Exhibit I: Fixed income indexes returns as of December 31, 2023, showing duration, total return, and excess return.
4Q Highlights
|
| Performance As of December 31, 2023 |
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|---|---|---|---|---|---|---|---|
|
Total Return |
Average Annual Total Returns |
|||||
Composite/Benchmark |
3 Mo. |
YTD |
1 Yr. |
3 Yr. |
5 Yr. |
10 Yr. | Since Inception |
BBH Limited Duration Fixed Income Composite (Gross of Fees) |
2.81% |
7.91% |
7.91% |
2.82% |
3.28% |
2.40% | 4.50% |
BBH Limited Duration Fixed Income Composite (Net of Fees) |
2.75% |
7.64% |
7.64% |
2.57% |
3.03% |
2.18% | 4.28% |
ICE BofA 1-3 Year US Treasury Index |
2.49% |
4.20% |
4.20% |
-0.05% |
1.28% |
1.04% | 3.67% |
| Past performance does not guarantee future results Returns of less than one year are not annualized Strategy Inception: 04/01/1990 |
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| The ICE BofA 1-3 Year US Treasury Index is an unmanaged index that tracks the performance of the direct sovereign debt of the U.S. Government having a maturity of at least one year and less than three years. One cannot invest directly in an index. Sources: Bloomberg and BBH & Co. |
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Market Environment
Interest rates fell and credit spreads narrowed across the fixed income markets during the fourth quarter. Just three months ago, the Bloomberg Aggregate Index (the “Index”) had a negative year-to-date total return after interest rates rose and market conditions suggested a “higher-for-longer” interest rate environment. Those conditions changed rapidly, as investor expectations now reveal quicker and larger Federal Reserve (Fed) rate cuts in 2024. The prospect of near-term Fed easing may also alleviate investor concerns about near-term economic risks.
Fixed income indexes experienced positive returns amid the decline in interest rates (see Exhibit I). Risk spreads narrowed significantly throughout the credit markets and provided an additional boost to the performance of credit indexes. Indexes of investment-grade (IG) corporate bonds, asset-backed securities (ABS), commercial mortgage-backed securities (CMBS), high yield (HY) corporate bonds, senior bank loans, and collateralized loan obligation (CLO) debt all outperformed Treasury alternatives during the quarter. The Agency MBS Index also posted notably strong performance after exhibiting volatility throughout the year as the Fed executes its quantitative tightening campaign.
Year-to-date, all credit indexes had positive excess returns. Non-agency CMBS outperformed comparable duration Treasuries slightly despite negative headlines regarding commercial real estate. Indexes of IG corporate bonds, senior bank loans, HY corporate bonds, nontraditional ABS, and CLO debt posted strong excess returns.
Valuations
Narrowing risk spreads caused valuations to weaken during the quarter. According to our valuation framework, the percentage of IG corporate bonds that screened as a “buy” decreased to 23% versus 32% at the start of the quarter, while the percentage for HY corporate bonds was 24% versus 33% at the start of the quarter. Senior bank loans continue to screen attractively, with over 90% of the universe screening as a “buy” candidate.
There remains an abundance of opportunities in select subsectors of the market (see Exhibit II). We continue to find opportunities in intermediate maturity bonds and IG bonds issued by companies operating in interest rate sensitive sectors, like banks, life insurance, and real estate investment trusts (REITs). Several double-B and single-B rated bonds issued by companies in the wireline, wireless, transportation services, and media-entertainment sectors screen attractively. In the structured credit markets, we observe a continuing disconnect between wider credit spread levels and solid credit performance. We are finding an abundance of attractively valued opportunities in non-traditional ABS issuances and CLO debt. We believe opportunities in the CMBS market will arise as stronger properties come to market with Single Asset, Single Borrower (SASB) securitizations that facilitate strong transparency. There are several sectors where valuation and durability concerns lead us to avoid positions in client portfolios. Valuations of agency MBS weakened amid strong spread compression during the fourth quarter, and only small segments of the market screen as a “buy” candidate to us. We continue to avoid non-agency residential mortgage-backed securities (RMBS) due to poor technical factors and weak fundamentals underpinned by weak housing affordability, low inventory of homes for sale, and stable-to-declining home prices. We continue to avoid emerging markets credits due to concerns regarding creditor rights in most countries.
