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C IO REPORTS
The Weekly Letter
Office of the CIO • DECEMBER 16, 2014
High yield stands out: We consider how rising interest rates, a pickup in issuer defaults, and low liquidity could impact high yield bonds going into next year. While we still believe an improving economy and relatively attractive yields should benefit the segment, it will likely be subject to lower returns and higher volatility going forward.
arkets In Review: Concerns over plunging crude oil prices, risks to growth in China and Europe, and a potential government
M
shutdown in the U.S. fueled a steep selloff in equities and high yield bonds last week (but a bill passed over the weekend
funding the government through September 2015). The S&P 500 fell 3.5%, and international equities as measured by the MSCI
EAFE Index were down 3.6%. The BofA Merrill Lynch High Yield Index dropped 2.1%. Treasuries rallied, with the 10-year yielding
2.08%, down from 2.31% the prior week. WTI crude oil fell 12.2%, while gold rallied 2.5% to $1,223 per ounce.
ooking Ahead: A report on the consumer price index (CPI) for the U.S. in November is likely to show a slight decline, while
L
for the euro zone it should be unrevised from the preliminary estimate. At the December meeting of the Federal Open Market
Committee no rate change is expected, however a clarification on policy guidance is possible.
As the new year approaches, we consider how the headwinds
of rising interest rates, an uptick in issuer defaults, and lower
levels of liquidity should impact high yield bonds. Over the past
few years, investors have been dialing up their risk tolerance
in search of yield, increasing their positions in this segment
and bidding up prices as a result. We have been advising an
overweight position within suitable fixed income portfolios,
and still believe an improving economy and relatively attractive
yields should benefit high yield bonds. However, in our
view they may be subject to lower returns and greater
volatility going forward, and now is not the time to add
to existing outsized positions.
High yield has been riding high
High yield has been one of our preferred segments within the
bond market for some time, as a favorable macroeconomic
environment and positive fundamentals have provided a solid
backdrop for the asset class. With its accommodative monetary
policy, the Federal Reserve (Fed) has poured liquidity into the
markets and kept interest rates low, driving investors to chase
yields. With the U.S. as an engine of growth and the Fed as a
backstop, high yield has done extremely well (see Exhibit 1).
A risk profile similar to equities has benefited high yield as well;
in fact, it was one of the few fixed income segments with a
positive performance in 2013. This year’s returns have been
Exhibit 1: High yield bonds have had a strong run over the
past five years
Cumulative Total Return
High yield stands out
160%
140%
120%
100%
80%
60%
40%
20%
0%
-20%
2009
High Yield
2010
Investment Grade
2011
2012
Treasuries
2013
S&P 500
2014
Source: Bloomberg, MLWM Investment Management & Guidance, data as of December 10,
2014. Note: High Yield – BofAML U.S. High Yield Index, Investment Grade – BofAML U.S.
Corporate Bond Index, Treasuries – BofAML Treasury Master Index
Past performance is no guarantee of future results.
less remarkable, as a large exposure to the energy sector,
which has faced plunging oil prices, has weighed on high
yield. Debt of energy companies currently makes up roughly
15% of the indexes, so the future course of oil prices is likely
to have a big impact on their performance.
Additionally, default rates remain at historic lows, further
supporting the asset class (see Exhibit 2). Corporations have
cleaned up their balance sheets, and access to capital at low
rates has kept interest coverage ratios manageable. As a result,
investors have downplayed the risks to the asset class and
increasingly shifted down in credit quality, helping narrow the
spread between yields of high yield bonds and Treasuries.
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May Lose Value
Exhibit 2: Default rates have remained low across the
credit spectrum
Annual Issuer-Weighted Corporate Default Rates
2013
Average (1920-2013)
0.04%
0.15%
Ba
0.52%
1.07%
B
0.89%
3.38%
Caa-C
9.53%
13.13%
High Yield
Investment Grade
Source: Moody’s Investor Service, MLWM Investment Management & Guidance. Data as of
February 28, 2014.
High yield faces mounting headwinds
Given the consistently strong performance of the asset class
in recent years, BofA Merrill Lynch (BofAML) Global Research
has lowered its expectations going into 2015, noting that fixed
income returns in general should be limited. Our caution on
high yield in particular is driven by rising interest rates
and a pickup in issuer defaults, which should cause the
spread between high yield and Treasury yields to widen.
The zero interest rate policy and aggressive easing of the Fed
have been a blessing for fixed income investors over the past
five years, especially those lower on the credit-quality spectrum.
