Exhibit I: Monthly change in the 10-year AAA Municipal Yield. Many characterize the municipal market as a low-volatility bond sector, but this was not the case in 2022.
Don’t Stop (Thinking About Tomorrow)
4Q Highlights
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The year 2022 has now assumed its place on the mantle of terrible bear markets. Decades-high inflation and intense selling pressure led to frayed nerves for investors and policymakers alike, as well as dreadful returns. Amid unprecedented stimulus measures in both 2020 and 2021, we entered 2022 with record-low yields, record-tight credit spreads, and enthusiastic investor sentiment. However — yesterday’s gone. In its place are higher yields, wider credit spreads, and attractive opportunities to provide liquidity to those seeking an exit. As we think about tomorrow, we see a much more attractive bond market, nearly free from policy suppression.
There will be plenty of time to reflect on 2022 and the case studies are probably already being drafted. One of the most important lessons learned was to not underestimate the consequences of monetary and fiscal policy coordination, especially when it is on a global scale. Debt monetization has real costs, historically resulting in high inflation. Despite the Federal Reserve’s (Fed) initial views to the contrary, inflation proved persistent and severe in 2022, requiring assertive tightening in response. The Fed raised its policy rate 425 basis points, twice the amount as during the last tightening cycle in one-third the time. Prior to the Global Financial Crisis, the Fed also tightened 425 bps, but it was over a span of two years, at 25 bps per meeting, for 17 consecutive meetings. Last year’s rate hikes bore little resemblance to any cycle since the Volcker Fed of the early 1980s.
Controlling inflation remains the Fed’s sole objective right now, even at the expense of higher unemployment and a potential recession. We ended the year with an implied peak funds rate of 4.75% and, despite the Fed’s messaging to the contrary, investor consensus expects the Fed to begin easing this summer. There is cause for optimism, but the inflation fight is far from over. We recognize the improvement in goods prices as supply chain difficulties ease. There are clear indicators that the housing market is cooling, which should help stem the sharp rise in shelter costs. Service prices represent the steepest challenge for the Fed. Prices remain elevated amid a tight labor market and strong wage growth. It is not unusual for investors to extrapolate good news, but when it comes to inflation, we believe it is best to remain cautious.
Aggressive monetary policy tightening drove deep negative returns in the bond market, with the aggregate taxable index down nearly 13% and investment grade corporates down nearly 16%. The municipal market typically outperforms in poor markets and 2022 followed the rule as the full maturity municipal index fell 8.5%, with intermediate benchmarks declining 5%-6%. Our intermediate municipal portfolios finished strong with over 3% returns for the fourth quarter, which was about 35 to 50 basis points ahead of the index. The largest contributors were our portfolio’s holdings of floating rate notes, zero coupon bonds, and State HFA bonds. The fourth quarter recovery allowed most of our portfolios to finish the year near their benchmarks. These results belied our team’s collective effort as 2022 was one of our most active years in terms of turnover. We significantly repositioned portfolios by taking advantage of widespread opportunities and we expect these new positions to benefit our clients for many years to come.
Attractive opportunities arose from rising yields, wider credit spreads, and rampant forced selling by mutual funds and other institutional capital pools. Even with the 40-to-60 basis point rally in the fourth quarter, yields ended the year 150-to-200 basis points higher than they began. Many characterize the municipal market as a low-volatility bond sector. In a typical year, 10-year municipal yields usually move 50-to-55 basis points. By comparison, six of twelve months this year saw market moves of a comparable magnitude (see Exhibit I).
We were also pleased that credit spreads normalized from their historic narrow levels at the end of 2021 (see Exhibit II). At that time, unprecedented fiscal and monetary stimulus measures helped mitigate short-term credit risk. This, combined with yield chasing amid record mutual fund inflows, stretched valuations of lower-rated bonds. Today’s wider spreads reflect less robust demand and growing recession risk, as well as more limited and expensive refinancing options.
Exhibit I: Monthly change in the 10-year AAA Municipal Yield. Many characterize the municipal market as a low-volatility bond sector, but this was not the case in 2022.
