Solutions - Putting It Together
March 25, 2019
Tony Rodriguez: Good afternoon, and welcome to Nuveen's live event hosted by Asset TV, Income Investing: Strategies for Sustainable Income. I'm Tony Rodriguez, Taxable Fixed Income CIO for Nuveen Asset Management. I'm delighted to be joined today by a group of my colleagues from around Nuveen: Katherine Renfrew, Global Fixed Income Portfolio Manager for TIAA Investments; Doug Baker, Head of Preferred Securities for Nuveen Asset Management; and Purva Patel, Senior Vice President and Client Portfolio Manager for Nuveen Asset Management. Thank you for joining us today.
Tony Rodriguez: Over the next hour, we'll be looking at some of the broader themes affecting income investors, and strategies to address those concerns. As a reminder, this is a live, interactive session, so I encourage you to ask your questions to our panel by submitting them in the field on your computer screen. We'll be fielding audience questions throat today's show. Let's start with some of the key concerns income-seeking investors face. There are four in particular that we hear often from investors: rising rates, low yields, higher volatility, and modest spreads or risk premiums. We believe that under these conditions investors need to take advantage of the only free lunch in investing -- diversification.
Tony Rodriguez: In a low yield and rising rate market, diversifying sources of income beyond traditional bond investments may help you earn sufficient income and reduce interest rate sensitivity when rates rise. Investors should keep in mind that traditional bond market benchmarks such as the Bloomberg Barclays Aggregate Index have significant weights to US Treasuries and agencies. These more traditional sources of income are sectors with low yields and therefore limited income for investors, long durations and therefore high sensitivity to rising rates, and they make up almost 45% of the benchmark.
Tony Rodriguez: We believe it's important to an active manager in the fixed- income market, and diversify your sources of income beyond traditional bonds. These areas may include investment-grade corporates', asset-backed securities, high-yield bonds, leveraged loans, emerging markets, foreign bonds, and preferred securities. In addition to higher income, these diversifiers have been less sensitive to rising rates compared to traditional bonds. Today, with Katherine and Doug, we'll examine a few of these sectors more closely.
Tony Rodriguez: We also believe it's important for income investors to remember that it's not what you earn, it's what you keep. The municipal bond market can provide attractive, after-tax income, high-quality investments, low correlation to equities, in large diversification benefits to an investor's portfolio. We'll take a closer look at the muni market today with Purva. Let's get started, and we'll take a look at the big picture today. Doug, what your outlook for the US economy, and where are you seeing opportunities in the fixed-income markets today?
Doug Baker: Yeah, this has been kind of an interesting topic as of late with the recent pullback in the equity markets, high yield spreads finally grinding a bit wider. We're starting to get questions on, "Is the recession around the corner?" But we're quick to point out that domestic growth is really still quite robust. Now, our outlook is that this growth is likely to trail off as the benefits from fiscal policy and tax breaks, though start to wane, but at the end of the day, we're really not looking for any sort of recession over the next year, year and a half.
Doug Baker: The fundamentals, we think, are still very constructive, especially for credit product, and we look at recent spread widening, recent pullback in equities, as probably an opportunity for investors to take some risk. Especially, in our space, talking about preferred emerging markets, high-grade credit, high-yield loans. Given that over the past 4 to 5 weeks we haven't seen a real change in fundamentals, the spreads widening I think really are giving as an opportunity. So, we're encouraging investors to maybe at least start considering dollar cost averaging any of these categories if they already have exposure.
Doug Baker: We're not saying and calling this as a bottom because there's also some geopolitical headline that we'll probably talk about a little bit later that are going to continue to add volatility to the market, and probably add other opportunities for entry. From our perspective, we think that actually the recent market moves are an opportunity, especially in fixed income and in the credit categories of fixed income.
Tony Rodriguez: Similar to what we said about diversification, it's probably important for people not to try to top the market or find the bottom. Averaging in is a great approach to looking at the opportunity, right?
Doug Baker: I agree 100%. One of the other questions we get today is, "Where is the big opportunity?" And in all honesty, we're not looking out there in the marketplace in fixed income, and finding one that jumps out above and beyond all other categories. In that type of environment, what we're recommending is that people, "Spread your chips out on the table. Let diversification work for you, and put yourself in a position where you're earning income, you're getting paid to wait for those opportunities to develop."
Doug Baker: From our perspective, that should also help individuals the are concerned about rising rates because, typically, credit product or credit categories in fixed income will provide some buffer against a rising rate environment. We do think at this point in time there are a lot of benefits for investors to look at the fixed-income opportunity today, and not only was an opportunity for them to earn income in their portfolio, it might also act as some protection against one of the biggest risks to fixed income, which would be rising rates which still seems to be a topic of conversation.
Tony Rodriguez: Sure, so looking at the US economy, now let's try to take a little wider picture. Katherine, how about the global economy, what you're seeing there in terms of laying the table out here for what's [00:06:00] happening in the markets?
Katherine Renfrew: Thanks, Tony. We've had I believe a slowdown in EM, and in particular, emerging markets' spreads had already widened out. In terms of the global outlook, while we started off the year pretty constructive and that there was a lot of synchronization in OECD countries, we've seen a bit of a slowdown, but as you pointed out, US is really still pretty strong, and even though the late cycle part of this economy seems to be coming closer and closer, we still don't see a real full-fledged recession call yet in 2019.
