Taxable Fixed Income Outlook: Waiting for Those Rising Rates

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1 Taxable Fixed Income Outlook: Waiting for Those Rising Rates Market Commentary Fourth quarter 2014 MOST INVESTORS UNDERSTAND THAT INTEREST RATES ARE UNPREDICTABLE. But we suspect few believed rates could actually fall in the fourth quarter. While the recent decline highlights the uncertainty of rates, we are undoubtedly approaching the day when the Fed will begin increasing the fed funds rate. Given this quandary, how should investors position their portfolios? We believe broadly flexible, multi-sector strategies that allow active managers latitude are best suited for an uncertain rate environment. How Fast and How Much? While much has been made about when the Federal Reserve (Fed) will begin raising rates, there has been little discussion about what happens afterward. Investors should be asking two central questions: How fast will rates rise? How much will they rise? Different rising rate environments affect fixed income assets in significantly different ways. A sharp increase in rates over a short period of time can result in negative fixed income returns. Conversely, incremental increases over a longer time frame may have less impact. We believe that rate increases during this cycle are more likely to be slow and incremental due to fundamental and technical factors that have been keeping rates relatively low and may mitigate future rate increases. Tony Rodriguez Co-Head of Fixed Income Nuveen Asset Management, LLC Exhibit 1: Factors May Persist That Have Suppressed Rates Fundamental Factors Economic Growth U.S. growing at only moderate pace Europe and Japan slowing Inflation Remains contained Low wage growth despite falling unemployment Falling commodity prices Monetary Policy Fed remains cautious Foreign central banks easing Technical Factors Global Capital Flows U.S. rates remain higher than those of other developed countries, driving demand Investor Positioning Persistent investor short duration positions cap upward rate movements Geopolitical Risks Cause periodic flight to quality in U.S. Treasuries Paul Blomgren Senior Vice President, Client Portfolio Manager Nuveen Asset Management, LLC We believe many of these factors may persist, muting some of the effects of Fed rate hikes. We anticipate that the mixed nature of the fundamental factors will allow the Fed to be very patient. Unwinding of policy accommodation will be measured based on clear signals in economic data and is more likely to be too slow than too fast. We expect the 10-year U.S. Treasury yield to be in the 2.75% area at the end of See page 5 for Our Favorite Things in the current bond market. NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

2 Focus on Income Generation Historically, nearly 93% of the total return of the bond market has been generated by income versus rate changes or other factors. The prospect of a slowly rising rate environment makes income even more critical. Income can help: Build total return before rates increase Cushion total return from the negative price impact of rate increases Augment total return in periods with minimal rate movements Exhibit 2: Income Has Generated the Majority of Total Return Percent of Total Return Generated by Income 100% 80% 60% 40% 20% 0% Total Return 83.8% 12/31/09-12/31/14 1/30/76-12/31/14 Barclay s Aggregate Bond Index 92.7% 89.5% 94.7% 12/31/09-12/31/14 1/31/93-12/31/14 Barclay s U.S. High Yield 2% Issuer Capped Index 4.5% 7.9% 9.0% 8.0% Data Source: Barclays. Data as of 12/31/14. Chart shows the percent of annualized total return derived from coupon return (as opposed to price appreciation). The Barclays Aggregate Bond Index has an inception date of 1/1/76. The Barclays U.S. High Yield 2% Issuer Capped Index has an inception date of 1/1/93. The index returns presented are for illustration purposes only and do not represent or predict performance of any Nuveen Investments product. Indices are unmanaged and unavailable for direct investment. Past performance is no guarantee of future results. Finding Attractive Income Opportunities When searching the universe for income, we continue to prefer the non-government related segments of the bond market, which offer: Higher yield and income potential Return potential from changes in yield spread over Treasuries Yield spreads are generally wider now than earlier in 2014, offering more opportunity for price improvement if economic conditions continue to improve. This can help offset the impact of rising rates. Exhibit 3: Non-Government Related Sectors Have Offered Higher Yields Yield 8% 6.61% 6% 4.64% 4% 3.11% 5.66% 2% 1.43% 0% Treasuries Investment Grade Preferred Securities High Yield Emerging Market Debt Source: Barclays. Data as of 12/31/14. Treasuries represented by the Barclays U.S. Treasury Index.; Investment Grade represented by Barclays U.S. Corporate Investment Grade Index; Preferred Securities represented by BofA Merrill Lynch U.S. Preferred Stock Fixed Rate Index; High Yield represented by Barclays U.S. Corporate High Yield 2% Issuer Capped Index; Emerging Markets represented by Barclays Emerging Market USD Aggregate Index. Past performance is no guarantee of future results. Indices are unmanaged and unavailable for direct investment. 2

