Managing fixed income late in the credit cycle: navigating the path forward
- While we are clearly in the late stage of the credit cycle, we don’t think a recession is imminent and believe investors should feel comfortable investing in credit markets throughout the rest of 2019.
- We believe investors should focus on higher-quality issues with improving credit fundamentals, while seeking to diversify across industries and geographies.
- Nuveen’s sector specialist teams are finding attractive opportunities in U.S. credit sectors, including high yield, but they are increasingly diversifying into other higher-income areas, such as emerging market debt and leveraged loans.
- Active management can add value in any environment, but we believe it is especially beneficial at the current stage of the credit cycle.
The multi-trillion-dollar question for investors: How late are we in the credit cycle, and what are the portfolio implications?
That’s the question we most often hear from our clients. And while there are few certainties in life or markets, we feel confident in our answer: We are clearly in the late stage of the credit cycle. But “late” doesn’t mean “done,” and credit cycles don’t die of old age. Rather, a combination of fundamentals and sentiment bring about their demise, and even in their later stages, savvy investors can find opportunities not only to protect their investments, but to position their portfolios for an emphasis on income as the cycle turns.
Nuveen believes most investors should be comfortable investing in the credit markets throughout the rest of 2019. But an increasing preference for higher-quality issuers and diversification across sectors and countries seems wise.
In this article, we ask investment professionals across our broad platform of fixed income specialists — who collectively manage approximately $400 billion in assets for clients — to assess risks and opportunities in all corners of the credit markets.1
We hope you enjoy this issue of Nuveen knows and we encourage you to contact your Nuveen representative with any questions, views or needs.
Why is the stage of the credit cycle important for fixed income investors? And where are we now?
The credit cycle tracks the expansion and contraction of access to credit over time. It influences the overall economic cycle because access to credit affects a company’s ability to invest in their business and drive economic growth. Over time, performance of sectors such as investment grade corporate bonds, high yield corporate bonds, leveraged loans, emerging markets corporate debt and preferred securities is linked directly to the credit cycle. While we think we are in the late stage of the cycle, this is not the same as being at the end of the credit cycle, and we see compelling opportunities for investors across the vast and diverse global fixed income markets.
There is no rule covering how long a cycle can last: Credit cycles don’t just end with age. While some parts of the U.S. and global economy appear to be in the late cycle, others do not. Global economic weakness remains a concern, and the effects of further trade tensions and tariffs can shift sentiment and stifle economic growth should the worst outcomes manifest. Consumers remain in good shape as it relates to household balance sheets and spending power, but corporate debt levels have reached historic highs.
We suggest combining a broad view across sectors with deep analytical resources to navigate the credit markets. All in all, there is no obvious indicator that the cycle is about to shift from “expansion” to “downturn,” as shown in Figure 1.
How can an active fixed income strategy add value in this environment?
At Nuveen, we firmly believe that an actively managed bond strategy can add value in any environment, but is especially beneficial at the current stage of the credit cycle. While the likelihood of a recession is based on a number of factors, the exact timing is almost always a surprise and can be driven by a geopolitical shock, policy shock or other events that change the landscape on short notice. Active managers have the flexibility to protect investor capital and take advantage of potentially wider spreads that arise from such shocks, unlike passive approaches that must stay closely aligned with their selected index and its associated methodology.
We believe that active management aids in reducing excesses that accumulate over an economic cycle and become embedded in market indexes. For example, there has been a significant increase in BBB-rated bonds (the lowest rating of bonds still considered investment grade) in the corporate bond market since the financial crisis (see Figure 2). This is a potential risk associated with a passive approach. That’s because, in fixed income indexes, securities are weighted by the market value of the outstanding debt, so issuers with the most debt comprise more of the index. When the concentration of weaker corporate securities in the market increases, so does an index’s (and, consequently, a passive strategy’s) exposure to them.
Active managers can potentially reduce risk not only by managing position sizes, but by capturing undervalued opportunities that happen to fall outside of traditional indexes. We see ample opportunity to identify mispriced bonds and sectors, yield enhancers and diversifies that are excluded from indexes because of their deal size, issuer type, structure or maturity. Such opportunities provide the potential for excess return over the index risk management.
How should fixed income investors prepare for late-cycle dynamics? What are the investment implications across corporate credit sectors?
We are comfortable investing in the credit markets at this stage of the credit cycle, given the collective judgment of our research and investment teams. We think investors should focus on higher-quality issues with improving credit fundamentals. Industry and geographical diversification also remain critically important.
Our sector specialist teams are finding attractive opportunities in U.S. credit sectors, including high yield, but they are increasingly diversifying into other higher-income areas, such as emerging markets debt and leveraged loans. The following sections highlight the current views of our highly experienced, sector-focused portfolio managers.