Katherine Renfrew: We're still have kind of more tailwinds than headwinds from the US. That's a very good, at least for global growth ... one of the issues has been that we got a little bit too enthusiastic about emerging market prospects, and there is a bit of a slowdown, there were some idiosyncratic, I would call them, speed bumps, but in general, our spreads are wide, valuations are good, and actually the anchored credit quality ratings of ... if you look at them at a broad index, they look very attractive when you look at the risk.
Katherine Renfrew: Emerging markets ranges from the low-investment grade up to the upper quality, and we have one phenomenon where we're going to see some Gulf entries as constituents into the benchmark. That means that that benchmark being BB+, so we're often compared to high yields, but our spreads are much wider and we have 50% of our opportunity set is in investment grade. Even there, when you compare just the investment-grade portion of our index to investment-grade credit opportunities in the US, you're getting very nice, attractive risk-adjusted returns.
Katherine Renfrew: Yes, volatility has picked up, headline noise has picked up, but we see this as still a good opportunity in the broad array of emerging markets. Clearly, you are going to have to be diversified. As you point out, it's not just across asset classes, but within the asset class it's very important. And now emerging markets is not so concentrated at least in the dollar-opportunity space.
Katherine Renfrew: It also lends itself well, for those who no corporate credit, to actually exploit that segment, which is as large as the hard currency sovereign segment, so we're finding it attractive, but obviously, the global macro -- slowing? Sure, but presenting an issue or a risk the way that we've seen in past cycles where you had the US, where you're worried about the US growth, and Europe, existential crisis, and we're not seeing those.
Katherine Renfrew: We're seeing some tail off, some slowdown in Europe. We don't expect that to be any reason to really alter our course. We have dialed down some of the tail ends of the risk spectrum. We're narrowing our risk-taking. We do acknowledge that we're in a late stage, and that as the US might start to slow down, you'll see some risk off, but we still think it's very attractive valuation-wise.
Tony Rodriguez: So, kind of a similar story. A little bit of moderation and growth in the US and in global, but not imminent recession, not the end of the cycle just yet. Looking at that macro picture, Purva, how do you think that's impacting kind of the municipal market and stay local fiscal health?
Purva Patel: Sure, our market is even more local focused, so a lot of what we spend our time on is fundamental credit research, and I think that's always going to be an important part of deciphering where value is in the municipal bond market. I totally agree with both Katherine and Doug, in that, yes, we might see a slowdown in US growth, but it's not going to be for some time, and during that time period we are getting paid to wait even in the municipal bond market, even with our tax free yields.
Purva Patel: In fact, on the long end of our curve right now, we're using about 100% of what US Treasuries are yielding, and that's a tax-free yield compared to a taxable yield. We think that long in that the curve is looking pretty cheap, and the intermediate spot on the curve, we're about fair value, but still the tax-free nature of the interest income is still going to continue to buoy us in terms of good performance in the marketplace.
Purva Patel: We also haven't seen these kinds of yields in years, and so when Doug's talking about dollar cost averaging into this type of market, I think I would absolutely agree with that because it's something ... these kinds of yields, we haven't come around for at least five years now, at least in the municipal bond market. We're excited to be able to put reinvestment money back to work at higher yields.
Tony Rodriguez: Good. Let's narrow the focus a little bit. A lot of investors are concerned, and there's a lot of news about trade tensions, geopolitical risk. Are they passing headlines do we think? Are they going to have long-lasting effects on the political landscape or the economy? Katherine, how are you seeing those specific risks?
Katherine Renfrew: Bigger and bigger. At least with respect to emerging markets, which has had to react much more to just US statements than in past times. I think we have reached kind of an inflection point, where like 20 years of pretty much moving towards open trade, now we're moving towards more of a closed-trade environment that protectionism has always been cited by us as a risk in the marketplace. I think it's happening gradually, so sometimes the overreactions of the market create opportunities for us, and we think that, as an example just today, there was a pleasant tweet from the US about China development. That can send markets, especially in FX, strongly tighter, where the Chinese Yuan strengthened.
Katherine Renfrew: Those are just examples, where markets are more riveted and more keyed on different forms of communication dissemination, which we really have to be used to. Emerging markets has always been an active ... we're global, so we have to respond to global developments overnight, but now it's often coming from the US, not from overseas. It's definitely something we're watching. I think, again, if you're diversified and if you can have an active team that does credit fundamental analysis, sovereign experts, which we have, we have a great research team, that's going to lend itself well the picking out what's just headline noise and what we really need to respond to in shaping a portfolio.
Tony Rodriguez: Right. Doug, what's your take on trade and geopolitical?
Doug Baker: I agree with everything that was just said. I think one of the other kind of components these you political headlines, is that they introduce the unknown into the marketplace, and I think that financial markets do a very poor job processing a lack of information. They can't assign risk, they can't assign a price, and so as we get some of these headlines behind this between now and, say, the end of the first quarter, all else equal, I think that that should be constructive for the markets.
Doug Baker: It's not so much what the outcome is, it's just the fact that we're going to have a data point, we're going to have some clarity, and that should be good for both the credit markets, the equity markets, but between now and then I think we're going to have a lot of volatility based off of things like trade tensions between the US and China, Brexit. We're getting kind of headlines that seem somewhat bullish over the past day, only to have somebody come out and say, "No, that's not the case."