However, our forecast for interest rates to begin rising later next
year means bond prices will face pressure.
In addition, BofAML Global Research expects default rates to
pick up slightly in 2015, with a forecast of 2.0% to 2.5% – a low
number by historical standards, and not yet concerning. However,
the steep drop in crude oil prices is pressuring energy companies
in the high yield space, and defaults in that sector would weigh
on the overall index. In addition, the combination of low yields
and tight spreads leaves lower-rated high yield bonds (such as
B and CCC-rated issues) offering little compensation for default
and rate risks.
Exhibit 3: Despite the recent selloff, high yield bond yields
remain low
ML High Yield Index
Yield-to-Worst (%)
25
ML Treasury Master Index
20
15
10
5
0
1994
1997
2000
2003
2006
2009
Source: Bloomberg, MLWM Investment Management & guidance. Data as of
December 11, 2014.
CIO REPORTS • The Weekly Letter
2012
The spread between the yields of high yield bonds and
Treasuries reflects the added return investors receive in
exchange for taking on greater risk. In the past three years
the strong financial performance of companies rated below
investment grade and the relentless search for income have
boosted demand for high yield bonds, pushing yields down (see
Exhibit 3). Despite the recent selloff driven overwhelmingly by
the energy sector, they remain below their long-term average.
Further reversion toward average levels could mean additional
price declines.
Investors should expect more volatility
Since the great recession, increasing regulation and risk aversion
on the part of banks have led to a reduction in broker/dealer
inventory, resulting in lower trading volumes for high yield bonds.
We expect the trend of low liquidity to continue, amplifying any
volatility, as leaner balance sheets leave dealers with less capacity
to absorb inventory during periods of market stress.
In addition, given the recent selloff some high yield bond funds
are currently down on the year. Tax-loss selling could potentially
add further pressure as 2014 comes to an end. The proportion
of high yield bonds owned by retail investors has ballooned
since the global financial crisis and currently makes up more
than 25% of the market. This is likely to continue to exacerbate
any selloffs, as retail investors are generally quicker to flee the
market when faced with volatility.
Portfolio Strategy: Although we maintain our favorable
view of high yield in the near-term, we caution investors
to consider the risks involved in purchasing bonds of
lower-quality companies. Each situation is unique, but
the maximum exposure to high yield we would typically
advise for most U.S. investors should not exceed 9% of
a fixed income allocation and 3% of a balanced portfolio.
Given the increased likelihood of defaults, as well as the
greater dispersion of returns among different segments
of the market, we advise investors who want exposure to
the space to consider active managers with a proven track
record and experienced credit research team.
One category within high yield debt we favor is senior
loans. The S&P/LSTA U.S. Leveraged Loan 100 Index has
roughly a third of the exposure to energy companies that
the high yield indexes do, and should therefore be less
influenced by volatility in oil prices. Senior loans should also
be supported by demand for higher quality, as credit ratings
within the segment are generally higher than for high
yield bonds, and some senior loans are even considered
investment grade. Lastly, loans are generally less sensitive
to rising interest rates as they typically have a floating
coupon component.
2
Markets in Review
Equities
Trailing Economic Releases
n
U.S. retail sales gained 0.7% month-over-month (MoM) in November, more
than expected, after rising 0.3% the prior month. Auto sales jumped and were
likely partially offset by a decline in gasoline spending due to the recent drop
in price. Core retail sales, which exclude autos, gasoline, building materials and
food, also increased more than expected, by 0.6% MoM following a 0.5% rise
in October.
n
The University of Michigan Consumer Sentiment Index rose to 93.8 in
December, beating expectations of 90.0 and gaining significantly from 88.8 in
November. Signs of labor market strength in growing payrolls and falling prices
at the gas pump likely supported consumer confidence.
n
Growth in euro-area industrial production in October slowed to 0.1% MoM
on a seasonally adjusted basis, after a 0.6% gain the prior month. Industrial
production in Germany disappointed, and it declined in France and Italy by
more than forecast. There are increased expectations of further easing by the
European Central Bank in the new year through sovereign bond purchases.