3 Less Sensitivity to Rate Changes Non-government sectors have higher yields and potential for spread compression, so they have been less sensitive to interest rate changes. Exhibit 4 shows the correlation between these sectors and the 10-Year U.S. Treasury yield. Note how these sectors have much less sensitivity to rising rates than the overall bond market. Exhibit 4: Non-Government Sectors Have Lower Correlation to 10-Year Treasury Yields Correlation to U.S. Treasuries Broad Bond Market 0.45 Investment Grade 0.05 Preferred Securities High Yield 0.18 Emerging Market Debt Source: Morningstar Direct. Correlations from 11/1/04 to 12/31/ Year U.S. Treasury Returns represented by the Barclays U.S. Treasury Bellwethers 10-Year Index.; Investment Grade represented by Barclays U.S. Corporate Investment Grade Index; Preferred Securities represented by BofA Merrill Lynch U.S. Preferred Stock Fixed Rate Index; High Yield represented by Barclays U.S. Corporate High Yield 2% Issuer Capped Index; Emerging Markets represented by Barclays Emerging Market USD Aggregate Index. Correlation measures how two securities move in relation to each other. Perfect positive correlation (+1) implies the securities will move in the same direction. Perfect negative correlation (-1) means the securities will move in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; they are completely random. Past performance is no guarantee of future results. Indices are unmanaged and unavailable for direct investment. Use Active Management to Adapt to Changing Rate Environments Designing a portfolio to perform in a rising rate environment requires more than selecting the highest yielding sectors. Yields, risks and relative attractiveness can vary substantially and change rapidly as conditions evolve. As the market cycle unfolds, returns are driven less by overall sector exposure and more by individual securities. Identifying solid credit stories requires diligent fundamental research. Balancing portfolio risks across sectors and security types generally necessitates professional management. In this changing environment, we like strategies that offer the flexibility to invest across market segments and provide access to the higher yielding, below investment grade sectors. These strategies, among others, have the potential to reduce portfolio sensitivity to rising rates and capitalize on opportunities in uncertain times. 3

4 Outlook: Modestly Rising Rates Amid Continued Growth We believe three themes will drive the broad market: RATES WILL RISE MODESTLY BUT REMAIN AT RELATIVELY LOW LEVELS. We expect the Fed will begin tightening policy in mid Given low inflation and moderate U.S. growth, we believe the process will be very deliberate, which is important to ensuring that financial markets do not overreact. Although we don t expect a dramatic uninterrupted rise in yields, interest rate volatility could occasionally spike in response to economic or geopolitical developments, or to renewed uncertainty about the Fed. We expect rates to rise gradually and the yield curve to continue to flatten, with short rates rising more than long rates. We estimate that the 10-year U.S. Treasury yield will settle around 2.75% by year-end DOMESTIC ECONOMIC RECOVERY CONTINUES. We remain fairly constructive on U.S. growth fundamentals and believe that the United States will continue to decouple from weak global growth. Job growth remains strong, manufacturing surveys remain consistent with moderate growth, business capital spending should remain supportive and consumer spending has rebounded in response to growth in disposable income from lower energy costs. Lower oil prices though certainly worrisome for highly levered, energy-related companies and weaker oil-exporting sovereign credits will likely be a net positive for the U.S. economy. Though we are starting to see early signs of tightening in labor markets, inflation should remain subdued and well below the Fed s 2% target in the short run, especially given broad commodity and energy price weakness. We believe U.S. growth will be around 3% in WE REMAIN FAIRLY CONSTRUCTIVE on U.S. growth fundamentals and believe that the United States will continue to decouple from weak global growth. GLOBAL GROWTH DIVERGES. European growth has deteriorated while the U.S. recovery remains intact. We believe the United States will continue to lead global growth, which will likely remain muted. Inflation remains low globally, with continued economic slack and declining commodity prices. While the Fed is reducing monetary accommodation, the European Central Bank is facing deflation and will likely begin a quantitative easing program this year. The Japanese economy continues to be sluggish, but additional supportive fiscal and monetary measures should help. China s growth has slowed, but policy makers have responded with measures we believe will be sufficient to maintain a near 7% growth target this year. The sharp decline in oil has been disruptive in the short run and will pressure some countries, but it is broadly positive for global growth and containing inflation. We believe that global GDP growth may exceed 3.0% in These divergent conditions will help to moderate the global cycle, control inflation and likely remain supportive of emerging markets. Although countries that depend on commodity exports will continue to face headwinds, cheaper currencies, global stimulus and U.S. growth will help emerging markets. Last quarter s selloff has created attractive valuations in some segments of emerging markets for patient investors. Investing in the right countries is critical for success. 4

