusted Returns

Exhibit 2 displays the comparative performance of the S&P U.S. High Yield Low Volatility Corporate Bond Index during the most stressed scenarios of the past two decades. There are two key takeaways.

• The S&P U.S. High Yield Low Volatility Corporate Bond Index outperformed its broad market high yield benchmark during each of these stress periods, including a 2.8% outperformance during the recent COVID-19 sell-off; and
• The defensive nature of the low volatility index has acted as cushion during market sell-offs.

Lastly, Exhibit 3 compares the return/risk trade-off among asset classes during 5-year, 10-year, and 20-year periods. There are several key points to be stressed.

• The S&P U.S. High Yield Low Volatility Corporate Bond Index consistently exhibited volatility levels lower than its broad-based high yield benchmark;
• In fact, its volatility levels fell between those of the investment-grade and high yield universes; and,
• For longer time periods (20 years), the S&P U.S. High Yield Corporate Bond Index delivered higher marginal returns than its broad-based high yield benchmark for every incremental unit of risk to investment-grade bonds.

Conclusion

There remains a lot of uncertainty surrounding the current pandemic. It remains to be seen how soon economic activity could start to pick up. Therefore, we might be looking at an extended period of time with an evolving and uncertain economic situation. All of this uncertainty leads to volatility and even more so for risky assets such as traditional high yield bonds.

During times of uncertainty and volatility, the S&P U.S. High Yield Low Volatility Corporate Bond Index provides exposure to high yield bonds with reduced volatility and the potential for higher risk-adjusted returns in the long term.

[1]   For information about the methodology, please refer to https://spdji.com/documents/methodologies/methodology-sp-us-high-yield-corporate-bond-strategy-indices.pdf.

Last year’s prognostications about the events and trends to monitor in 2020 have evaporated as COVID-19 has upended people’s lives and caused massive recalibrations in financial markets.  In Q1 2020, we said “goodbye to the bull market”; large market movements became the new normal; correlations and dispersion shifted drastically; quantitative easing returned; and access to liquidity was important for many, in both equity and fixed income markets.  Remarkably, all of this took place in little over a month. So much for 2020 foresight!

As COVID-19 dominated headlines, the S&P 500 finished with its worst quarterly total return (-19.60%) since Q4 2008’s 22% decline.  Matters would have been even worse had it not been for the S&P 500’s best 5-day total return since November 2008; the benchmark rose 17.4% between March 23 and March 30 to recover some of the prior losses.  [Through March 23, the S&P 500’s cumulative total returns since the start of the last bull market stood at the same level as in May 2017.]  Volatility goes both ways!

At a sector level, there was no place to hide to avoid declines in absolute terms in Q1: all S&P 500 sectors finished down for the quarter, only the seventh time this has happened since the end of 1989.  However, there was enormous value in identifying the relative winners or avoiding the relative losers: a whopping 38.5% separated the best performing sector in Q1 (Information Technology, -11.93%) and the clear laggard (Energy, down 50.45% amid oil prices plunges).  This quarterly difference was the highest since December 2001, and reflected a dramatic increase in stock and sector dispersion.

Across the market capitalization spectrum, the S&P 500 beat both the S&P MidCap 400 (-29.70%) and the S&P SmallCap 600 (-32.64%).  This may reflect expectations that larger companies may have stronger balance sheets and may be better able to weather the storm.

So what’s next?  Although the sea of red across dashboards makes for unpleasant reading, it is worth noting that first quarter declines don’t necessarily mean the rest of the year will be negative.  For example, the S&P 500 posted 31 negative first quarter total returns between 1937 and 2019.  In most cases (19), the benchmark posted a positive return over the next three quarters, including in 2009 when the S&P 500 fell more than 11% in the first three months before rising 42.11% over the last three quarters.

As a result, even though 2020 foresight has gone out of the window,  it may be worth staying the course instead of giving up on a possible recovery.

It is difficult to accurately express the magnitude of the health, societal, and economic costs of the COVID-19 pandemic. Through the lens of the commodities markets, the economic impact has been swift and severe. The broad-based S&P GSCI ended March down an extraordinary 29.4%, the largest monthly drop in performance in the index’s nearly 29-year history. While it remains valuable to review past performance during times of such extremes, it is also imperative that market participants identify the longer-term trends that may emerge in the wake of this devastating economic shock. In this sense, commodities markets can offer valuable insight into real-time economic impacts and, as such, may be the first to offer confirmation of conditions in the real economy.

The energy sector was decimated in March, with the S&P GSCI Petroleum down a staggering 49.6%. The market has faced an unprecedented, simultaneous demand and supply shock. The next step for the energy complex is to achieve some level of price stability and for the difficult process of restructuring to commence, but at this point, it is almost impossible to predict how long it will take for the current oil surplus to be eliminated. The only light on the horizon is the fact that at some point, lower energy prices should act as a mechanism to stimulate demand, especially consumer demand in countries such as the U.S.

Metals prices outperformed energy but did not escape the high volatility and general risk-off sentiment across all asset classes in March. Bellwethers for economic growth, metals experienced broad weakness as the cuts to GDP forecasts cascaded through the financial ecosystem. The S&P GSCI Industrial Metals fell 10.2% for the month. However, outside of the traditional industrial metals, one commodity performed admirably. The S&P GSCI Iron Ore continued to outperform, down only 0.2% for the month, benefiting from China restarting some of its manufacturing capacity. The dislocation between individual asset price performance even within the same broad asset class or sector will likely persist as the scale, geographic scope, and impact of the pandemic ebb and flow.