Doug Baker: Then, obviously, over the next couple weeks, Italy's going to have to respond back to the EU with their budget. So, this may not be such a long-lasting, permanent type of situation. It may be this short batch of volatility, and once we get this behind us, the markets, I think, can get their feedback underneath them. They'll have information to process to assign risk to price, and I think actually just getting that information will be constructive overall for the financial markets.
Tony Rodriguez: Great. Thanks. So, the calendar's flipped to November, which means the midterm elections are less than a week away. Let's start with you, Purva. Do you think they'll be a shift in Congress, and how do you think that's going to impact the muni market and your portfolio positioning as a result?
Purva Patel: Well, I'm not going to predict if there's going to be a shift in Congress, but there's certainly a possibility, at least what the polls are showing is that perhaps the House flips but the Senate stays Republican, which would reduce a lot of gridlock in Washington, and I don't know how much will actually get done in terms of policy making. If that is the case, I think one of things that we're really looking for and if we see different types of results, that if the Republicans keep the House, and they continue to have the Senate as well, that could mean that the ACA is back on the docket in terms of debate and perhaps changing it, and that could affect the municipal sector of healthcare.
Purva Patel: At the local level, we're actually seeing several states voting on the potential for expansion on Medicaid, which could help the healthcare sector as well. Even our home state Illinois is looking at a governor's election, and so we are in the midst of that, and all the mudslinging that goes along with that, so that's going to be interesting, but the state itself has been struggling for quite some time. So, it will be interesting to see what kind of leadership takes over, and what kind of hard decisions they'll have to make financially for the state.
Purva Patel: At the city level, too, in the city of Chicago, the mayor decided not to run, Mayor Rahm Emanuel, and so we are looking at an election next year for that. That could have some credit indications for us in the municipal bond market. But as you look across the country, I think it's an interesting dynamic that's happening right now, where there are several states that are looking to raise taxes. For instance, Colorado and Arizona both have on the ballot higher income tax rates for the highest income earners in those states, and those revenues should go to funding education.
Purva Patel: Then on the flip side, you have some states like Florida and Oregon that are looking to reduce or limit their ability to raise taxes. All of this certainly has an effect on credit quality. In the municipal bond market, obviously, a lot of municipal debt is backed by taxes and property taxes, so we're keeping a close eye on some of these really local elections and the effect of back on credit quality.
Tony Rodriguez: How about you, Katherine? How about you think about the midterms and their impact?
Katherine Renfrew: Well, certainly it matters, and it matters to us because at least in the dollar space of emerging markets, the anchor is the US Treasury, and our sovereign index is slightly longer. It actually has a longer duration than, say, a high-yield complex. It's seven years, and the corporate space that I focus on mostly is a bit shorter. So, I think what we're really keyed on is the outcome and how it changes dynamics were kind of the fiscal prospects of the US, and whether or not that's likely to lead to even greater volatility, rising rates.
Katherine Renfrew: If you get like a growth infrastructure billow through, which could happen if you get more Republican leaning outcomes, that could have an impact, but it depends on the mix really, and the interpretation of how this administration then takes those results and acts. So, we think we know how certain parties might behave, but it's clear that we need to be more reactive. In that regard, we tried to make sure that we're not too far from the benchmarks and our benchmark products, but also being sensitive to risk.
Katherine Renfrew: In our space, a lot of emerging market credit spreads are actually quite steep, and so we like the long end at times, but we also realize that the amount of investor appetite for the long end of some of our complex is actually very risk sensitive. So, that's just something that we're watching, and it might have implications post the election.
Tony Rodriguez: Sure. How about you, Doug?
Doug Baker: Well, I think in my space we spend a lot of time looking at banks. So, banks are our largest sector in the preferred market, but I think banks obviously are large sector outside of the preferred space as well, and so what will the elections mean as far as, say, the regulatory environment because, obviously, that affects the credit quality of our domestic banks?
Doug Baker: We actually tell people even if the House were the flip, the assumption is that that will but a nice roadblock into the rollback of some crisis era legislation that's really clamped down on the risk taking that the banks could pursue otherwise, but the reality is even with the current administration and with Congress set up the way it is today, not much that's material has really gone through to meaningfully alter the credit profile of that sector. So, while at the margin it will probably mean that they're going to be more debates about rolling back pieces of Dodd-Frank era legislation, or things related to that. We don't think that really a change in Congress is going to make all that much of an impact.
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Doug Baker: Really a change in Congress is going to make all that much of an impact, that at the end of the day, whether you're Republican, whether you're a Democrat, you don't want your face on the poster that says you're bank friendly, even in this environment. So, I think that people are still, in general, reticent to have the stigma associated with them, and it's I think reasonable. That being said, I think we just want to make sure that we communicate with people that as far as the bank sector goes, that we don't see the elections really resulting in a meaningful shift in the credit profile of that sector.
Tony Rodriguez: Perfect. Well, let's start to dive into some of the specific areas that we mentioned we'd cover. We'll start with you, Katherine, on emerging markets. You've talked a little bit about maybe some of the broader trends, but feel free to add to that, but then also how do you take a look at emerging markets, sovereign, and corporate issuers as you're evaluating opportunities in the market?
Katherine Renfrew: Well, clearly the spectrum ranging from A rated down to even defaulted, it varies, but what we like to do is have a sovereign view that is formulated at the research level where they're comparing, basically, similarly rated types of credits, and both within their region. So, our analysts have a regional approach, and they analyze the credits, they make recommendations based on the spread premium that we're receiving, and the portfolio managers either act on the recommendations or they'll ... and generally put in that view.
