BBH Structured Fixed Income Quarterly Strategy Update – Q2 2024

Portfolio Managers, Neil Hohmann, Chris Ling, Andrew Hofer, and Thomas Brennan provide an analysis of the investment environment and most recent quarter-end results of the Structured Fixed Income strategy.

2Q Highlights

  • The Strategy outperformed the Index during the quarter as sector allocation drove results, and structured credit sectors performed strongly.
  • Credit spreads narrowed across sectors and qualities despite the rigorous pace of issuance during the quarter, but opportunities in select subsectors of the market remain.
  • We identified new opportunities within select sectors and industries for the Strategy despite waning opportunities in the credit markets.
Performance
As of June 30, 2024

 

Total Return

Average Annual Total Returns

Composite/Benchmark

3 Mo.

YTD

1 Yr.

3 Yr.

5 Yr.

Since Inception

BBH Structured Fixed Income Composite (Gross of Fees)

2.19%

4.66%

10.62%

3.53%

3.87%

4.48%

BBH Structured Fixed Income Composite (Net of Fees)

2.10%

4.48%

10.24%

3.17%

3.51%

4.11%

BBH Structured Fixed Income Benchmark

1.12%

1.92%

5.75%

0.63%

1.57%

1.93%

Past performance does not guarantee future results
Returns of less than one year are not annualized
BBH Structured Fixed Income Composite inception date is 01/01/2016
BBH Structured Fixed Income Benchmark is a combination of two indices. The Bloomberg US ABS Index was used prior to 11/1/2023; the Bloomberg U.S. ABS ex.
Stranded Cost Utility Index is used subsequently. Due to recent changes in the composition of the Bloomberg US ABS Index, the new Bloomberg U.S. ABS ex.
Stranded Cost Utility Index more closely reflects the effective duration of the strategy. One cannot invest directly in an index.Sources: Bloomberg and BBH & Co.

Market Environment

Treasury rates continued to respond to investors’ predictions for forward-looking Federal Reserve (Fed) interest rate decisions. Strong economic data and still-high inflation data caused investors to continue to shift towards a “higher for longer” disposition for the remainder of 2024. Investors still believe the Fed will cut rates by 50 basis points1 during 2024, but the anticipated amount of rate cuts was 150 basis points at the start of the year. Longer-term interest rates increased across the yield curve to reflect those changes in expectations. Shorter duration fixed income indexes generated positive returns during the second quarter while longer duration indexes experienced negative total returns. Excess returns to credit were generally positive with two notable exceptions: agency mortgage-backed securities (MBS) and long duration corporate bonds.

Credit conditions remain accommodative. High yield default rates remain subdued and continue to be concentrated among CCC-rated issuers, although default rates for all rating categories are below their respective long-term averages. Economic data remained strong, with inflationary pressures persisting and few signs of recession on the horizon. Headline consumer inflation prints have been declining, but wage growth and job openings remains higher than historic averages and could still exert upward pressure on inflation. The Chicago Fed National Activity Index remains above its recession indicator. The U.S. consumer appears to be strong, with loan delinquency rates generally rising off very low bases and not indicating widespread issues. Auto loan delinquency rates rose to their highest levels since 2009 but are within expected ranges for Asset-Backed Securities (ABS) to withstand losses without risk of impairment to bondholders. Business loan performance appears healthy, as delinquency rates are low and default rates are declining. Office delinquency rates remain elevated, while non-office commercial mortgage delinquency rates rose moderately. Return to office dynamics remain weak and continue to pressure office real estate values. The weakening office market has not had an outsized impact on banks’ commercial real estate loan portfolios to date, as delinquency rates and charge-offs have been muted.


Exhibit I: Fixed income index returns for various indexes as of June 30, 2024, displaying duration, total return, and excess return.