The S&P GSCI Gold continued to outperform in March, highlighting its safe-haven status, but it likely did not outperform to the extent that many market participants would have expected. The level of liquidity in the gold market made it an attractive asset to liquidate in order to access cash during the market turmoil. In addition, gold had already enjoyed a surge in investor interest prior to the current crisis on the back of low to negative interest rates across the globe, geopolitical flare-ups, and a global rush for assets that retain their value. Even when conditions for an asset remain favorable, asset prices do not necessarily react positively.

A variation on the so-called breakfast trade—long wheat, coffee, and orange juice—was the highlight of the agriculture market in March. The S&P GSCI Orange Juice rallied 25.3%, the S&P GSCI Wheat returned 8.4%, and the S&P GSCI Coffee was up 7.4% over the month, as demand for consumer staples surged and top suppliers mulled export restrictions to protect domestic supplies. The longer and more severe the global pandemic, the more likely global food supply chains become stressed and the more likely agricultural commodity prices dislocate from the broader commodity complex.

Finally, it is worth pointing out that, while the focus of market participants since the start of the COVID-19 pandemic has rightly been on the scale and longevity of demand destruction, supply disruptions will increasingly be a factor in price discovery. Companies involved in the production of commodities are undoubtedly cutting production as a function of government-enforced shutdowns and in response to collapsing prices. As levels of economic activity start to pick back up, supply should play an increasingly important role in the price discovery process for commodities.

The S&P/TSX Capped Information Technology Index gained a whopping 62% in 2019, topping all other Canadian equity sectors and beating the broad market S&P/TSX Composite by about 40%. Given the traditionally cyclical nature of the Information Technology sector and its outsized gains during the bull market, the sector might be expected to lag during the COVID-19 downturn.

However, Information Technology continued to outperform YTD through March 26, surpassing the traditionally defensive Consumer Staples, Utilities, and Communication Services sectors. In addition, it experienced the second-lowest volatility during the crisis period out of the 11 S&P/TSX Capped Sector Indices.

So, why has Information Technology been so resilient despite a steep market downturn and growing expectations that there will be a historically deep recession? For one, this pandemic-driven economic shutdown will clearly affect industries differently compared with what has played out in past recessions. With consumers and businesses forced to remain home in isolation, many technology-related companies are likely to see increased demand for their services. We are seeing this play out in the U.S. and many other markets, as stock prices of companies in many technology-related areas including e-commerce, software, semiconductors, communications equipment, and others have fared well due to expectations that the world will rely heavily upon these products and services during the pandemic and in the ensuing recovery.

In addition, as most keen Canadian market observers are aware, Shopify, a leading provider of e-commerce software solutions to businesses, is the largest Canadian Information Technology company and has performed well in the recent environment. As Exhibit 3 illustrates, the strength of Shopify has been the largest single driver of S&P/TSX Capped Information Technology Index performance in 2020. However, other large constituents such as Constellation Software, Open Text Corporation, and Kinaxis contributed to the sector outperformance as well.

It’s important to recall that the recent relative outperformance of the Information Technology sector is an extension of a longer-term trend. In fact, despite recent declines, the S&P/TSX Capped Information Technology Index remains up 22% over the trailing 12 months, outperforming the S&P/TSX Composite by 37% and easily beating all other sectors.

While the Canadian equity market has fallen sharply during the COVID-19 crisis, there has been wide divergence across equity sectors. Given the sharp decline in oil prices, Energy companies have taken the steepest hit, while Health Care has fallen sharply due to the sector’s unusually large exposure to the cannabis industry. Unsurprisingly, defensive sectors such as Utilities, Consumer Staples, and Communication Services have fared relatively well, along with Information Technology, which has thus far proven to be an unlikely beneficiary from this unique downturn.

Since March 9, 2020, we have seen equities and bonds fall together. As bonds fail to provide the diversification benefit in the short term, some investors may choose to use inverse exchange-traded funds as short-term trading tools for an explicit hedge.

Inverse strategies typically aim to replicate the daily performance of their underlying indices with a constant multiplicative factor (such as -1, -2, or -3). While the daily rebalancing allows the products to seek to invert the return of their underlying indices on a daily basis, returns for longer periods are a product of the compounded daily inverse returns during the period, and they could deviate significantly from the stated daily objective. Therefore, although such products offer short-term trading tools for explicit purposes, they may not be suitable as long-term holdings for some investors.

Exhibits 1 and 2 illustrate how inverse daily indices performed in two recent time periods: a period of seven trading days from Feb. 20, 2020, to Feb. 28, 2020, and another period of seven trading days from March 10, 2020, to March 18, 2020. In both periods, the S&P 500^® (TR) dropped close to 13%, while the inverse daily indices’ returns were vastly different.

From Feb. 20, 2020, to Feb. 28, 2020, the S&P 500 was trending down every single trading day. In this case, or when the market was trending in one direction in general, the cumulative performance of the inverse daily indices tended to exceed the invert return of the index during the period.

However, from March 10, 2020, to March 18, 2020, the S&P 500 was trending further downward with huge daily swings (from -12% to 5%). In this case, the pursuit of daily investment targets typically had a negative impact on performance for periods longer than one day. The negative impact could have been larger for inverse indices with higher multiples.

This effect of compounding on the cumulative returns may not be trivial for many retail investors. The S&P Leverage and Inverse Indices aim to provide transparent benchmarks for leverage and inverse products.

Further details on the S&P Leverage and Inverse Indices are available here: TalkingPoints: S&P Leverage and Inverse Indices. Additionally, the recent performance of key indices is displayed in Exhibit 3 (from Feb. 19, 2020, to March 31, 2020).