The high yield market, as measured by the Bank of America Merrill Lynch High Yield Master II Constrained Index (the “Index”), was down 2.64% for the month of June. Yields moved sharply higher during the month as the high yield market experienced record retail outflows, quickly adjusting expectations around the Treasury market, and increased equity price volatility. Volatility spiked after a more hawkish message emanated from the Fed after the Federal Open Market Committee (FOMC) meeting on June 19th. In particular, Fed chairman Bernanke articulated a quantitative easing (QE) tapering pace in his press conference, which assuming growth stays at the present pace, includes tapering later this year and ending purchases by mid-2014.
Since Chairman Bernanke testified before the Joint Economic Committee on May 22nd, changes in financial markets most significant to the economic outlook have been in long-term interest rates. Interest rates have gone up substantially across the yield curve. For example, 5-10yr Treasury yields are back to June 2011 levels. We believe these increases probably reflect, primarily, increases in risk premia, rather than any substantial change in the expected path of short-term interest rates. An increase in long-term interest rates may reflect an improvement in long-term growth prospects (a positive signaling effect). But higher interest rates tend to discourage current investment and consumption (a negative structural effect). Thus, it is not always obvious what long-term interest rate movements imply for the economic outlook. The predominant information communicated by Chairman Bernanke and the FOMC over the last four weeks was related to the likely course of its asset purchases, not the outlook for the economy. That said, Federal Reserve policymakers continue to stress that the full course of the plan for asset purchases is “data dependent.” In future communications, we expect FOMC participants to acknowledge that higher interest rates and tighter financial conditions may slow the pace of economic activity. Any additional drag on the economy from higher interest rates and tighter financial conditions could extend the asset purchase program.
While Bernanke’s timetable for tapering QE3 was sooner than the market expected, and 10-year Treasury yields widened from 1.67% to 2.61%, we remain constructive on high yield fundamentals. Global volatility and rising interest rates have the possibility of slowing U.S. growth, though we expect the U.S. economy to be resilient. The Housing, Energy, and Automotive sectors could all help support U.S. economic growth. The Fed is still in a stimulative posture with the clear history of resuming stimulus if it appears necessary (Federal Reserve policymakers continue to stress that the full course of the plan for asset purchases is “data dependent.”) Further, the fiscal situation in the U.S. is improving, while the federal deficit has dropped a bit. The current state of credit fundamentals, alongside a slowly improving economic backdrop, is consistent with our outlook for a low high yield default environment.
High yield bonds are subject to greater price volatility and may be less liquid than higher rated
securities; are subject to greater sensitivity to interest rate and economic changes. As interest rates rise, the value of debt securities decreases; whereas prepayment risk tends to occur during periods of declining interest rates. The decline in an issuer’s credit rating can negatively affect the value. International investing involves certain risks and increased volatility not associated with investing solely in the U.S. These risks include currency fluctuations, economic or financial instability, and lack of timely or reliable financial information or unfavorable political or legal developments. These risks are magnified in emerging markets. Distressed securities are speculative.
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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.
This material contains the current opinions of the author, which are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information used to compile this report has been obtained by sources deemed to be reliable, but its accuracy and completeness are not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Past performance is no guarantee of future results.
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