Exhibit II: Fixed income sector outlook as of December 31, 2023, for reserves, structured credit, corporate credit, and other credit categories.
Performance
Sector and rating emphases contributed to relative results during the quarter. The Strategy was overweight to strong-performing segments of the credit markets, including IG corporate bonds, senior bank loans, HY corporate bonds, and ABS.
Security selection was also additive to relative performance, and contributions were diversified among sectors (see Exhibit III). The Strategy experienced favorable selection results from its holdings of ABS, IG corporate bonds, HY corporate bonds, and CMBS, while selection of senior bank loans hindered results. Subsectors that contributed to the Strategy’s selection results included senior bank loans to electric utilities, HY corporate bonds issued by technology companies, and IG corporate bonds issued by banks and property and casualty (P&C) insurers. Holdings of senior bank loans to wireline telecommunication companies hindered selection results.
Exhibit III: Representative account attribution as of December 31, 2023, showing average weight and contribution in basis points.
Duration contributed to total returns but hindered relative results as shorter duration bonds trailed 1-3 year Treasuries during the quarter.
Transaction Summary
We continued to find durable credits offering attractive value despite dwindling attractiveness of valuations of credits in Indexes. The purchases were made across a variety of sectors and industries. Descriptions of a few notable portfolio additions are included below.
VFI 2023-1A is a large ticket equipment ABS deal brought by VFI Leasing. VFI originates mid- and large ticket leases and loans for critical use assets to well established, high credit middle market through Fortune 500 companies. The company’s lending performance has been strong with consistently low loss rates, and the bonds feature structural protections that promote quick deleveraging and strong credit support. We purchased the 1-year weighted average life (WAL), single-A rated bonds at a spread of 205 basis points over Treasuries for a yield of 7.4%. WLAKE 2023-4A is a subprime auto ABS deal brought by Westlake Financial Services. Westlake specializes in the acquisition and servicing of full spectrum automotive retail installment contracts, and their past ABS issuances compared favorably to other subprime issuers with lower losses and delinquencies. The ABS are structured to delever quickly and have strong credit support. We purchased the 2-year WAL, single-A rated bonds at a spread of 190 basis points over Treasuries for a yield of 7.0%. MFIT 2023-AA is a personal consumer loan ABS deal brought by Mariner Finance. Mariner is a community-focused financial services business that offers auto-secured, soft-secured, and unsecured personal consumer loans in 22 states to below prime credit borrowers. The collateral pledged to the securitization is subprime and near-prime, fixed rate, fully amortizing, personal consumer loans and indirect sales finance contracts originated by Mariner Finance’s branch network. The bonds feature sizable credit enhancement levels and strong structural protections. We purchased the 2-year WAL, triple-A rated bonds at a spread of 190 basis points over Treasuries for a yield of 6.9%.
CCG 2023-2 is a large ticket equipment ABS deal brought by CCG, a large equipment finance and leasing company with a core focus on the construction, waste, and transportation industries. The company boasts an experienced management team, long-term client relationships, and minimal net losses. The securitization is well diversified by borrower, equipment type, and industry, and the deal possesses strong structural protections, healthy credit enhancement, and sizable excess spread. We purchased the 2-year WAL, triple-A rated bonds at a spread of 135 basis points over Treasuries for a yield of 6.4%.