Katherine Renfrew: The sovereign team and the corporate team actually interact a lot in our group, and then we think that that's extremely healthy, and one that is really vital to our success, and has actually I think allowed us to avoid a lot of bad situations where in emerging markets some of the bigger corporate and the sectors like banks can often have a big impact on the sovereign dynamics and vice versa. The sovereign can often overwhelm and dwarf what might be happening at a company. It might be all good, but if the macro isn't so great, that's going to impact the outcome.
Katherine Renfrew: So, our team is really analyzing as a sovereign level things like balance of payments, debt dynamics, currency volatility, and putting that into their framework and making their recommendations, and then we're obviously taking that, putting in place good outcomes for investors based on their objectives. If it's an income objective, we're going to make sure that we deliver a solid, risk-adjusted returns, and that can be done in a host of ways, whether it's even in the dollar space or the local, it's just that in local markets in particular, we want to manage downside volatility. I think that right now valuations are quite supportive for the investor that chooses to invest in emerging markets.
Tony Rodriguez: We have gotten a few questions in from viewers, and one of them is for you, Katherine. It is, "Considering global diversification and the strength of the US dollar, do you have an opinion on hedging against currency risk?"
Katherine Renfrew: Again, there are portfolios the exclude non-dollar opportunities, but if you have portfolios that can take that, there is ... I think you can modify it in a number of ways. We take active currency risk in some cases, and in that example, our local-markets' team is really looking through the ... culling the opportunities, and when there are spikes in volatility such as we've seen in, say, Argentina or Turkey, for instance, you're not going to be necessarily either overweight or you're going to limit your exposure to those. You can hedge using nondeliverable forwards, but those are often very expensive.
Katherine Renfrew: Often times, it's more an allocation issue to the local market segment, and I think that there are a number of tools that you can use if you want to minimize the volatility in a portfolio, especially those that are dollar benchmarked. We will very daily manage our tracking error and the volatility associated with non-benchmark exposures.
Katherine Renfrew: So, what we've seen is FX and emerging markets, if it's compared to a dollar benchmark it's using up quite a bit of your tracking error budget, so you just have to be cognizant of that, and it can work well within portfolios. Local market yields have actually increased. Some so much that it's obviously ... these our pressure points for some of these economies, but if they make the right moves, they do the right structural reforms, they address some of the fiscal questions that the marketplace have, they might be extremely attractive in the future. So, luckily we rely on expert team, and have so far managed to optimize our returns versus our benchmarks.
Tony Rodriguez: For an investor looking across the markets, what would you kind of identify and highlight for them about how an emerging market help them to generate income, to get diversification, and then you think they are being paid for the higher volatility of the asset class?
Katherine Renfrew: All right. I think if you look at risk-adjusted returns historically of emerging-market debt, again, looking at the dollar space where it's very diversified and you compare it to high-yield, they're comparable. So, if you just want to provide maybe ... at one point, high-yield spreads were quite tight as you mentioned, they've widened out, and we're not trying to say that emerging markets is better than high-yield, but if they complement, and in most core plus portfolios the plus is not just high yields, it's also EM.
Katherine Renfrew: Again, if you have an active manager who can look through the top-down prism and say, "Maybe we shouldn't the in the B- category right now, or at least underweight that segment," you can go up in quality and find very attractive risk-adjusted returns, and that's been proven time and time again. I think the diversification, though, has lent itself to some interesting dynamics, where we have more frontier. We just had our 68th country, Papua, New Guinea, just issued a ten-year, and it adds .1% of diversification. So, the diversification has now created ... I think it makes it harder for an impact.
Katherine Renfrew: For an active investor, we can say, "Is that meaningful? Is that attractive or not?" And our team of analysts is really doing a great job of picking the right ones to get involved in when they're new, but if we can look at the pricing of these bonds and compare them to, say, Rwanda, where we've had a lot of exposure and frontier, we just really are being selective about where we're getting exposure.
Katherine Renfrew: The 20% frontier space is one where that selectivity is key, and so I think that it's definitely a component for income, in that, these markets, they are not ... they're kind of on the right track, at least with the ones that we like. They're providing increased ample returns. You're getting often 8 to 9%, and really the risks, at least short-term, are really not there. These are traded markets. The average issue size, or at least just to be index eligible, they have to issue $500 million worth of debt to be included. Most of these governments have issued much more, and they're far more sensitive about defaulting in external markets than they ever have.
Katherine Renfrew: It is a big stain when that occurs, and I think that it's clear that not every country, every government, wants to emulate what happened in Venezuela. Venezuela even went a long time trying to pay, but their ability to pay was compromised. I think that there's a lot of standardization out there, a lot of disclosure that's required on the part of the investor base, and that's making these governments more disciplined, and that's lent itself to being a very attractive place to invest.
Tony Rodriguez: We talked earlier about geopolitical risk. You just mentioned Venezuela, theirs Saudi Arabia, you could talk about Russia, Syria, you could talk about Brexit, lots of geopolitical flashpoints out there, if you were to identify what hits the top of the concerned chart for you, are there one or two do you think investors should be most focused on here over the next few months?