5 Our Favorite Things Against this backdrop, we continue to favor the non-u.s. government-related asset classes, including: Selected investment grade corporates High yield corporates Selected foreign markets Preferred securities CORPORATE BONDS are attractive, both investment grade and high yield with intermediate durations. Credit fundamentals, though having softened modestly, remain solid and are fully supported by current risk premiums. The recent cheapening of credit has increased the attractiveness of the corporate sectors. Given near-term uncertainty in oil prices, we see continued volatility in credit spreads but ultimately expect them to tighten as energy prices stabilize. Strong fundamental analysis should be rewarded as most credits will successfully weather this near-term volatility. We also believe we have transitioned to a more selective environment, where issue and credit selection will be the primary drivers of performance. WE EXPECT MODEST SPREAD TIGHTENING over the year as investor confidence returns, especially if oil prices stabilize or begin to recover. We think the financial sector is attractive due to improving balance sheets at large financial institutions as regulation increases. We also are finding good value in selected cyclicals. Within investment grade, we prefer BBB-rated over A-rated industrials because of better relative value, generally lower rate sensitivity and less risk of re-leveraging behavior in lower-rated credits. HIGH YIELD CORPORATE BONDS have the potential to generate significant income with moderate interest rate risk. During the fourth quarter, the precipitous drop in oil prices and net outflows weighed on the sector. The sector is more exposed to the price of oil than other markets because approximately 14% of common high yield indices consist of energy-related credits. While we continue to be cautious near-term on energy credits, we believe the sector has been oversold and diligent credit research can uncover attractive long-term opportunities. Credit work is critical in this sector because of the challenges posed by lower oil prices and changing supply dynamics. The fundamentals of the high yield sector outside of energy remain strong. Some sectors are expected to benefit from lower energy prices. Solid economic growth and healthy earnings outside of energy still signal a benign default environment over the coming year--even though a small group of energy-related credits may have increased default risk. The global default rate held steady at 2.2% in November, down from 2.9% at this time last year and well below the long-term historical average of 4.7%. Looking ahead, Moody s default rate forecasting model predicts that the global default rate will edge up slightly to 2.6% by the end of This outlook is supported by low refinancing risk as many companies have enjoyed easy access to the debt market, pushing out refinancing needs and lowering debt costs. 1 Source: Moody s. December

6 In addition, wider credit spreads (over 500 basis points at yearend 2 ) have created an attractive entry point for the high yield asset class. We expect modest spread tightening over the year as investor confidence returns, especially if oil prices stabilize or begin to recover. The current yield of 6.61% can also cushion returns from the expected modest rate increases. 2 The higher income potential makes the sector more attractive going forward as continued low yields in the broader fixed income markets drive investor demand for higher yielding assets. SELECTED FOREIGN MARKETS can offer value. We prefer countries with better growth prospects, sound monetary policies or attractive interest rates. In addition, these investments diversify away from U.S. interest rates and the U.S. dollar. The path of global growth and differing domestic monetary and economic conditions will continue to drive valuations. European yields are likely to remain in check, even as U.S. yields rise. We also like selected emerging market corporate bonds and specific sovereign debt of countries whose policymakers have demonstrated sound policies to improve competitiveness, promote structural reforms and enhance fiscal and monetary credibility, such as Mexico and Poland. The U.S. dollar is likely to further benefit from continued U.S. economic improvement and growth, but individual currency performance will vary based on local fundamentals. We are negative on the yen and euro, given the widening gap in economic fundamentals and policy objectives. PREFERRED SECURITIES can also be attractive for both yield and diversification. These hybrid securities tend to trade inefficiently, so they may benefit from active, professional management. In addition, the changing bank regulatory environment creates opportunities. We favor the fixed-to-floating rate coupon structures, which mitigate the risk of increasing interest rate sensitivity as rates rise. 2 Source: Barclays. Based on Barclays High Yield 2% Issuer Capped Index as of 12/31/14. For more information, please consult with your financial advisor and visit nuveen.com. INDEX DEFINITIONS Barclays Emerging Market USD Aggregate Index includes USD-denominated debt from emerging markets around the world. 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. Barclays U.S. Corporate Investment Grade Index is a broad-based benchmark that measures the investment grade, fixed-rate, taxable corporate bond market. Barclays U.S. High Yield 2% Issuer Capped Index tracks the performance of U.S. noninvestment-grade bonds and limits each issue to 2% of the index. Barclays U.S. Treasury Bellwethers 10-Year Index is a universe of Treasury bonds, and used as a benchmark against the market for long-term maturity fixed-income securities. The index assumes reinvestment of all distributions and interest payments. Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury. Treasury bills are excluded by the maturity constraint but are part of a separate Short Treasury Index. In addition, certain special issues, such as state and local government series bonds (SLGs), as well as U.S. Treasury TIPS, are excluded. STRIPS are excluded from the index because their inclusion would result in double-counting. BofA Merrill Lynch Preferred Stock Fixed Rate Index is designed to replicate the total return of a diversified group of investment-grade preferred securities. RISKS AND OTHER IMPORTANT CONSIDERATIONS 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. 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. This information represents the opinion of Nuveen Asset Management, LLC and is not intended to be a forecast of future events and this is no guarantee of any future result. It is not intended to provide specific advice and should not be considered investment advice of any kind. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. This report contains no recommendations to buy or sell specific securities or investment products. All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager. Nuveen Asset Management, LLC is a registered investment adviser and an affiliate of Nuveen Investments, Inc. GPE-TFICOM-1214D 5402-INV-Q04/15 Nuveen Investments 333 West Wacker Drive Chicago, IL nuveen.com

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