PNC is a large U.S. regional bank holding company with consistent earnings, strong liquidity, strong asset quality, satisfactory capital, and well-regarded management. We purchased the new issue 4-year, A+ rated bonds at a spread of 160 basis points over Treasuries for a yield of 6.6%. In the HY market, ams AG came to market during the quarter. The Austrian company is the third largest sensor and photonics provider in the world behind Sony and Samsung. The company recently lowered its debt load, has a solid liquidity profile, is cushioned by a $1.0 billion equity market capitalization, and has a path to decrease leverage in 2024. We purchased the new issue 5-year, BB- rated bonds at a spread of 803 basis points over Treasuries for a yield of 12.5%. Credit Acceptance Corp provides funding, receivables management, collection, sales training, and related services to automobile dealers. The company has a proven track record in underwriting lower tier subprime borrowers, their strength is accurately forecasting collection rates on loans, and losses have been negligible because it advances, on average, only 45% of the gross amount of the installment sales contract to dealers. We purchased the new issue 5-year, BB rated bonds at a spread of 499 basis points over Treasuries for a yield of 9.3%. Bread Financial Holdings is a publicly traded provider of loyalty and affinity credit card solutions. The company has a strong position in its industry, produces significant cash flow for debt servicing, and demonstrated resiliency during COVID-19. We purchased the new issue 5-year, BB- rated bonds at a spread of 548 basis points over Treasuries for a yield of 9.8%.
Characteristics
At the end of the quarter, the Strategy’s duration was 0.9 years (see Exhibit IV). HY and nonrated investments represented 10.6%, were comprised primarily of credits rated double-B, and consisted of a blend of corporate bonds and loans. Yield to maturity was 6.7% and remained elevated versus short-term bond market alternatives. The option-adjusted spread (OAS) was 169 basis points over Treasuries; for reference, the longer-duration Bloomberg U.S. Corporate Index’s OAS was 99 basis points at month-end.
Exhibit IV: Representative account characteristics as of December 31, 2023, showing credit rating, sector allocation, effective duration, spread during, yield to maturity, and option-adjusted spread.
Concluding Remarks
Several forces are being exerted on credit markets in 2024, and the effect on credit spreads and transaction volumes is uncertain. Valuations, potential defaults and recession, the prospect of Fed easing, heightened refinancing needs, and fund flows in a higher Treasury rate environment can cause the market to behave erratically in any given year, and this year promises to be no different. That is why strong valuation and credit disciplines are imperative to performing in the market.
1 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.
2 Basis point (bps) is a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.
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.
The securities 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.
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 speculative in nature and are vulnerable to the possibility of issuer failure or business interruption.
Purchase and sale information provided should not be considered as a recommendation to purchase or sell a particular security and that there is no assurance, as of the date of publication, that the securities purchased remain in a portfolio or that securities sold have not been repurchased.
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 not intended to be and should not be interpreted as recommendations.
Definitions
ICE BofA 1-3 U.S. Year Treasury Index is an unmanaged index that tracks the performance of the direct sovereign debt of the U.S. Government having a maturity of at least one year and less than three years.
Duration is a measure of the portfolio’s return sensitivity to changes in interest rates.
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, maturity, call and inflation risk; investments may be worth more or less than the original cost when redeemed. Bond prices are sensitive to changes in interest rates and a rise in interest rates can cause a decline in their prices. Mortgage-backed securities have prepayment, extension, and interest rate risks.
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.
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.
The Strategy invests in derivative instruments, investments whose values depend on the performance of the underlying security, assets, interest rate, index or currency and entail potentially higher volatility and risk of loss compared to traditional bond investments.
Foreign investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging market securities can be significantly more volatile than the prices of securities in developed countries, and currency risk and political risks are accentuated in emerging markets.
The Strategy may engage in certain investment activities that involve the use of leverage, which may magnify losses.
A significant investment of assets in one or more sectors, industries, securities and/or durations may increase its vulnerability to any single economic, political, or regulatory developments, which will have a greater impact on returns.
Illiquid investments subject the investor to the risk that she may not be able to sell the investments when desired or at favorable prices.
Portfolio Characteristics are of the Representative Account. The Representative Account is managed with the same investment objectives and employs substantially the same investment philosophy and processes as the Strategy.
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 W. 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 reflects the deduction of 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 Limited Duration Fixed Income Strategy is to deliver excellent returns in excess of industry benchmarks through market cycles. The Composite includes all fully discretionary fee-paying accounts with an initial investment equal to or greater than $10 million with a duration of approximately 1.5 years. Accounts that subsequently fall below $9.25 million are excluded from the Composite.
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.
Not FDIC Insured No Bank Guarantee May Lose Money
IM-14138-2024-02-01 Exp. Date 04/30/2024