S&P 500 Sector Returns (as of last Friday’s market close)
Consumer Discretionary
Consumer Staples
Energy
Financials
Healthcare
Industrials
Information Technology
Materials
Telecom
Utilities
-2.2%
-2.0%
-8.0%
Total Return in USD (%)
WTD
MTD
YTD
-3.7
-2.9
6.7
-2.6
-2.9
12.7
-3.5
-3.1
10.5
-2.9
-2.7
5.9
-2.5
-1.7
0.2
-3.6
-3.7
2.8
-3.5
-3.9
-5.4
-4.8
-6.6
-4.2
Yield (%)
2.10
2.08
2.41
3.13
7.04
Total Return in USD (%)
WTD
MTD
YTD
0.7
0.2
6.4
1.9
0.9
11.3
0.5
0.5
9.7
0.7
-0.1
7.5
-2.1
-3.1
0.8
Fixed Income
ML U.S. Broad Market
U.S. 10-Year Treasury
ML Muni Master
ML U.S. Corp Master
ML High Yield
Commodities & Currencies
-2.9%
-2.9%
-4.2%
-3.4%
-6.2%
-5.7%
0.2%
-5.0%
DJIA
Nasdaq
S&P 500
S&P 400 Mid Cap
Russell 2000
MSCI World
MSCI EAFE
MSCI Emerging Mkts
Level
17,280.8
4,653.6
2,002.3
1,402.4
1,152.4
1,675.0
1,767.1
938.4
0.0%
Prior Week
5.0%
Bloomberg Commodity
Gold Spot 1
WTI Crude $/Barrel 1
Level
223.1
1,222.5
57.8
Level
EUR/USD
USD/JPY
Current
1.25
118.8
Total Return in USD (%)
WTD
MTD
YTD
-1.3
-1.9
-11.9
2.5
4.7
1.4
-12.2
-12.6
-41.3
Prior
Prior
2013
Week End Month End Year End
1.23
1.25
1.38
121.5
118.6
105.3
Source: Bloomberg. 1Spot Price Returns. All data as of last Friday’s close.
Past performance is no guarantee of future results.
Looking Ahead
The report on the consumer price index (CPI) for the U.S. in November is likely to show
a slight decline, while for the euro zone it should be unrevised from the preliminary
estimate. At the December meeting of the Federal Open Market Committee no rate
change is expected, however a clarification on policy guidance is possible.
Upcoming Economic Releases
We await the following market developments coming Wednesday:
n
We expect no change in rates from the FOMC meeting, but believe the Fed may
re-evaluate the U.S. economic outlook and adjust its policy statements. We are
looking in particular for whether the Fed acknowledges low inflation, which would
imply a later start in raising rates.
n
n
BofA Merrill Lynch Global Research
Key Year-End Forecasts
S&P Outlook
S&P 500 Target
EPS
Real Gross Domestic Product
2015 E
3.2%
3.7%
U.S.
2.3%
3.3%
Euro Area
Emerging Markets
0.8%
4.3%
1.2%
4.5%
U.S. Interest Rates Fed Funds
10-Year T-Note
CIO REPORTS • The Weekly Letter
2,200
$124
2014 E
the previous month. Core CPI, which excludes food and energy, is expected to be
up 0.1% after falling 0.2% in October. Various measures of inflation have been
soft over the last few months.
preliminary estimate of a 0.3% YoY gain. The increase in the core CPI is expected
to be unrevised at 0.7% YoY. As economic indicators continue to deteriorate,
deflationary risks increase, leading to greater expectations of further monetary
stimulus from the European Central Bank.
2015 E
2,000
$118
Global
We expect that the U.S. CPI fell by 0.1% in November after remaining unchanged
The November euro-zone headline CPI should remain unchanged following a
2014 E
Commodities
2014 E
2015 E
0-0.25%
2.40%
0.50-0.75%
2.75%
2014 E
2015 E
Gold
1,272
1,225
WTI Crude Oil
$93.5
$77
All data as of last Friday’s close.
3
Office of the CIO
Ashvin B. Chhabra
Chief Investment Officer, Merrill Lynch Wealth Management
Head of Investment Management & Guidance
Mary Ann Bartels
Christopher J. Wolfe
CIO, Portfolio Solutions,
U.S. Wealth Management
CIO, Portfolio Solutions,
PBIG & Institutional
Hany
Boutros
Sarah
Bull
Niladri “Neel”
Mukherjee
Adon
Vanwoerden
John
Veit
Vice President
Vice President
Director
Asst. Vice President
Vice President
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review for changes in your individual circumstances, including changes in market conditions and your financial ability to continue purchases.
Asset allocation and diversification do not assure a profit or protect against a loss during declining markets.
Investments in MLPs in the energy sector will be subject to more risks than if the investment were broadly diversified over numerous sectors of the economy. A downturn in the energy
sector of the economy could have a larger impact than on an investment that does not concentrate in the sector. At times, the performance of securities of companies in the sector may lag
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Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any
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categories. Investments in foreign securities involve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic
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