Katherine Renfrew: From a concern standpoint, we just got some sharp moves in oil, so I would just definitely be monitoring oil. We think it's still at a healthy level, where it doesn't bring in the question payment capabilities of most of our issuers that are oil exporters. It's important to keep an eye on commodities. It's actually been a good kind of tailwind, not a headwind, for our marketplace these days, but that's just something to keep an eye on.
Katherine Renfrew: The second thing I would just say is, China, well, I think it actually plays a pretty stable role, but they play a big role in the corporate space. They're the largest issuer, and there's a healthy ... a high degree of real estate issuance in the China property space, and it's just something that we've seen more recently, some of the issuers tapping the markets in the front end at pretty high yields. It's something to watch.
Katherine Renfrew: We think that the Chinese government, centrally planned economy, they manage through a lot of crisis pretty well, so the hard landing scenario's still not one that we're [00:30:00] that worried about. Growth is expected to slow. The marketplace broadly accepts that, and there was this movement of the currency weakening, and a lot of that did trigger on a lot of the trade tensions, but we've saw the sharp rally. That might actually be more sustainable, and it's just something that I think investors need to keep an eye on China. It's the second largest economy in the world.
Katherine Renfrew: This makes it extremely different from 20 years ago when we started investing, and [00:30:30] I think the issue of calling a sharp correction is one that you have to do very carefully, and it's something that they have managed a deleveraging process more recently, but they've also provided some stimulus. So, they do a good job of policy management, and their objective has been stability, so as long as that remains anchored I don't think it's that great of a risk.
Tony Rodriguez: Great. Thanks, Katherine. Let's switch our focus to the preferred market, Doug.
Doug Baker: Sure.
Tony Rodriguez: Why don't we start with some basics? What are preferred securities? Why do firms issue them?
Doug Baker: Sure. Absolutely. For those that are familiar with the preferred market, or for those that aren't familiar with the preferred market, one of the things you'll notice is that the financial services' sector is by far the biggest sector. So, banks and insurance companies, and you also have a lot of utility exposure, and the one thing those three categories have in common, they have a regular, and typically the regulator is going to make their member firms hold certain amounts of capital on their balance sheet to allow [00:31:30] them to operate through, say, a recession, or to absorb an idiosyncratic shock to that particular institution.
Doug Baker: There are typically three things that will call as revelatory capital: retained earnings, so the profits that the company generates that they haven't paid out as dividends, common stock, and then most regulators will let preferred stock, preferred securities tone is revelatory capital. For regulatory capital purposes, that's probably the primary driver in the bank sector. Insurance companies will also use preferred securities to manage their credit rating. Institutions like Moody's, S&P, Fitch, and so on, they'll actually give quote, unquote, "Equity credit," to some of these structures depending on the terms and features that the issuer decides to place in the prospectus.
Doug Baker: As a result, when that particular insurance company is getting its rating from these agencies, they can adjust their mix of equity to debt to try and target a particular rating. So, very important in the insurance industry when you're selling policies, if much more appetizing for someone to buy one from a AA rated institution than a BB, and so those securities often in the insurance sector are also used to manage credit ratings. Now, you'll often hear the preferred security asset class referred to as a hybrid category.
Doug Baker: Why is that? Well, it's tough to define exactly what a preferred security is. We look at an area of the balance sheet, and it's this area that kind of tows the line between debt and equity. So, you have certain structures without a doubt that are going to land on the equity side of the balance sheet. Typically, what we refer to as the preferred stock. Then you have these other securities that end up being very junior subordinate pieces of debt, and are absolutely without a doubt and the liability side of the balance sheet. We call those ... we call the asset class often times a hybrid asset class because depending on the market environment you're in, these securities the exhibit features or behavior of common stock or debt.
Doug Baker: So, it also then kind of dovetails into the question, maybe front running a question you might have, "Where do investors ... how do they categorize these things? Where do they put them in their portfolio?" And that's where I come with a nice mealy mouth answer, "It depends." It depends. It depends what you want to accomplish, so we at Nuveen, and most index providers, absolutely look at these securities as fixed-income instruments, but because of their volatility, it's something that's comparable to traditional high-yield corporate bonds, if an advisor has built a portfolio or an investor has built a portfolio where that fixed-income allocation is their sleep at night money, they might want to find another place for preferreds.
Doug Baker: Then we'll see people ... the next natural step is to put it in their equity bucket, and that's a nice way for them to boost income out of that equity sleeve that may not be generating the same income did pre-financial crisis, and it also will take down, in most instances, the volatility of the allocation too. Then, kind of the third, is to put it in a catchall bucket, where people just don't want to make that type of decision. It goes into an alt category. It goes into the other, and just to save some time and headache. Really, it just depends on what the investor is trying to accomplish with their portfolio, how they [00:35:00] positioned it for themselves or for a client, that will often dictate then what category they'll assign, kind of the preferred asset class.
Tony Rodriguez: So, in terms of what they're trying to accomplish. I wanted to ask you, what are the key risks and benefits to preferreds?
Doug Baker: Absolutely.
Tony Rodriguez: We did, as I mentioned, that some of your questions. One of which dovetails with this nicely, and the question for you was, "How do you expect preferreds to act during a late cycle or recession scenario?" So, talking about the risks and benefits, and how they'll react in that scenario?
Doug Baker: Absolutely, so the key risks to the preferred category. First, it's the concentration of financial services, which we're actually constructive on today. Within the asset class, you really can't diversify a way too much from that, so actually investors and advisors, they manage that risk by how much they actually allocate to the category to begin with. We have interest-rate risk. There are different structures in the preferred category we can use to manage that risk.
