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Equity re-classifications may trickle down to bonds

admin | September 21, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Long proposed and discussed updates to the Global Industry Classification System (GICS) will go into effect September 28th. The updates will change the sector or industry of over 2000 companies worldwide. The formerly defensive sector of Telecommunications will be renamed Communication Services and substantially broadened, becoming a cyclical sector under the new methodology. The greatest impact will be among equity portfolios and exchange traded funds, where benchmarking to particular GICS sector or group indices is common. US fixed income markets could see a modest amount of elevated activity among the 17 names with $240 billion in debt outstanding that will be subject to reclassification, roughly equally split between investment grade and high yield.

Background

The Global Industry Classification Standard (GICS) was developed in 1999 by Morgan Stanley Capital International (MSCI) and Standard and Poor’s (S&P) to provide a reliable industry classification framework for investment research, portfolio management and asset allocation. The classification system is designed to reflect a company’s financial performance based on a common global standard. GICS currently classifies over 26,000 active, publicly traded companies – 95% of the world’s equity market capitalization – based on a four levels of hierarchy: sectors, industry groups, industries and sub-industries. The GICS classification applies to both equity and debt securities of a company. Bloomberg has developed competing classification systems, but the sector stratification is nearly identical.

GICS has been widely adopted by asset managers, portfolio strategists, buy-side and sell-side firms worldwide. A cottage industry among portfolio managers and asset allocation strategists has been to diversify equity holdings based on the classification system, then choosing which sectors or industries to overweight or underweight. An entire universe of exchange traded funds now exist that are bench-marked to a particular sector. This is much more common measure to evaluate and track equity performance, though there are long-standing bond indices which use the GICS / MSCI system that stratify bond returns by sector and industry as well.

Updating the classification system

The GICS structure is reviewed and updated semi-annually. The latest changes – which are scheduled to take effect after the close on Friday, September 28th – are material. They include renaming the Telecommunications sector to Communications Services and broadening its scope; this will result in reclassifying a select group of companies which are currently assigned to the Consumer Discretionary sector to Communications Services. In all, over 2000 companies worldwide – more than 400 of which are in the US – will be impacted by the updates. The changes were proposed about a year ago, and GICS has released extensive information, available here, on the methodology, and updated lists of companies to be affected in order to smooth the transition.

Debt Market Impact

Investors have had plenty of warning, and we expect most of the necessary portfolio or sector re-balancing in equities will occur seamlessly within the usual flurry of month-end trading. Although credit markets are widely discussed and analyzed by calculating betas and correlations among the various sectors and groups, it is much less common for fixed income portfolio managers to create or benchmark their portfolios that track a particular sector or industry. Though we don’t expect a meaningful amount of re-balancing to occur in bond portfolios, Exhibit 1 identifies the names which could see elevated activity going into month-end as a result of the reclassification:

Exhibit 1: US names with debt outstanding whose GICS classification changes on September 28, 2018

Source: GICS, S&P, Bloomberg and Amherst Pierpont

A lot of media ink has been devoted to the reclassification of behemoths Google and Facebook from the Information Technology to Communications Services sector, but these are almost meaningless for fixed income – Facebook has no outstanding debt and Google has barely $4 billion outstanding. The amount of outstanding debt subject to the reclassification is $130 billion for investment grade and $109 billion for high yield. The “old” Telecommunications Services sector was classified as “defensive” with an equity beta of 0.88, and the new Communications Services is projected to have an equity beta of 0.99, which GICS classifies as “cyclical”. To the extent that any fixed income portfolios gauge this, there could be a modest underweight of these names in favor of more defensive sectors when the business cycle eventually begins to downshift.

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