1Q Highlights
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Q1 2024 Commentary
Treasury rates continued to be volatile as strong economic data and stubbornly high inflation data drove market sentiment back towards a “higher for longer in 2024” disposition, although the yield curve still had three 25 basis point1 Federal Reserve (Fed) interest rate cuts priced in by the end of this year. Shorter-duration fixed income indexes generated positive returns during the first quarter while longer-duration indexes experienced negative total returns. Excess returns to credit were positive across sectors, with agency mortgage-backed securities (MBS) being the notable exception that underperformed comparable duration Treasuries as the Fed continued shrinking its balance sheet.
Last quarter, we wrote about the necessity of a more cautious outlook given the robust rally in credit spreads. Valuation and credit discipline were important criteria to remember as issuers sought to refinance looming maturities opportunistically in an environment of strong demand for credit. New bond and loan issuance was robust during the first quarter as narrow credit spreads, stronger economic data, and differentiation among industry subsectors, and commercial real estate property types, mitigated the concerns of issuers about higher nominal interest rates. Investors met the supply with strong demand as credit spreads narrowed throughout the quarter. Investment-grade corporate credit issuance increased 30%, bank loan issuance rose 171%, high yield bond issuance increased 117%, asset-backed security (ABS) volumes surged 54%, and commercial mortgage-backed security (CMBS) issuance increased 165% versus their respective 2023 paces. ABS issuance was record-breaking and eclipsed its previous quarterly record by 25%, while high-grade corporate bonds saw the highest volumes since the second quarter of 2020.
Credit spreads narrowed across sectors and qualities despite the deluge of issuance during the quarter. This highlights both the intense demand for credit and the increasing complacency of investors evaluating new issues. The average option-adjusted spread (OAS) of the Bloomberg U.S. Corporate Index was 90 basis points at the end of the period, which was the lowest level since December 2021. When the Index’s spread is less than 100 basis points, the Index tends to underperform Treasury alternatives moving forward.
As a result of the tighter credit spread environment, we are finding fewer opportunities in traditional segments of the credit markets. According to our Valuation Framework,2 the percentage of investment-grade corporate bonds that screened as a “Buy” decreased to 13% versus 23% at the start of the quarter and 47% at the end of the first quarter last year, with the prospects for longer-duration bonds looking particularly unattractive. The percentage of high-yield corporate bonds that screened as a “Buy” in our Valuation Framework declined to 16% from 24% at the start of the quarter and 47% at the end of the first quarter last year, with “Buy” candidates having become sparse in the double-B benchmark. No cohort of 30-year or 15-year agency MBS met our Valuation Framework criteria for new purchases at quarter-end.
However, there does remain opportunities in select subsectors of the market. Senior bank loans continue to screen attractively, with 87% of the universe screening as a “Buy” candidate. We continue to find opportunities in investment-grade bonds issued by life insurers and banks. Several “BB” and “B” rated bonds issued by specialty financial companies, banks, and real estate investment trusts (REITs) screen attractively in the high yield bond universe. In the structured credit markets, opportunities remain 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 CMBS market as investors differentiate between office properties and other property types with solid credit dynamics. 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.
Economic data has remained strong as inflationary pressures persist and there are few signs of recession on the horizon. Headline consumer inflation prints have been stronger than anticipated, and wage growth remains higher than historic averages. The Chicago Fed National Activity Index remains above its recession indicator threshold. Default rates of below investment-grade companies also remain subdued despite higher interest rates. The U.S. consumer appears to be on solid footing, with loan delinquency rates generally rising off very low bases and not indicating widespread issues. Although auto loan delinquency rates have risen to their highest levels since 2009, and defaults for subprime auto loans have increased above their pre-COVID-19 levels, these data points are within expected ranges for losses in ABS and do not currently pose risk of impairment to bondholders. Delinquency rates on business loans held at U.S. commercial banks remain near cyclical lows. Commercial real estate loan delinquency rates at U.S. banks continue to creep higher, which parallels the rising delinquency rates being experienced in CMBS related to office properties.
We believe credit and valuation discipline remain essential as others may be tempted to reach for yield with still-elevated interest rates. With robust issuance, eager investor demand, and narrow credit spreads, it is imperative that each opportunity be carefully vetted for durability and meet our required valuation criteria prior to investment. The most worrisome risks are often those that are unanticipated. Therefore, we continue to evaluate each credit’s durability, structure, management, and transparency while stress-testing the credit to the worst environment its industry faced before investing. We believe preparation and discipline will be necessary for navigating the months and quarters ahead.
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.
Past performance is no guarantee of future results.
Index Definitions
Ice BofA U.S. Corporate Index tracks the performance of USD denominated investment grade corporate debt publicly issued in the U.S. domestic market.
Bloomberg U.S. Corporate Bond Index represents the corporate bonds in the Bloomberg US Aggregate Bond Index, and are USD denominated, investment-grade (rated Baa3 or above by Moody’s), fixed-rate, corporate bonds with maturities of 1 year or more.
Bloomberg U.S. Aggregate Bond Index covers the USD-denominated, investment-grade (rated Baa3 or above by Moody’s), fixed-rate, and taxable areas of the bond market. This is the broadest measure of the taxable U.S. bond market, including most Treasury, agency, corporate, mortgage-backed, asset-backed, and international dollar-denominated issues, all with maturities of 1 year or more.
Uniform Mortgage Backed Security (UMBS) means a single-class MBS backed by fixed-rate mortgage loans on one-to-four unit (single-family) properties issued by either Enterprise which has the same characteristics (such as payment delay, pooling prefixes, and minimum pool submission amounts) regardless of which Enterprise is the issuer
“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 BBH Strategy. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to the fund.
The Indexes are not available for direct investment.
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.
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.
Investing 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.
Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax.
Single-Asset, Single-Borrower (SASB) securities lack 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.
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.
Portfolio holdings and characteristics are subject to change.
Basis point is a unit that is equal to 1/100th of 1% and is used to denote the change in price or yield of a financial instrument.
The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option.
Traditional ABS include prime auto backed loans, credit cards and student loans (FFELP). Non-traditional ABS include ABS backed by other collateral types.
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. High yield bonds, commonly known as junk bonds, are subject to a high level of credit and market risks.
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. 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.
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IM-14542-2024-04-23 Exp. Date 07/31/2024