Doug Baker: Adjustable-rate coupons come into play quite often to manage that risk, but if we're talking about entering into the late cycle stage, maybe the recession becomes more and more apparent or more likely, this is probably going to behave much like any other area in credit, but here's the difference: there's the big difference between preferreds and, say, high yields, or preferreds and floating-rate loans. Not that one is better than the other. These categories actually work really well together because the underlying issuer base in the preferred category -- thanks, insurance companies, utilities, we have some REIT exposure in there -- you find very little of that exposure in those other income categories like high-yield and floating-rate loans.
Doug Baker: So, we're often having the discussion, "It's not an or, which one, is it high yield or preferreds in my portfolio? Is it loans or preferreds?" see. It's an and. They're the complement to one another. It's a great way to diversify that risk, and what I do like about preferreds is that with banks being our largest sector, they are probably the best capitalized they've been due to all this new legislation, new bank capital standards, since the mid to early 1940s, and they've been capitalized to weather an economic downturn, and not just the recession.
Doug Baker: I mean, the stress test that the US banks go through on an annual basis assume variables even worse than the financial crisis we went through in 2008, and over a longer period of time. When those banks come out of those stress tests, they actually still have more capital on their balance sheet than they had in 2007 before the crisis started.
Doug Baker: What I like to tell people is, "Absolutely, without a doubt, there could be some volatility. We could see some price swings. We could see some spread moves, but what I would say is very different this time around is that the odds of there being a permanent impairment of capital through a regular recession from one of our large issuers in the preferred market, in our opinion, is quite low," [00:38:00] and it all has to do with, really, the work that Congress and the regulators have done in establishing these large capital bases in the bank sector, which is our largest sector in the preferred market.
Tony Rodriguez: One more for you. We talk at the top of the show about how active management and fixed income makes sense in looking at these kind of nontraditional income diversifiers, so talk about the preferred market specifically, and why active management's important in that sector.
Doug Baker: Yeah, absolutely. It's for a couple reasons. One that really jumps out to me and maybe Purva's seen this in her space as well, but in our asset class, we have a very large, direct retail presence, and the retail investor can do a lot of interesting things to move valuations around. We will actually look at our market in certain instances and find large categories of securities that are actually trading at negative yields to call, negative yields to worse, and why is that?
Doug Baker: It's because we have an investor base that is very, very focused on income, and they have a natural bias for that, but have trouble distinguishing sometimes between coupon and yield, or sometimes don't have the information available to them to understand that some of the securities are actually callable. So, when it feels like it's okay to pay a small premium for some of the securities if they're redeemable in six months, 12 months, 18 months, the return profile to actually look quite nasty.
Doug Baker: So, active management can go a long way in help gleaning out attractive opportunities. It can also go a long way into structure selection, away from passive strategies to find securities that have, say, adjustable-rate coupon features to protect us from rising-rate environments. Of course, and we touched on earlier, the importance of fundamental credit research. We're not, I would say, completely out of the woods yet. There's still some lingering things, I think, out there both at the economic [00:40:00] level and at the individual company level that need to be investigated.
PART 2 OF 3 ENDS
Doug Baker:... level at the individual company level that need to be investigated and need to be documented and thoroughly researched. And so, we're no exception to the rule, and fundamental credit research for us at Nuveen in the preferred category really is our first step in the investment process in how a credit makes it into or gets taken out of our strategy.
Tony Rodriguez: Thanks, Doug. So, let's switch gears now, and let's focus on the municipal market a bit.
Purva Patel: Sure.
Tony Rodriguez: So, let's start of by tell us how the municipal markets have been impacted by tax reform, limitation on SALT deductions, things of that nature. What has been the impact?
Purva Patel: Sure, sure. Doug mentioned the inefficiencies of our market. Absolutely, we are similar to the preferred market in that we're retail dominated. And so, as tax reform was happening or being debated last year, it was a very interesting process, and we're happy that it's done because it's taken a big uncertainty out of the municipal bond market. And so, removing that helps us function more normally.
Purva Patel: One of the biggest fears that municipal investors have always had, and institutional investors in municipal bonds as well, is that the tax-exempt nature of the interest income would be taken away or muted somehow. And so, both sides of the aisle during the Obama Administration had proposals to kind of take it away or limit it. Now that we finally have some tax reform, and we probably won't see it debated for another 10 years, hopefully. I think we're in a good space in terms of knowing that that tax-free interest income is going to be maintained.
Purva Patel: However, we weren't completely unscathed. We did feel a little bit of a change or a shift in the municipal bond market. So, towards the end of the last year when tax reform was being debated, one of the things that was included in the House proposal was private activity bonds being removed out of the municipal bond market. I think there was a bit of a misunderstanding of what private activity bonds actually were. These actually include hospitals and charter schools and higher ed and things that are naturally part of the municipal bond market, and we are happy that that didn't get included because it would have taken out about a third of new issuance out of the market. So, several sectors would have been forced into the taxable market instead of the tax-free market.
Purva Patel: What we did see was a removal of advance refunding bonds, and one of the really interesting things about the municipal bond market was that you were able to advance refund outstanding debt. So, when a municipal bond gets issued, it's usually a long-term bond maybe 30-year maturity with a 10 or a 15-year call, and that call date allows the issuer to call back those bonds. In the municipal bond market, you're able to do that. You were able to do that prior to the call date, and so I think it was debated, or it was deemed, that it looked like we were double-dipping in that market. So, we'd have two sets of bonds out on the same deal, and I think it was the IRS that didn't like it so much. So, that is removed from the market.
