INCOME INVESTING Managing fixed income late in the credit cycle: navigating the path forward nuveen knows 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 2Q19 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. Bill Martin Tony Rodriguez Head of Global Fixed Income Head of Fixed Income Strategy nuveen knows income investing / 2Q19 1 Why is the stage of the credit cycle important for fixed income investors? And where are we now? The credit cycle tracks the expansion at the end of the credit cycle, and Consumers remain in good shape and contraction of access to credit we see compelling opportunities for as it relates to household balance over time. It influences the overall investors across the vast and diverse sheets and spending power, but economic cycle because access to global fixed income markets. corporate debt levels have reached credit affects a company’s ability historic highs. There is no rule covering how long a to invest in their business and cycle can last: Credit cycles don’t just We suggest combining a broad view drive economic growth. Over time, end with age. While some parts of across sectors with deep analytical performance of sectors such as the U.S. and global economy appear resources to navigate the credit investment grade corporate bonds, to be in the late cycle, others do not. markets. All in all, there is no obvious high yield corporate bonds, leveraged Global economic weakness remains indicator that the cycle is about to loans, emerging markets corporate a concern, and the effects of further shift from “expansion” to “downturn,” debt and preferred securities is linked trade tensions and tariffs can shift as shown in Figure 1. directly to the credit cycle. While we sentiment and stifle economic growth think we are in the late stage of the should the worst outcomes manifest. cycle, this is not the same as being Figure 1: Credit cycle in the late expansion stage FALLING LEVERAGE Repair Recovery • Debt repaid/balance sheets strengthened • Restructuring boosts profit margins • Leverage declines • Leverage falls HIGHER GROWTH • Focus on cost cutting and cash generation • Free cash flow grows Downturn Expansion LOWER GROWTH • High leverage • Leverage rises • Lower earnings • Speculative and M&A activity increases • Recessions or falling asset prices • Volatility increases • Defaults spike • Credit cycle peaks We are here! RISING LEVERAGE 2 nuveen knows income investing / 2Q19 How can an active fixed income strategy add value in this environment? At Nuveen, we firmly believe that an We believe that active management the market increases, so does an actively managed bond strategy can aids in reducing excesses that index’s (and, consequently, a passive add value in any environment, but accumulate over an economic cycle strategy’s) exposure to them. is especially beneficial at the current and become embedded in market Active managers can potentially stage of the credit cycle. While the indexes. For example, there has been reduce risk not only by managing likelihood of a recession is based on a significant increase in BBB-rated position sizes, but by capturing a number of factors, the exact timing bonds (the lowest rating of bonds undervalued opportunities that is almost always a surprise and can still considered investment grade) in happen to fall outside of traditional be driven by a geopolitical shock, the corporate bond market since the indexes. We see ample opportunity to policy shock or other events that financial crisis (see Figure 2). This identify mispriced bonds and sectors, change the landscape on short notice. is a potential risk associated with a yield enhancers and diversifiers that Active managers have the flexibility passive approach. That’s because, are excluded from indexes because of to protect investor capital and take in fixed income indexes, securities their deal size, issuer type, structure advantage of potentially wider are weighted by the market value or maturity. Such opportunities spreads that arise from such shocks, of the outstanding debt, so issuers provide the potential for excess unlike passive approaches that must with the most debt comprise more of return over the index, as well as stay closely aligned with their selected the index. When the concentration risk management. index and its associated methodology. of weaker corporate securities in Figure 3: Guide to credit ratings Figure 2: The amount of BBB-rated bonds has increased Rating Description significantly since 2008 AAA BBB exposure in U.S. investment grade corporate market AA Investment grade A BBB BB B Below investment grade CCC % % 33.1 51.2 D In default 2008 2018 Source: Nuveen 31 December 31 December Source: Bloomberg, as of 31 Dec 2018. nuveen knows income investing / 2Q19 3 How should Sector views from our fixed income portfolio managers investors prepare for late-cycle dynamics? What INVESTMENT GRADE CORPORATE BONDS are the investment s we entered 2019, risk assets were heavily oversold and implications across valuations appeared attractive resulting from the “risk-off” corporate credit A sentiment that was prevalent late in 2018. However, an improving macroeconomic environment, a more dovish stance from the Federal sectors? Reserve (Fed), and expected progress on U.S. and China trade have supported a relatively dramatic rebound in asset values across the board. In the near term, we don’t expect further spread tightening in the We are comfortable investing in investment grade corporate sector, as credit spreads have reached our the credit markets at this stage near-term forecasts. However, fundamentals are generally healthy, and we of the credit cycle, given the expect supply to drop in the coming year, supporting yields for investment collective judgment of our research grade corporate bonds. Strategically, we continue to prefer the financials and investment teams. We think sector over non-financials given their strong capital positions relative investors should focus on higher- to event risk, such as M&A activity. Tactically, we see value in banks, quality issues with improving telecommunications, higher-quality energy and autos, but have a less credit fundamentals. Industry and favorable view on most other industries in the sector. geographical diversification also remain critically important. We think the market’s concerns over BBB-rated concentration risk is overblown, and we are not overly concerned about “fallen angel” risk. Our sector specialist teams are Many corporate issuers that have increased debt levels for mergers and finding attractive opportunities in acquisition (M&A) activity have indicated plans to reduce that debt. In the U.S. credit sectors, including high event of an economic slowdown, these issuers have many levers to pull to yield, but they are increasingly avoid a downgrade to high yield, such as cutting dividends, reducing capital diversifying into other higher-income spending, and curtailing share buybacks. We think investors should be areas, such as emerging markets debt more vigilant about managing exposures to single-A issuers that may risk and leveraged loans. The following dropping to BBB for the sake of M&A transactions or other shareholder- sections highlight the current views friendly initiatives. of our highly experienced, sector- focused portfolio managers. What is a A fallen angel is a bond that was issued with an “fallen angel” investment-grade rating (BBB or higher) but has since bond? been downgraded to below investment grade due to the weakening financial condition of the issuer. Fallen angels can include corporate, municipal or sovereign issuers. Initial ratings