Indexology^® Blog

Recently, I seem to have gotten a bit addicted to online shopping, after experiencing the ease of online transactions and the constant exposure to multiple options.

Choice is important, and we are increasingly becoming spoiled by abundant choices in our everyday lives, be it with consumer goods or investments.  Online transactions are gaining popularity, not only due to their ease of execution, but also because of the convenience of being able to compare a varied number of options that meet one’s needs.  Furthermore, there is an increased awareness of new market entrants and ideas in the online space.  When there is a plethora of options from various sources, it becomes critical to be organized in order to evaluate them.  Hence, classification is essential.

This is applicable to financial market indices, as well.  There are multiple markets globally, with regional preferences and different rules and standards governing each one.  However, there are some common classifications that can be used to create comparable indices across regions. For example, every market does classify its components into large-cap, mid-cap and small-cap companies.  While the market itself could comprise various sizes based on regional capabilities, there seems to be standardization and a clear trend on how this classification is done.  The large-cap classification generally represents a significantly large percent of the total market capitalization, typically over 50%, followed by the mid-cap category, normally in the range of 10%-15%, and finally the small-cap label, which usually consists of a small percentage of total market cap.

Index classification is not only restricted to market capitalization—there are a number of other categories to choose from, as well.  Regional indices cover areas like the U.S., LATAM, APAC, EMEA, etc.  The regional offerings can be further defined into sub regions and countries.  There are sector indices offering other splits, like information technology, auto, banking and financials, manufacturing, etc., as there are many sectors that can prove useful to market participants and have a clear classification.  Additionally, there are an asset class-based index, which means there are either equity, fixed income, or commodities in the index universe.  While the aforementioned classifications are fairly generic for indices, there are also other classifications that offer access to a specific strategy or theme.  For example, S&P Dow Jones Indices has created the Shariah index series, which uses screening techniques to provide a variety of indices that are Shariah compliant, and this series is subdivided by region, as well.  In India, the S&P BSE 500 Shariah is the regional offering.  Themes such as asset allocation, dividends, etc. can also be used to classify indices.  Finally, custom indices can be created from standard classifications, offering another wide range of choices.

The classification of indices offers product providers the choice to create a range of offerings for investors.  Index providers are recognizing the need for choices and are creating innovative and varied options to suit market requirements.

Lower yields and newly issued coupons have added an element of danger to fixed income investing.

The following chart shows that since September 2013, the weighted average coupon of the S&P U.S. Issued Investment Grade Corporate Bond Index has trended down, as higher-coupon bonds are called away and lower coupon new issuance is added to the index at the monthly rebalancing.  The result of a lower coupon for the index is that the modified duration has been moving up, or longer out on the curve.  The modified duration of the index is currently at 6.9 years, and the coupon is 4.35%.   The index has returned 0.41% MTD and 2.11% YTD as of March 31, 2015.

As issuance in the primary markets hits record levels, lower coupons, yields, and longer bonds could change the characteristics of an index.

• The lower the bond’s coupon or yield, the higher the duration and volatility of price. Bonds with low coupon rates and lower yields will have a higher duration than bonds that pay high coupon rates or offer higher yields.  Because the bond pays a low coupon rate, the holder of the bond receives repayment of the bond at a slower rate.
• Longer-maturity bonds also have higher durations and are exposed to more risk.
  

 
Source: S&P Dow Jones Indices LLC.  Data as of March 31, 2015.  Charts and tables are provided for illustrative purposes only.  Past performance is no guarantee of future results.

Since the S&P/Case-Shiller National Home Price index bottomed in December 2011, the national index is up 24% or 7.5% annually. While the Index is about 10% below the peak level set in July 2006, the indices for Denver and Dallas set new all-time peaks last year. Boston and Charlotte NC are both closing in on new record highs. The rise in home prices comes against a background of stagnant wages gains, raising worries that some people are at risk of being priced out of the home market.

The short term picture, shown in the first chart, may be cause for concern.  The chart compares the S&P/Case-Shiller National index with per capita personal income during 2012-2014.  Home prices rose steadily except for a brief pause in early 2014. Incomes also rose, but by 9% over three years, only one-third as much.  The spike in income at the end of 2012 reflects a one-time shift in the pattern of dividend payments caused by fears that the Congress would not renew their favorable tax treatment.

