BofA Merrill Lynch predicts continued high-grade outflows, gains for high yield, Fed taper in 2014

By Andrea Heisinger

New York, June 12 - Bank of America Merrill Lynch analysts are predicting that the Federal Reserve will not taper its quantitative easing activities until 2014 and that the rotation out of high-grade bonds into equities will continue, according to statements at the bank's Global Research press conference in New York on Wednesday.

Short term, there is a lot of risk with talk of the Fed tapering and higher interest rates, along with spreads that are back at 2003 levels, said credit strategist Hans Mikkelsen.

"Credit spreads have widened on both high grade and high yield," he added. "Even some of the most patient investors have been buying at higher rates."

Ethan Harris, co-head of global economics research at the bank, said the Fed is not tapering in 2013, and if they do, it will be a technical adjustment.

"There's a 30% chance they'll cut back on the buyback this year," Harris said.

One of the biggest risks at the moment is the rotation out of high-grade bond funds, Mikkelsen said, adding that as soon as there is some stabilization of rates, there will be a rebound of inflow into high-yield funds.

"It will be hard for investment-grade funds to recover inflows," he said.

Investors should position for spread compressions, Mikkelsen said. BofA Merrill Lynch is also recommending investing in high-yield over high-grade bonds among U.S. issuers. European investment-grade names are favored over U.S. high-grade issuers.

Michael Hartnett, the bank's global research chief investment strategist, said that they are underweight on bonds.

With the recent drop in the 10-year Treasury yield, it's "hard to be constructive on bonds," Hartnett said. He added that the only area the bank is long on is high yield.

Banks have been the best-performing sector of the past 18 months in both equities and high grade, he said.

One of the largest risks seen recently is the "bit of a crash" in the past couple of weeks in the bond market, Hartnett said.

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