Structured Credit – A Full Toolbox to Protect Against Uncertain Rate Environments

February 25, 2022

Neil Hohmann

The first six weeks of 2022 have been marked by historic declines in the bond market. Structured credit has weathered this storm far better than most fixed income. We focus on the features of non-traditional structured credit that explain their resilience – and why this should continue despite an uncertain environment for interest rates.

The first six weeks of 2022 have been marked by historic declines in the bond market. Interest rates rose dramatically and resulted in sizable negative total returns across most segments of the market, including short-term U.S. Treasuries, where negative performance episodes have been almost non-existent.

Structured credit has weathered this storm far better than most fixed income. In our 2021 year-end commentary, we addressed why we believed structured credit was poised to perform through turbulent bond markets. Thus far, the thesis has held, and the asset class now stands to benefit from now higher interest rates.

We want to focus on the features of non-traditional¹ structured credit that explain their resilience – and why this should continue despite an uncertain environment for interest rates.

Point 1: A higher initial yield helps cushion against rising risk-free rates.

At similar durations, portfolios with higher yields should outperform portfolios with lower yields as U.S. Treasury rates rise. That is because investors earn higher levels of income that cushion against the price declines associated with rising Treasury rates. Non-traditional segments of the structured credit markets offer particularly appealing yields and short defensive durations heading into this environment. This aids growth of capital relative to similar duration alternatives in the market.

Exhibit I demonstrates how structured fixed income can add a level of protection against rising rates due to their higher levels of income. For this illustration, we assume interest rates rise by 1.00% over the next quarter while credit spreads remain constant. Then we assume Treasury rates remain at their new, higher levels while spreads remain constant. As shown, the higher income levels from a structured fixed income portfolio help absorb the price decline associated with the rise in interest rates while also allowing for a quick rebound from the price decline.

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Exhibit I – Structured Fixed Income Performance Assumes 6.10% Yield and 2.4 Year Duration (2/15/22) with a 1.0% Rate Increase Over Next 3 Months. Stacked bar chart showing the quarterly income levels and the price effect from changes in yields for a representative structured fixed income portfolio with a duration of 2.4 years. This chart includes a plotted point for each time period that shows the combined effect of positive returns from income and negative returns from assumed price declines. The graph includes five discrete three-month periods: the actual three months ending 2/15/22, and the hypothetical total return for the trailing three months ending 5/15/22, 8/15/22, 11/15/22, and 2/15/23. Total returns are positive and increasing for the forecasted periods due to increasing levels of income.

Point 2: Amortizations are a source of protection against rising rates.

Amortizations are a tremendous feature of certain fixed income instruments during a period of rising interest rates. The cash flow pattern of amortizing instruments differs significantly from the more familiar “bullet” structure. Amortizing instruments pay principal back to bondholders in installments prior to the security’s maturity date. Bondholders of amortizing securities receive higher cash flows with greater frequency than bondholders of bullet securities. As a result, amortizing securities allow investors more opportunities to reinvest cash flows into higher yields and spreads as soon as they are available. This creates a benefit to bondholders during periods of rising interest rates.

Exhibits II and III highlight these differences between amortizing and bullet maturity structures. As shown, amortizing securities return cash to bondholders with far greater frequency.

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Exhibit II – Quarterly Cash Flow, $1,000 Invested in a 3 Year, 3% Bullet Maturity Bond. Combination stacked bar and area chart that shows the periodic and cumulative semi-annual levels of principal and income earned over the life of the hypothetical 3-year, 3% bullet maturity bond.

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Exhibit III – Quarterly Cash Flow, $1,000 Invested in a 3 Year, 3% Amortizing Bond. Combination stacked bar and area chart that shows the periodic and cumulative semi-annual levels of principal and income earned over the life of the hypothetical 3-year, 3% amortizing bond.

Point 3: Structured credit securities can be floating rate.

There are floating-rate structured credit securities available, and we invest in them for our client portfolios when valuations are attractive. The floating-rate structures provide price stability which is a nice attribute when yields are rising.

Point 4: Active approaches continually optimize portfolios.

As a leading active manager in structured credit, we can further optimize portfolios to take advantage of value opportunities that rising rates may bring against a static portfolio.

BBH Structured Credit Portfolio

BBH structured credit portfolios are well-positioned to perform through a variety of interest rate conditions, including a rising rate environment that is of current concern. This stems from a combination of bond attributes – their yields, valuations, and fundamental strength – as well as their structural features – how the securities generate cash flows, including amortizations and floating-rate provisions. Exhibit IV demonstrates that a substantial segment of the portfolio benefits from some combination of the cash flow features mentioned above.

At BBH, we focus on identifying durable credits at attractive yields and constructing portfolios bond-by-bond. A byproduct of this approach is that it may create benefits should investors’ concerns of a continued rise in rates manifest.

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Exhibit IV – Representative Structured Credit Portfolio. Pie chart that shows the distribution of a representative structured credit portfolio by market weights to securities that are currently amortizing, floating-rate, currently amortizing and floating-rate, and fixed rate and not amortizing. Data as of January 31, 2022.

¹ Traditional ABS include prime auto backed loans, credit cards and student loans (FFELP). Non-traditional ABS include ABS backed by other collateral types.

Opinions, forecasts, and discussions about investment strategies are as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations.

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.

Single-Asset, Single-Borrower (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.

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 failure or 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 ratings from other nationally recognized statistical recognized statistical rating organizations.

Brown Brothers Harriman & Co. ("BBH") may be used as a generic term 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. 2022. All rights reserved.

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IM-10747-2022-02-24 Expiration Date: 02/28/2023