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Nuveen knows: Income investing

 

Positioning credit investments in portfolios

 

When deciding the amount and types of credit sectors to include in a portfolio, investors should distinguish between strategic, longer-term allocations and more tactical, shorter-term positioning. Regardless of time horizon, we think investors would benefit from working with active managers who have proven track records in risk management when determining these allocations, particularly in the late stages of the credit cycle.

Strategic allocation view

 

The amount of credit exposure to hold within a strategic fixed income allocation depends on an investor’s intended long-term outcome. For growth investors, the fixed income allocation should provide attractive risk-adjusted returns over time and diversify the overall equity risk of the portfolio.

Diversified credit sectors such as high yield bonds, leveraged loans, preferred securities and emerging markets debt have shown to diversify core bonds and improve risk-adjusted returns over various time periods (see Figure 7). For most growth investors, we believe that the appropriate allocation to a diversified basket of credit sectors falls somewhere in the range of 15-30% of the total fixed income allocation. The remaining fixed income should be allocated to core fixed income strategies, which are designed to diversify equity risk and mitigate portfolio volatility.

 

Income investors should place higher emphasis on the current income a portfolio can generate, typically measured by current yields. We think investors should consider increasing their allocation to diversified credit sectors to meet their income goals, but to do so cautiously given that the higher allocation to certain credit sectors may increase portfolio sensitivity to equity market swings.

Tactical allocation view

 

Over the next six to 12 months, we see more attractive risk-adjusted return prospects from taxable investment grade credit than from U.S. high yield bonds, as late cycle dynamics may create increased price volatility in lower-quality sectors. With regard to leveraged loans, we expect the U.S. Treasury yield curve to remain flat, or even bull steepen (where short rates fall more than long rates) if the Fed reverses course and decides to cut rates in 2019.7 If this plays out, it may create a ceiling on leveraged loan demand.

Shifting from low- to high-quality fixed income would mean that investors would be accepting lower yields in an effort to better protect principal. For income investors who wish to maintain higher yield levels, we suggest over-weighting emerging markets debt, given that higher credit quality than U.S. speculative grade credit, attractive valuations, and (in our view) a U.S. dollar stabilized by accommodating monetary policy could create tailwinds for the remainder of 2019. For income investors comfortable with added U.S. equity market volatility, allocating to preferred securities is another way to increase credit quality, but without sacrificing as much yield when compared to investing in investment grade corporate bonds. For tax-sensitive income investors, we continue to see value in longer-dated municipals as well, including high yield municipals, which remain attractive based on AAA/U.S. Treasury yield ratios and favorable supply/demand dynamics.

 

Putting it all together

 

Following are our summary views for how investors may want to consider constructing portfolios in the latter stages of the credit cycle:

  • We believe the current economic cycle still has room to run, and see no evidence that we will see a near-term end to the credit cycle.
  • As such, our fixed income portfolio managers see select opportunities in diversified credit sectors such as leveraged loans, preferred securities and emerging market debt.
  • Above all, retain a focus on research-based active management, which has the flexibility and nimbleness to seek out opportunities across sectors, credit qualities and geographies.


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Endnotes

1 Assets under management as of 31 Dec 2018.

2 Source: Nuveen.

3 Source: Morningstar, as of 21 Mar 2019.

4 Ibid.

5 Source: IMF as of Oct 2018. Percent of global gross domestic product (GDP) is based on purchasing power parity (PPP).

6 S&P LCD.

7 As of 4 Apr 2019.

 

Glossary

Beta is a measure of the variability of the change in the share price for a fund in relation to a change in the value of the fund’s market benchmark. Securities with betas higher than 1.0 have been, and are expected to be, more volatile than the benchmark; securities with betas lower than 1.0 have been, and are expected to be, less volatile than the benchmark. Bloomberg Barclays U.S. Aggregate Index represents securities that are SEC registered, taxable and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities and asset-backed securities. Bloomberg Barclays U.S. High Yield 2% Issuer Capped Index tracks the performance of U.S. non-investment-grade bonds and limits each issue to 2% of the index. Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the USD-denominated, high-yield, fixed-rate corporate bond market. Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. Loans are added to the index if they qualify according to the following criteria: The highest Moody’s/S&P ratings are Ba1/BBB+, only funded term loans are included, and the tenor must be at least one year. Duration measures how long it takes, in years, for an investor to be repaid a bond’s price by total cash flows. Generally, for every 1% change in interest rates, a bond’s price will change approximately 1% in the opposite direction for every year of duration. Earnings before interest, tax, depreciation and amortization (EBITDA) is a measure of a company’s operating performance. Essentially, it’s a way to evaluate a company’s performance without having to factor in financing decisions, accounting decisions or tax environments. First lien is the first to be paid when a borrower defaults and the property or asset was used as collateral for the debt. A first lien is paid before all other liens. ICE BofA Merrill Lynch Core Plus Fixed Rate Preferred Index is designed to replicate the total return of a diversified group of investment-grade preferred securities. ICE BofA Merrill Lynch U.S. All Capital Securities Index is a subset of the ICE BofA Merrill Lynch U.S. Corporate Index including all fixed-to-floating rate, perpetual callable and capital securities. JPMorgan Emerging Markets Bond Index (EMBI) Global tracks total returns for U.S.-dollar denominated debt instruments issued by emerging market sovereign entities. Leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. Russell 3000 Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market. S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. S&P/LSTA Leveraged Loan Index is a market value-weighted index designed to measure the performance of the U.S. leveraged loan market based upon market weightings, spreads and interest payments. Sharpe ratio (risk-adjusted return) is a risk-adjusted return measure calculated using standard deviation and excess return to determine reward versus unit of risk. The higher the Sharpe ratio, the better the historical risk-adjusted performance.

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain "forward-looking" information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible. 

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. 

 

A word on risk

 Investing involves risk; principal loss is possible. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, derivatives risk, dollar roll transaction risk and income risk. As interest rates rise, bond prices fall. Below investment grade or high yield debt securities are subject to liquidity risk and heightened credit risk. The guarantee provided by the U.S. government to treasury inflation protected securities (TIPS) relates only to the prompt payment of principal and interest and does not remove the market risks of investing in the fund shares. Preferred securities are subordinated to bonds and other debt instruments in a company’s capital structure and therefore are subject to greater credit risk. Foreign investments involve additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. Asset-backed and mortgage-backed securities are subject to additional risks such as prepayment risk, liquidity risk, default risk and adverse economic developments.

The investment advisory services, strategies and expertise of TIAA Investments, a division of Nuveen, are provided by Teachers Advisors, LLC and TIAA-CREF Investment Management, LLC. Nuveen Asset Management, LLC is a registered investment adviser and affiliate of Nuveen, LLC.

 

This information does not constitute investment research as defined under MiFID. In Europe this document is issued by the offices and branches of Nuveen Real Estate Management Limited (reg. no. 2137726) or Nuveen UK Limited (reg. no. 08921833); (incorporated and registered in England and Wales with registered office at 201 Bishopsgate, London EC2M 3BN), both of which entities are authorized and regulated by the Financial Conduct Authority to provide investment products and services. Please note that branches of Nuveen Real Estate Management Limited or Nuveen UK Limited are subject to limited regulatory supervision by the responsible financial regulator in the country of the branch.