Purva Patel: But since we've seen rates decline following the 2008 credit crisis, liquidity crisis, whatever you want to call it, we've seen a tremendous amount of advance refunding. So, anything that had a rate that was higher than what they had originally issued their debt at was getting advance refunded. This was to the benefit of a lot of creditors because you were essentially reducing your borrowing costs, and that's a credit positive. So, that was great while it happened, and for the last five years, more than 50% of new issuance was advance refunding and current refunding. So, some sort of refunding activity.
Purva Patel: Now, as we started to see the debate continue through the end of 2017, we started to see a lot more deals that were supposed to come in January and February move to December and November, and so we saw an incredible amount of issuance in those two months. December 2017 was the all-time highest new issue month for municipal bonds, so private activity borrowers as well as any borrower that was planning an advance refunding were all trying to come to the market during [00:44:30] that period.
Purva Patel: So, we saw we did fare pretty well. I think we held our own in that market, in that type of rush to the market and spike in supply, if you will. So, we've fared that part of tax reform pretty well. I think what we're going to see going forward is the SALT deduction, and that's one of the things I think people don't fully understand yet. We'll start to see that filter through the system as investors start [00:45:00] really focusing on their 2018 taxes. So, in 2017, you could take all these state and local tax deductions. In 2018, you're going to be capped at $10,000, and so if you have property taxes that are in excess of $10,000, you cap right there. And then, your state and local taxes are not deductible from your federal income taxes.
Purva Patel: So, what we think might happen, even though we've seen a shift down in every tax bracket at the federal level, we might still see certain investors that were taking a lot of deductions have a higher tax liability overall after doing their taxes and going through this tax deduction cap. And then, also, another thing that we're not really talking about and people don't really understand yet is that we are expecting a 98% drop in AMT filers from 2017 to 2018, and a lot of it has to do with deductions and how deductions are handled in 2018.
Purva Patel: So, a lot of interesting things coming out of tax reform, and I don't think the full brunt of it is felt yet in terms of how that's going to affect the market. We think that if, indeed, people are seeing that their taxes are higher, you're probably going to see more demand coming out of high income tax states or high property tax states so California and New York. California spreads have actually come in already. New York is feeling like that, too. Florida doesn't have a state income tax, but it has a lot of high-dollar property. So, we would expect demand from those places to kind of grow and maybe support us a little bit more as we go into kind of a softer part of the market or the year.
Tony Rodriguez: All right, sure. So, we talked earlier about how kind of 2018, we've seen significant volatility in the fixed-income markets. We've seen rising rates in the fixed-income markets, yet the municipal market has had one of the best relative returns of the various fixed-income asset classes. So, can you tell us and explain a little bit about that dynamic?
Purva Patel: Yeah, it's interesting because a lot of investors assume that whatever the Treasury does, the municipal bond market is going to do, too. And I bet Doug and Katherine would agree with me that that's not necessarily the case, and it depends on the features of each of these fixed-income markets, and the same is true for municipals. A lot of investors believe that municipals are the next step after Treasury bonds, and that's kind of true, because our default rates are very low. But the tax-free [00:47:30] nature of it, I think, supports us.
Purva Patel: We also are looking at a pretty steep yield curve in the municipal bond market. There's so much talk about the Treasury yield curve flattening, and the potential for it to invert and signaling the recession. We're not seeing that in the municipal bond market because there's always a little element of credit exposure in the municipal bond market that allows us to have investors always interested in the shorter part of the market.
Purva Patel: We still see, if you look at ratios on the short part of the market, we talked about long-end of the curve was 100% or the same yield as what Treasurys were yielding. The short part of the market, in the two-year spot, we're looking at a 60% ratio, so we are significantly less in yield than what Treasurys are showing at this point. So, it's been, I think one of the reasons ... Well, I don't even know if it's a reason. I think this just happens naturally in the municipal bond market that we decouple from the Treasury market at certain points in time when the Treasury market is kind of all over the place.
Purva Patel: We function based on our fundamentals, and we have seen in municipal high yield, that credit spreads have come in. And so, that's been a great source of return. So, if you're looking at the municipal bond market and returns across the credit spectrum, lower quality municipal bonds have actually been producing positive returns this year. The Barclays High Yield Municipal Indexes has a total return of more than 3% so far this year.
Tony Rodriguez: Which is interesting because we've talked about kind of what's happened to spreads, too, in the preferred market and emerging markets, so you just mentioned about muni spreads. What's the outlook on muni spreads, credit spreads, as we look out through the balance of this year and into 2019?
Purva Patel: Yeah. I think as long as we continue to see the economy grow, even if it is at a slower pace, I think you'll still continue to see credit spreads stay in this range or even get a little bit lower because our spreads have been wide for quite some time now. We haven't really been in an area where we felt more normal, or what a normal spread environment is for municipal bond markets.
Purva Patel: I think a lot of it has to do with what Doug touched on, that our market is still very retail oriented, and investors are slower to recover versus maybe the corporate bond market that's more dominated by large institution, pension funds, governmental entities that are investing in it. Whereas, we are talking about every person in the United States that pays taxes that could be eligible to benefit from municipal bonds, and that's the dominating factor. So, I think that allows us to have a lag in terms of performance and a shield, per se, for good performance when we're seeing that.