Valuations

Credit spreads narrowed across sectors and qualities despite the rigorous pace of issuance during the quarter. This highlights both the intense demand for credit and the increasing complacency of investors evaluating new issues. As a result of the tighter credit spread environment, we are finding fewer opportunities in traditional segments of the credit markets. No cohort of 30-year or 15-year agency MBS met our Valuation Framework2 criteria for new purchases at quarter-end, and traditional segments of the ABS market, such as prime auto and bank credit card securitizations, continue to offer limited appeal to us.

Several segments of the ABS market continue to screen attractively despite the recent narrowing of credit spreads, with spreads in some select sectors remaining disconnected from their underlying credit risk. Opportunities are also arising in the commercial mortgage-backed securities (CMBS) market as investors differentiate between office properties and other property types with solid credit dynamics. We continue to find collateralized loan obligation (CLO) issuances with attractive valuations and strong structural protections. Debt issued by business development companies (BDCs) continues to offer attractive prospects.

We continue to avoid non-agency residential mortgage-backed securities (RMBS) due to poor technical factors, and weak fundamentals, underpinned by poor housing affordability, low inventory of homes for sale, and stable-to-declining home prices.


Exhibit II: Market outlook by sector as of June 30, 2024.

Performance

Selection drove relative results, with contributions in all sectors that the portfolio was allocated. Holdings of large loan CMBS, secured electric utility company loans, collateralized loan obligations (CLOs), data center ABS, business development company (BDC) debt, recurring revenue ABS, and triple net lease ABS impacted results favorably during the quarter. Positions in Single-Asset, Single-Borrower (SASB) CMBS and agency CMBS hindered selection results slightly.

The portfolio’s sector and rating emphases contributed to relative results during the quarter due to the portfolio’s overweight exposure to strong-performing segments within the CMBS and corporate credit markets.

The portfolio’s duration profile had a small but positive impact on relative returns during the quarter.


Exhibit III: Attribution as of June 30, 2024, showing average portfolio weight and gross contribution displayed in basis points.

Transaction Summary

We continued to find durable credits3 offering attractive value despite weak attractiveness of valuations of credits in Indexes. The purchases were made across a variety of sectors and industries. The table below summarizes a few notable portfolio additions.


Exhibit IV: Notable transactions as of June 30, 2024.

Characteristics

At the end of the quarter, the portfolio’s duration was 1.8 years and continued to approximate that of its benchmark. The portfolio had 87% of its investments in investment-grade credits, while high yield and unrated investments represented 13%. The portfolio’s yield to maturity was 8.2% and remained elevated versus bond market alternatives. The portfolio’s option-adjusted spread was 320 basis points over Treasuries; for reference, the Bloomberg U.S. Corporate Index’s was 94 basis points and the Bloomberg ABS Index’s, a proxy for traditional ABS, was 57 basis points at quarter-end.


Exhibit V: Characteristics as of June 30, 2024, including credit rating and sector allocation.

Conclusion

An environment like this can test the resolve of credit investors. Credit conditions appear relatively benign and issuance is robust, leading even the most disciplined investors to question the virtues of a valuation discipline when no observable risk event appears on the horizon. Opportunities remain, yet the importance of calibrating valuation and credit discipline is of utmost importance when conditions appear calmest.

1 Basis points (bps) is a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.
2 Our valuation framework is a purely quantitative screen for bonds that may offer excess return potential, primarily from mean reversion in spreads. When the potential excess return is above a specific hurdle rate, we label them “Buys” (others are “Holds” or “Sells”). These ratings are category names, not recommendations, as the valuation framework includes no credit research, a vital second step.
3 Obligations such as bonds, notes, loans, leases, and other forms of indebtedness, except for cash and cash equivalents, issued by obligors other than the U.S. Government and its agencies, totaled at the level of the ultimate obligor or guarantor of the Obligation. Durable means the ability to withstand a wide variety of economic conditions.

Definitions

Bloomberg US ABS Index is the asset backed securities component of the Bloomberg US Aggregate Bond Index. The index includes pass-through, bullet, and controlled amortization structures. The ABS Index includes only the senior class of each ABS issue and the ERISA-eligible B and C tranche. The Bloomberg U.S. ABS ex. Stranded Cost Utility Index excludes certain stranded cost utility bonds included in the Bloomberg US ABS Index.

