The high yield market, as measured by the Bank of America Merrill Lynch U.S. High Yield Master II Constrained Index, posted a positive total return of 1.38% in January, as the high yield market continued to rally into the new year.
With the debate over the revenue portion of the fiscal cliff behind us, market participants turned their attention to steadily improving global economic sentiment, diminishing risks of unexpected events, and falling market volatility. In the U.S., overall economic data was positive during the month of January, with the Housing sector continuing to lead the way. The Bureau of Economic Analysis (BEA) reported a poor gross domestic product (GDP) headline. According to its preliminary estimate for the fourth quarter of 2012, GDP declined by an annualized rate of 0.1%, the first quarterly decline in GDP since the second quarter of 2009. A drop in government spending on national defense and a large drawdown in inventories contributed most to weakness in the GDP headline, each shaving off roughly 1.3% from growth.
While the headline number was negative, there were a number of bright spots in the report that pointed to continued economic recovery. First, the drop in defense spending may not be primarily driven by the looming sequester. Given the way defense spending is reflected in the National Income and Product Accounts (NIPA), it is likely the drop reflects the ratcheting down of defense spending that began some time ago. Second, consumer spending increased by 2.2%, driven largely by strong gains in motor vehicle sales and double digit growth rates in housing investment (+15.3%) for a second straight quarter. Third, business investment in equipment and software was driven higher by the desire to make capital outlays ahead of scheduled expirations in various tax breaks.
We believe that the Housing sector may continue to have a positive impact on U.S. GDP in 2013. The U.S. housing market found a bottom in late 2011, and began to experience a material recovery in 2012, particularly during the second half. There are several reasons why we believe that the U.S. housing industry will continue to improve in 2013 – significant pent-up demand, record home price affordability, the cost to own versus renting near record low levels, historically low interest rates, and low levels of new home starts. Commercial construction in the U.S. has also improved in recent months. We believe that the Equipment Rental sector may benefit from larger construction projects.
The Energy sector continues to enjoy improving credit fundamentals and could help in healing the U.S. labor market. There has been a massive increase in drilling for oil and natural gas in the U.S. These positive developments in the Energy sector are leading to material investment in infrastructure, which may lead to an increase in domestic job creation. Natural gas prices have been low, but prices may be supported by increased usage. Also, capital is being directed to higher return natural gas liquids plays.
We continue to believe in our base-case scenario that the U.S. economy continues to ‘muddle’ along. With global economic indicators starting to show signs of improvement, and with central bank policy action in motion, we believe that the U.S. economy may expand at about a 1.5% to 2.0% rate. We remain positive on both the return prospects and the underlying credit fundamentals of the high yield market. Companies continue to refinance higher-coupon debt, extend maturities, and focus on balance sheet repair. The quality of new issuance remains strong. In recognition of these fundamentals, inflows have also been strong. The Fed, in our opinion, may likely keep Treasuries in their current range, economic growth should remain steady, and defaults may remain low. In that scenario, we could see modest spread tightening and the yield of the market ending the year around where it is now. Given the positive backdrop, our base-case remains that high yield should perform well going into 2013.
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The Bank of America Merrill Lynch U.S. High Yield Master II Constrained Index tracks the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market. One cannot invest directly in an index.
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