Tony Rodriguez: That's good. Well, we've gotten more questions in from some viewers, so we're going to maybe walk through a couple of these. I'm going to start with you, Doug, a pretty straightforward one about the preferred market. Is it completely domestic?
Doug Baker: No, it's not. Actually, I would say close to half the market is outside the U.S., so we can loosely cuff the preferred market by its loosest definition, including all currencies, is probably just shy of about a trillion, which I think surprises a lot of people. It's a really big market, and people sometimes get the idea, "It's retail," so they just think small, and it's something that probably doesn't need or require much thought. But at its loosest definition, it's quite a large market.
Doug Baker: If you look at a little bit more of a conservative definition, something that's U.S.-dollar-denominated, primarily domestic issuers, it's going to be probably about 2/3 of the overall market. Now, there's a lot of U.S. dollar-denominated paper that's issued by non-U.S.-domiciled firms, so our Western European banks, banks out of Asia, very big players in our space, and we'll hold a lot of that paper in our strategies. Those are large, big, benchmark issues and trade just as actively and are just as liquid as some of our largest domestic benchmark issues here in the U.S.
Doug Baker: So, we like to say it's the one thing that we can do in the preferred market is get exposure outside the U.S., and actually, at this point in time, we think most of the very interesting opportunities are actually outside of our borders. A lot of the story outside the U.S. and especially in the non-U.S.-bank space, we think is one that's misunderstood and creating a lot of opportunities today.
Doug Baker: Now, again, it all boils down to what are your research resources? Do you have the capability, and can you take that risk prudently in your portfolios? I think that's one of the things that we can lean on at Nuveen, whether you're talking about our muni research team, our taxable fixed-income research team. We're deep. We're deep in resources. We can go into those areas with confidence, ferret out the problem children, and find those diamonds in the rough. When you can and do so, especially in a market like the preferred category, the rewards can be pretty handsome, and on a risk-adjusted basis as well.
Tony Rodriguez: Since you mentioned about the deep research at Nuveen available most certainly to the preferred and credit markets, the emerging markets, but also in the municipal market.
Purva Patel: Absolutely.
Tony Rodriguez: One of our viewer questions said, "Tell us a little bit about the risk of unfunded pension liabilities that we're all reading about."
Purva Patel: I knew that was going to come up. I think what's important to really understand about the unfunded pension liabilities is that you cannot aggregate them all and say, "This is such a big problem." There was a report that came out a couple of years ago from a think tank that said, "There's $4 trillion of pension liabilities that are unfunded." And so, that gives a scare to the market, and it kind of spooks the municipal bond market. Of course, again, we're talking about retail investors that are reading the Wall Street Journal, watching CNBC, and this headline shows up. I don't think it does any services in terms of making good decisions about their investments when they read this stuff.
Purva Patel: So, I think when we look at pensions, we're absolutely looking at the annual required contribution. Are we in it? How far unfunded are we? And unfunded doesn't necessarily mean the end of the world, either because I think generally speaking, having an 80%-funded pension is very, very good because these entities are in perpetuity because it's cities, counties, states. They're always going to be around. There's no reason to be 100%-funded.
Purva Patel: So, you certainly have those states and those locals that have 70 and 80%-funded ratios, but then you also have states like New Jersey, Illinois. There's Connecticut, and several others that are struggling with this problem, and we think it's a long-term problem. It's not going to blow up the market tomorrow; however, we need to see improvement. It's a good thing that we're talking about this right now, and it's a good thing that it is coming out into media, that it's putting pressure on politicians to make this happen because one of my colleagues says, "Politicians don't make any changes unless there's a crisis." We're getting closer and closer to potentially having a crisis in some of these pension entities, and so we need to make those hard decisions right now.
Purva Patel: That's why when we were talking about the local elections, the election in Illinois and the election in Chicago is very, very important because two of the worst entities that have pensions connected to them that have really low funding ratios, and they have been missing their annual required contributions and not paying into the pensions like they had promised. They've promised all of these benefits. So, you can't do that, and you can't do that forever. And so, as we kind of get closer and closer to the point where it becomes a crisis, it's like, "Can we make these decisions now? Make them smaller and easier to deal with, or do we have to wait until we kind of fall off a cliff and something must be done?" So, it's a difficult situation. I don't think it blows up the market tomorrow, but it's certainly a big problem for certain parts of the municipal bond market.
Tony Rodriguez: So, it speaks to the need to have deep national-
Purva Patel: Absolutely.
Tony Rodriguez:... credit research expertise and capability.
Purva Patel: The rating agencies even just recently started talking about how they're looking at pensions. I think it was kind of a back-burner thing before, and so now it's become a much more important focus in terms of research.
Tony Rodriguez: Super. Well, that was all great information. I wish we had more time. We could probably talk for another hour on a lot of the different issues in the fixed-income market. But I want to say, Katherine, Doug, Purva, thanks for the time and for your insights.
Tony Rodriguez: And to our audience, thank you for participating. I know we weren't able to get to all of your questions, so if you have a topic you'd like to discuss, you can reach out to your Nuveen relationship manager or visit nuveen.com. Further information and commentary addressing a wide variety of fixed-income related topics is available in the Thought Leadership section on nuveen.com. Thank you, again, for viewing today.
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Video was filmed on November 1, 2018