An index is not available for direct investment.

“Bloomberg®” and the Bloomberg indexes are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indexes (collectively, “Bloomberg”) and have been licensed for use for certain purposes by Brown Brothers Harriman & Co (BBH). Bloomberg is not affiliated with BBH, and Bloomberg does not approve, endorse, review, or recommend the Strategy. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to the Strategy.

Risks

Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Mortgage-backed and asset-backed securities have prepayment and extension risks.

SASB lacks the diversification of a transaction backed by multiple loans since performance is concentrated in one commercial property. SASBs may be less liquid in the secondary market than loans backed by multiple commercial properties.

Asset-Backed Securities (“ABS”) are subject to risks due to defaults by the borrowers; failure of the issuer or servicer to perform; the variability in cash flows due to amortization or acceleration features; changes in interest rates which may influence the prepayments of the underlying securities; misrepresentation of asset quality, value or inadequate controls over disbursements and receipts; and the ABS being structured in ways that give certain investors less credit risk protection than others.

Below investment grade bonds, commonly known as junk bonds, are subject to a high level of credit and market risks.

Foreign investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards.

The Structured Fixed Income Strategy Representative Account is managed with the same investment objectives and employs substantially the same investment philosophy and processes as the strategy.

The securities discussed do not represent all of the securities purchased, sold or recommended for advisory clients and you should not assume that investments in the securities were or will be profitable.

Opinions, forecasts, and discussions about investment strategies represent the author’s views as of the date of this commentary and are subject to change without notice.

Issuers with credit ratings of AA or better are considered to be of high credit quality, with little risk of issuer failure. Issuers with credit ratings of BBB or better are considered to be of good credit quality, with adequate capacity to meet financial commitments. Issuers with credit ratings below BBB are considered to be of good credit quality, with adequate capacity to meet financial commitments. Issuers with credit ratings below BBB are considered speculative in nature  and are vulnerable to the possibility of issuer failureor business interruption. The Not Rated category applies to Non-Government related securities that could be rated but have no rating from Standard and Poor’s or Moody’s. Not Rated securities may have ratingsfrom other nationally recognized statistical recognized statistical rating organizations.

Brown Brothers Harriman Investment Management (“IM”), a division of Brown Brothers Harriman & Co (“BBH”), claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.

To receive additional information regarding IM, including a GIPS Composite Report for the strategy, contact John Ackler at 212 493-8247 or via email at john.ackler@bbh.com.

Gross of fee performance results for this composite do not reflect the deduction of investment advisory fees. Actual returns will be reduced by such fees. “Net” of fees performance results reflect the deductionof the maximum investment advisory fees. Returns include all dividends and interest, other income, realized and unrealized gain, are net of all brokerage commissions, execution costs, and without provision for federal or state income taxes. Results will vary among client accounts. Performance calculated in U.S. dollars.

The objective of our Structured Fixed Income Strategy is to deliver excellent returns in excess of industry benchmarks through market cycles. The Composite is comprised of all fully discretionary, fee-paying structured fixed income accounts over $10 million. Investments are focused on asset-backed securities, commercial mortgage-backed securities, collateralized loan obligations, and corporate debt securities that are primarily investment grade. Non-investment grade securities may be held. Investments are focused on U.S. dollar denominated securities, but non-U.S. dollar securities may be held. The accounts are managed to a duration +/- 2 years of the Bloomberg ABS ex-Stranded Cost Utility Index. Effective December 1, 2022, the composite definition was slightly altered to establish a band around the duration of the Bloomberg ABS ex-Stranded Cost Utility Index.

Standard deviation measures the historical volatility of a returns. The higher the standard deviation, the greater the volatility. The Sharpe ratio is the average return earned in excess of the risk-free rate (the Fed Funds rate).

Brown Brothers Harriman & Co. (“BBH”) may be used to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2024. All rights reserved.

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IM-15093-2024-07-31        Exp. Date 10/31/2024

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