A longer view of the data tells a different story, as shown in the second chart. From 1975, when the S&P/Case-Shiller National Index starts to about 1990, home prices and per capita income tracked one-another quite closely.  In the early 1990s the combination of the 1990-91 recession followed by Fed tightening of monetary policy a few years later caused home prices to flatten out while incomes continued to rise. In the late 1990s the housing boom began to gather steam and home prices rapidly out-paced incomes (and much else). The dip in incomes and the collapse in home prices beginning in 2007 stand out, as does the recent faster growth in home prices.  With both house prices and incomes driven by the overall economy, a gradual convergence of the series is possible.  If home prices do outpace incomes, some potential home buyers will be priced out of the market and prices will slow or possible drop in response.

The S&P Municipal Bond Puerto Rico Index was the only state or territory index to finish the quarter in the red, down 1.25% with its yield to worst at 7.89%. Yields continue to rise as investors become more skeptical about Puerto Rico’s ability to fulfill obligations to their creditors.

The S&P Municipal Bond Puerto Rico General Obligation Index saw yields climb to 8.36% to finish the quarter. Yields on the index have not been this high since January 2014. The S&P Municipal Bond Puerto Rico General Obligation Index includes bonds from the Puerto Rico Electric Power Authority (PREPRA) that have received a 15-day extension on their debt. Investors have been concerned, as it appears the leveraged utility may have to borrow upward of USD 600 million in additional funds just to keep the lights on, with a looming USD 400 million debt payment scheduled for July 2015.

The S&P Municipal Bond Tobacco Index has outperformed all other muni sectors thus far in 2015, returning 3.66% YTD. In contrast, the S&P Municipal Bond Nursing Index was the sector loser, finishing the quarter up just 0.22% YTD. The yields are comparable; however, it is important to remember that the Tobacco Master Settlement Agreement of 1998 is a 25-year settlement. All things equal, longer duration reduces yield. Tobacco munis have a modified duration of 10.1, compared with the nursing sector’s modified duration of 3.2. Comparable yields and contrasting durations indicate that, while tobacco may be the flavor of the month, the market (and hopefully the end user) associates much more risk with tobacco than with nurses.

CORPORATE COMPARISON

When examining yields and returns on tax-free munis, it is imperative to consider the potential tax benefit. The investment-grade issues in the S&P National AMT-Free Municipal Bond Index have a tax equivalent yield of 2.89%, which is superior to the yield of 2.73% posted by the S&P U.S. Issued Investment Grade Corporate Bond Index.

Government intervention globally has driven yields lower, as the yield of the S&P Global Developed Sovereign Bond Index is down 34 bps to 0.74% from the start of 2015 (1.08%).  The U.S. Fed finished its quantitative easing program in October.  Japan has been in the process of purchasing securities, and the European Central Bank has started purchasing as well, in order to stave off deflation.

Headlines* globally tout record-setting lows:

Italy Sells Bonds at Record-Low Yields as ECB Backstops Demand
Poland to Sell First Euro Bond in Year as ECB Drives Down Yields
South Korean Bond Yields Drop to Record on Rising Rate-Cut Bets

The recent March 18, 2015, FOMC announcement pushed the interest rate increase speculation out toward later in the year, while moving the yield of the S&P/BGCantor Current 10 Year U.S. Treasury Bond Index lower by 14 basis points in one day (to 1.92% from 2.05%).  The yield level of the index is now 1.93%, and the index has returned 0.76% MTD and 3.06% YTD as of March 31, 2015.

The recent stimulus buying by the ECB has pushed the yield of the S&P Eurozone Developed Sovereign Bond Index down to 0.42%.  Presently, the index has returned 1.16% MTD and 4.02% YTD.

The S&P Japan Sovereign Bond Index’s yield is at 0.33%, as Japan’s central bank has been purchasing a broader selection of securities than just Japanese Government Bonds for a much longer time than Europe.  The index has returned 0.04% MTD and is down -0.45% YTD as of March 31, 2015.

One has to wonder, if the U.S. Fed does eventually raise short-term rates, would the yield curve remain flat, or would global demand for longer assets move the curve into an inverted state?

Exhibit-1: S&P Global Developed Sovereign Bond Index

Source: S&P Dow Jones Indices LLC.  Data as of March 31, 2015.  Charts and tables are provided for illustrative purposes only.  Past performance is no guarantee of future results.

*Bloomberg Headlines