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Nuveen knows: Income investing

 

Managing fixed income late in the credit cycle: navigating the path forward

 

 

Highlights
  • 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.


Figure 1: Credit cycle in the late expansion stage

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.

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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.