Throughout the year, we balanced portfolio liquidity needs and leaned into new opportunities. Simple to say, but not easy in a year like 2022, and we were fortunate to enter the year with ample reserves. Never has the municipal market been subjected to such a prolonged onslaught of forced selling and liquidity challenges. The record mutual fund redemptions of 2022 not only dwarfed prior peaks, but also resulted in a record number of $1+ billion selling days, which accounted for 75% of total trading sessions. Low liquidity might give our traders headaches, but it also provides opportunities, especially during periods of heightened volatility. For more on how we manage liquidity, please look out for a special commentary later this month.
Unlike prior periods of high volatility which have involved fears of credit defaults, last year’s investor worries centered on the Fed and rising interest rates. We believe 2023 will begin with growing fundamental challenges and rising recession risks. We remain vigilant on the credits we own, knowing that, in contrast to the past, policymakers are unlikely to rescue a weakening economy. Ironically, a recession might be the Fed’s best hope to sustainably control inflation and most sectors are well-suited to withstand one. In general, municipal governments are facing this potential economic downturn from a position of strength, with record reserves.
The healthcare sector remains a primary area of concern as hospitals are struggling with wage inflation and a shortage of nurses. Through November, total labor expenses were up 23%5 compared to the same period in 2019, harming margins. Many hospitals also face a growing preference for lower-margin outpatient procedures, which has slowed revenue growth. Unlike other sectors that continue to benefit from pandemic aid, the healthcare sector does not. During the onset of the COVID-19 pandemic, the federal government advanced future Medicare payments to healthcare providers to help stabilize cashflows. Payroll taxes were also deferred. Hospitals were required to pay back these advances by the end of 2022. Between these repayments, declining margins, and negative investment returns on their endowments, hospitals enter the new year with fewer resources to face their stiff headwinds. Finally, should Congress vote to end the Public Health Emergency, Medicaid funding will be reduced, further dampening the outlook.
The risks facing the sector are sizeable, but our hospital credits remain strong. At BBH, we are focused on building portfolios one credit at a time and rely on our research to keep our portfolios safe. We emphasize owning a limited number of durable credits6 that are resilient to unexpected challenges. Our healthcare credits are no exception. Like our recent purchase of Baylor Scott & White Health, the rest of our credits in this sector are well-managed with histories of strong cashflows, robust reserves, and appropriate leverage. We remain surprised that healthcare spreads generally do not reflect the significant challenges the sector faces.
We ended the year with another very active quarter. In contrast to healthcare, municipal airport spreads widened significantly during the year despite strong fundamentals, leading to a wide range of opportunities. We have a strong preference for “Origin and Destination” airports with a monopoly over regional air transportation. We also look for well-managed airports with a history of strong operations and substantial reserves. In many respects, municipal airports serve as quasi-utilities for interstate commerce and travel. Following a near-cessation in air travel during the spring of 2020, most airports have returned to their pre-pandemic level of enplanements. Among others, two new credits for us in this sector include Denver and Nashville airports.
In other activity, we increased our exposure to the Prepaid Natural Gas sector, adding bonds supported by Morgan Stanley and Goldman Sachs. For our longer portfolios, we also purchased a bond backed by Citigroup. The bank exposure inherent in many of these bonds has led to much wider spreads, even for securities with floating-rate coupons. As in past quarters, we continued purchasing State HFA bonds and longer-maturity School District zero-coupon bonds. Both areas still offer very attractive spreads relative to their underlying risks.
We will all remember 2022 as the year the global easy money experiment overstayed its welcome. The revaluation of fixed income and record forced selling in municipals created significant anxiety and reinforced the importance of managing portfolio liquidity. Keeping resources handy in the event of the unexpected has always been crucial to taking advantage of volatile markets. That may provide little solace to 2022’s ocean of red ink. Instead, we would prefer to think about all the new opportunities we added and the end of income challenges for bonds that persisted for much of the prior decade. Don’t stop thinking about tomorrow, it’ll be better than before.
Best wishes for a happy and healthy 2023.
