BBH Municipal Fixed Income Quarterly Strategy Update – 1Q 2022

March 31, 2022
Portfolio Manager, Gregory Steier, provides an analysis of the investment environment and most recent quarter-end results of the Municipal Fixed Income strategy.


Don’t Go with the Flow

The first quarter marked the beginning of a transition for fixed income. Investors faced significant uncertainties with a pivot away from unprecedented stimulus measures, the challenges of multi-decade inflation highs, and the consequences of the Russian invasion of Ukraine. For the first time in several years, markets will have to find a new, more natural, equilibrium without Fed rate suppression. The municipal market has a history of large unpredictable swings in sentiment, leading to market volatility that is often difficult to justify relative to underlying fundamentals. These episodes most often provide us with our best active management opportunities.

Sentiment has fluctuated widely over the last few years. At the end of 2018, many municipal investors were fearful that the Fed had tightened too much, leading to large redemptions. This negative sentiment swung to bullishness, large-scale inflows, and record-tight credit spreads by the end of 2019. In the Spring of 2020, pandemic-induced fear consumed investors as we all experienced unprecedented disruptions of work and life. But, by the end of 2021, municipal credit had not only recovered, but hit new record-tight spreads. This year, that positive sentiment quickly reversed, and we are in the early days of a new Fed tightening cycle. The good news is that yields are higher and attractive purchase opportunities are becoming much more prevalent.

Shifts in market sentiment are mighty important, as they bring real shifts in capital flows, especially in mutual fund flows. Since the Global Financial Crisis (2008-09), the municipal market has become increasingly susceptible to flow-driven volatility. This has occurred as a result of:

  1. Mutual funds and ETF growth relative to the overall size of the market
  2. A decline in traditional tax-exempt issuance following 2017’s Tax Cuts and Jobs Act
  3. Broker-dealer consolidation and tougher regulations

Over the last ten-to-fifteen years, the share of municipal bonds owned within mutual funds, closed end funds, and exchange-traded funds (ETFs) has grown significantly. Today, these vehicles own about 30% of all outstanding municipals and offer investors much greater liquidity than owning individual bonds. In the past, many municipal bonds were simply purchased and held to maturity. The proliferation of funds has promoted greater trading activity and allowed periods of heavy subscription and redemption activity to have a greater influence on valuations, both for the better and the worse.


Exhibit I: Shows total municipal issuance vs. net issuance. While total supply has been growing, net issuance has remained near zero over the past four years. The graphic also displays the percentage of issuance that is taxable, which has grown significantly since 2017’s tax reform.

 

Unlike the other major fixed income sectors, the size of the municipal market has remained steady. For most of the past decade, there has been approximately $4 trillion of outstanding municipal debt. At current supply levels, reinvestment demand almost absorbs all of the new issuance. The red line in Exhibit I indicates the portion of total municipal issuance that is taxable, which has grown in recent years. In fact, since 2017’s tax reform legislation, taxable municipal issuance has displaced about $100 billion of traditional tax-exempt issuance each year. The legislation restricted municipal issuers from refinancing old, higher cost tax-exempt debt, with new tax-exempt bonds in advance of a maturity or call date. A few issuers have used a loophole called delayed delivery bonds, but the vast majority of advance refundings are now executed with taxable bonds. During periods of heavy inflows, such as in 2021, the dearth of tax-exempt supply helps create an exaggerated positive impact to valuations.

In an over-the-counter market like fixed income, traders and broker-dealers carefully monitor market liquidity and customer flows. Anecdotally, dealers will look to build positions on their balance sheet when they sense growing demand and vice versa. The primary pattern that we have observed during periods of heavy investor selling is that dealer bids are much weaker when they are bidding for their own balance sheets, as opposed to when they have customer orders in hand. During periods of heavy outflows, such as during the spring of 2020 and the first quarter of this year, this creates an exaggerated negative impact (see Exhibit II). Transaction costs rise, liquidity sinks, and price movements can be violent. The upside is that this volatility often provides generous opportunities.

There is this odd phenomenon in municipals that inflow and outflow cycles tend to feed on themselves and valuations have little to do with it. For example, positive returns, declining yields, and narrowing credit spreads tend to make investors more enthusiastic even though the value is disappearing, and the opposite holds true. Negative returns, higher yields, and wider credit spreads tend to make investors pessimistic even though there are better values! We have never understood why investors get more excited about less attractive values, and they get pessimistic when opportunities arise. This is perhaps the most important reason we do not go with the flow.


Exhibit II: Displays the virtuous cycle in 2021 vs. the vicious cycle of 2022. 2021: Declining yields leads to positive returns which leads to investor enthusiasm, which leads to net inflows, which leads to heavy buying, reinforcing the cycle. 2022: Rising yields leads to negative returns which leads to investor pessimism, which yields net outflows, leading to heavy selling, reinforcing the cycle.

As the first quarter progressed, domestic inflation concerns became even more entrenched. On top of strong wage gains of over 5%, we have record home price gains of nearly 20%, and ongoing supply chain difficulties. The growing emphasis on renewable sources of energy will likely require a long and expensive transition. Declining investment in fossil fuel extraction will also create ongoing vulnerability to higher energy prices, which the Russian invasion of Ukraine has only exacerbated.

Recognizing that inflation was more persistent and less transitory than previously perceived, the Fed’s stance on monetary policy toughened, with their pandemic-driven quantitative easing program ending in mid-March. Along with this change in Fed sentiment, investor expectations for Fed tightening moved up rapidly as well. Currently, investors have priced in 275 basis points1 of additional tightening over the next two years, split between 200 additional basis points this year and another 75 basis points in 2023. For context, the Fed tightened a total of 250 basis points from 2015 through 2018. Not only do investors expect more tightening than the last cycle, but they also anticipate a much more rapid pace including several 50-basis point hikes this year.

Growing expectations of an aggressive tightening cycle led to a rough start to 2022, with significant outflows leading to the municipal market’s worst quarterly performance on record. In total, investors redeemed over $20 billion of capital during the first quarter. To highlight the breadth of selling, there were 28 days during the quarter in which investors, in aggregate, tried to sell over $1 billion of municipals. This quarter presented the most active selling in the last twenty years, other than the fourth quarter of 2018 which was at the end of the last Fed tightening cycle. Yields moved up dramatically, particularly for short maturities that had been anchored by the Fed. For the quarter, two- to five-year maturity yields were up about 150 basis points and long rates were up 120 basis points. The five-year municipal yield ended the quarter at 2.05%, 90 basis points above its pre-pandemic level. This has been an epic sell-off, reminiscent of 1994.

The municipal sector has historically been resilient to rising rate environments. Last year was a great example as the municipal market returned 1.5% while Treasuries were down 2.4%, an outperformance of almost 400 basis points. But this outperformance left municipals vulnerable. Remember, municipals ended the year at very expensive relative valuations, especially in short maturities. What is good for past performance is often a headwind against future performance. And this has been true thus far in 2022. Ratios moved up sharply during the quarter, doubling in maturities less than five years. With the first quarter now in the past, valuations for the highest quality bonds look far more attractive today than they have been in several years.

Despite the substantial rate move, credit spreads remained stubbornly stable and well below longer-term averages. In fact, performance for all different grades of credit was very consistent. Similar to the Spring of 2020, investor redemptions have led managers to sell significant quantities of shorter maturity, higher-quality paper to minimize the pain of raising cash. Although broad measures of fundamentals remain solid, we expect credit valuations to normalize. With AAA yields now significantly higher, investors have less reason to stretch into lower-rated credits.

Although account performance ended the quarter near our benchmarks, we added many new opportunities that should produce benefits well into the future. Consistent with our approach, we leaned into market weakness and took advantage of volatility with a wide array of purchases in both the new issue and secondary markets. Many new issues were priced with concessions. We participated in several deals including Yale University put bonds, Becker Minnesota School District zero-coupon bonds, Northside Texas School District put bonds, a prepaid gas floating-rate-note supported by Morgan Stanley, and a range of State Housing Finance Authority bonds. We also participated in delayed delivery bonds issued by Miami University in Ohio and Jacksonville Florida, backed by the city’s appropriation pledge. In the secondary market, the rapid repricing and heavy selling of short-maturity bonds created a wide range of opportunities throughout the quarter in sectors that included school districts, industrial development revenue bonds, prepaid natural gas, and housing, among others. We have always said that it is better to name your price and buy from a forced seller, than to be one.

As we look ahead, policy makers will be hoping for a mythical soft landing. We expect more volatility that should continue to provide opportunities to invest in high-quality bonds with more yield than they should. Last quarter was full of such opportunities. When flows are positive and market conditions are strong, it is important to be cautious and adhere to our investment criteria and not buy into the momentum. Good values will be scarce. When sentiment is weak and outflows dominate, we stick to our process, and find good opportunities as others are fleeing. These are often the best times to go shopping for bargains. As always, we rely on our criteria to keep us steady while the market veers from fear to exuberance and back again. We are excited that more attractive purchase opportunities are emerging, but patience and selectivity remain critical. And above all, we are not inclined to go with the flow.

Sincerely,

Gregory S. Steier
Porftfolio Manager

Performance As of March 31, 2022
  Total Returns Average Annual Total Returns
  3 Mo.* YTD* 1 Yr. 3 Yr. 5 Yr. 10 Yr. Since
Inception
BBH Municipal Fixed Income Composite (Gross of Fees) -5.10% -5.10% -3.93% 1.59% 2.56% 2.64% 3.71%
BBH Municipal Fixed Income Composite (Net of Fees) -5.16% -5.16% -4.17% 1.34% 2.30% 2.38% 3.45%
Bloomberg 1-10 Yr. Municipal Bond Index -4.76% -4.76% -4.00% 1.03% 1.77% 2.00% 3.31%

* Returns are not annualized.
BBH Municipal Fixed Income inception date is 05/01/2002

Past performance does not guarantee future results.

Representative Account
Top 10 Obligors
As of March 31, 2021
California School District General Obligations 8.6%
Texas School Bond Guarantee Program
3.5%
State of New Jersey 3.5%
Philadelphia School District, PA
3.4%
Texas Municipal Gas Corporation II
3.2%
State of Maryland 3.2%
Texas Department of Housing and Community Affairs
2.8%
Pre-Refunded or Escrowed to Maturity 2.7%
Texas Municipal Gas Acquisition and Supply Corporation
2.3%
State of Ohio 2.2%

Total

35.4%

1 One “basis point” or “bp” is 1/100th of a percent (0.01% or 0.0001).

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®” 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. 2022. All rights reserved.

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IM-10959-2022-04-14     Exp. Date 07/31/2022

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