Sincerly,
Gregory S. Steier
Porftfolio Manager
Performance As of December 31, 2022
Total Returns |
Average Annual Total Returns |
||||||
|---|---|---|---|---|---|---|---|
Composite/ |
3 Mo.* |
YTD |
1 Yr. |
3 Yr. |
5 Yr. |
10 Yr. |
Since |
BBH Municipal Fixed |
3.98% |
-5.41% |
-5.41% |
0.12% |
1.80% |
2.25% |
3.55% |
BBH Municipal Fixed |
3.91% |
-5.65% |
-5.65% |
-0.13% |
1.54% |
2.00% |
3.30% |
Bloomberg 1-10 Yr. |
3.12% |
-4.84% |
-4.84% |
-0.10% |
1.37% |
1.69% |
3.19% |
* Returns are not annualized. BBH Municipal Fixed Income inception date is 05/01/2002. |
|||||||
| Sources: BBH & Co. and Bloomberg | |||||||
Past performance does not guarantee future results. |
|||||||
Representative Account |
|
|---|---|
California School District General Obligations |
7.1% |
State of Maryland |
3.4% |
| Texas Municipal Gas Corporation II | 3.0% |
| Texas School Bond Guarantee Program | 2.8% |
| Texas Department of Housing and Community Affairs | 2.6% |
| State of New Jersey | 2.6% |
| Public Energy Authority of Kentucky Gas Supply Revenue | 2.5% |
| Texas Municipal Gas Acquisition and Supply Corporation I Series 2008D | 2.5% |
| Port Authority of New York & New Jersey | 2.5% |
| Salem-Keizer School District #24J, OR | 2.3% |
Total |
31.2% |
| Sources: Bloomberg and BBH Analysis | |
1 Bloomberg U.S. Aggregate Bond Index.
2 Bloomberg U.S. Corporate Bond Index.
3 Bloomberg Municipal Bond Index.
4 Bloomberg Muni 1-10 Year Blend Total Return Index & Bloomberg Muni 1-15 Year Blend Total Return Index.
5 Kaufman Hall National Hospital Flash Report, November 2022.
6 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.
Risks
There is no assurance that a portfolio will achieve its investment objective or that the strategy will work under all market conditions. The value of the portfolio can be affected by changes in interest rates, general market conditions and other political, social and economic developments. Each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.
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.
Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax.
The Strategy also 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 stock or bond investments.
As the Strategy’s exposure in any one municipal revenue sector backed by revenues from similar types of projects increases, the Strategy will become more sensitive to adverse economic, business or political developments relevant to these projects.
The Representative Account is managed with the same investment objectives and employs substantially the same investment philosophy and processes as the strategy.
The objective of our Municipal Fixed Income Strategy is to deliver excellent after-tax returns in excess of industry benchmarks through market cycles. The Composite includes all fully discretionary fee-paying municipal fixed income accounts with an initial investment equal to or greater than $5 million that are managed to an average duration of approximately 4.5 years. Portfolios that subsequently fall below $4.5 million are excluded from the Composite.
Bloomberg 1-10 Year Municipal Bond Index is a component of the Bloomberg Municipal Bond index, including bonds with maturity dates between one and 17 years. The Bloomberg Municipal Bond Index is considered representative of the broad market for investment grade, tax-exempt bonds with a maturity of at least one year. One cannot invest directly in an index.
Bloomberg US Aggregate Bond Index is a market value-weighted index that tracks the daily price, coupon, pay-downs, and total return performance of fixed-rate, publicly placed, dollar-denominated, and non-convertible investment grade debt issues with at least $300 million par amount outstanding and with at least one year to final maturity.
Bloomberg US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility and financial issuers. The Index is a component of the US Credit and US Aggregate Indices. “Bloomberg®” and the Bloomberg 1-10 Year Municipal Bond Index are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the index (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 BBH Strategy. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to the fund.
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 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.
Holdings are subject to change.
Credits: 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.
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.
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. References to specific securities, are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.
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. 2023. All rights reserved. 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. 2023. All rights reserved.
NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE MONEY
IM-12231-2023-01-17 Exp. Date 4/30/2023
