BBH Taxable Fixed Income Quarterly Strategy Update – 4Q 2023

December 31, 2023
  • Investment Management
Co-Portfolio Managers, Andrew Hofer, Neil Hohmann, and Paul Kunz provide an analysis of the investment environment and most recent quarter-end results of the Taxable Fixed Income Strategy.

4Q Highlights

  • The robust rally in corporate credit spreads has changed the valuation landscape. Index spreads now rival those witnessed in the fourth quarter of 2021 when we last wrote about our concerns of weak valuations.
  • Valuation discipline will be essential as borrowers seek to issue opportunistically to refinance looming maturities of debt issued when interest rates were lower.
  • Several forces are being exerted on credit markets in 2024, and the effect on credit spreads and transaction volumes is uncertain. That is why strong valuation and credit disciplines are imperative to performing in the market.

Credit Discipline in a Higher-Rate Environment

Interest rates fell and credit spreads narrowed across the fixed income markets during the fourth quarter. Just three months ago, the Bloomberg Aggregate Bond 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; the Index gained 6.82% during the fourth quarter with expectations of quicker and larger Federal Reserve (Fed) rate cuts in 2024. These market dynamics may continue to attract bond investors as the 10-year Treasury yield ended the year at 3.88%, the exact same level as at the start of 2023, and real yields remain positive across all tenors. The prospect of near-term Fed easing may also alleviate investor concerns about near-term economic risks. We remain committed to our investment process which does not rely on active interest rate decisions to drive performance, as recent history shows the difficulties in producing consistent top-level performance using such an approach.

The robust rally in corporate credit spreads has changed the valuation landscape. Index spreads now rival those witnessed in the fourth quarter of 2021 when we last wrote about our concerns regarding weak valuations. A steadfast valuation discipline coupled with our rigorous credit underwriting will be essential in 2024 as issuers rush to opportunistically refinance looming maturities in this more-advantageous yield environment.

We are pleased to report BBH fixed income strategies outperformed their benchmarks during the fourth quarter. Sector and rating exposures impacted results favorably, as client portfolios emphasized strong-performing segments of the credit markets. Security selection was another performance factor, and that contribution was diversified among corporate credit, nontraditional asset-backed securities (ABS), and commercial mortgage-backed securities (CMBS).

Our bottom-up approach is directing us to focus on several segments of the market offering compelling yields due to broad concerns about elevated interest costs, the prospects of default or recession, and pending debt maturities that will need to be refinanced or repaid. Strong credit discipline, active management, and persistent opportunity origination are paramount to performing through a credit environment where valuations of benchmark credits are weakening.

The Big Picture – Buyer Beware of Weak Valuations

We are concerned about the current state of credit market valuations as we position client portfolios. We believe inadequate credit valuations warrant careful attention as risks related to higher borrowing costs and a potential economic slowdown remain. Further, we caution against complacency as investors pursue still-attractive yields.

This is a salient point entering 2024 with expectations that new bond issuance will address several questions on investors’ minds about looming maturities and credit durability. We do not believe in the concept of a “maturity wall,” but rather a pile of looming maturities to be addressed piecemeal. The highest-quality issuers will refinance looming maturities with the most ease, while troubled issuers wait for either opportunistic episodes or concede other terms to refinance their debt. In either scenario, credits will have to pay more in the form of increased coupons versus the debt likely to be retired. The fundamental strength of each credit will remain an important determinant on how much more that interest cost will be placed on borrowers. However, with the very recent decrease in both interest rates and credit spreads, combined with the prospect of actual Fed easing, the environment is currently more conducive for borrowers looking to issue new debt this year.

Sorting the strong from the weak by focusing on credit durability should remain a focus for investors. Investor money has recently been flowing to many non-bank lending platforms that will be looking to issue various types of debt for the purpose of growth and refinancing. Incremental yield in these areas may lure investors towards untested debt structures. In contrast, we insist on demanding durability, strong management teams with time-tested track records, and transparency for investment.

We turn to a discussion of key considerations for investors in major segments of the credit markets.

Investment-Grade Corporates

Valuations in investment-grade (IG) corporate bonds declined rapidly during the fourth quarter. According to our valuation framework,1 the number of “buy” candidates in the ICE BofA U.S. Corporate Index fell to 23% from 32% at the start of the quarter. The average option-adjusted spread (OAS) of the Bloomberg U.S. Corporate Index was 99 basis points  at quarter-end, its lowest level since December 2021. When the Index’s spread is less than 100 basis points, it tends to underperform Treasury alternatives moving forward, as shown in Exhibit I.


Exhibit I: A bar graph displaying the investment grade corporate bond starting option-adjusted spread and subsequent 3-year excess returns as of 12/31/2023, where the Bloomberg U.S. Corporate Index was its lowest level since December 2021.

Thankfully, the average doesn’t fully describe the distribution of opportunities. Despite the unattractive spreads of the broad IG corporate bond market, there remains an abundance of attractively valued individual opportunities in several subsectors in the market. More than half of the bonds issued by banks and life insurers screen as potential “buy” candidates, as well as more than 25% of bonds issued by real estate investment trusts (REITs), specialty financial companies, and electric utilities. In several of those sectors, average index spread levels mask the opportunities within the sector. We believe this underscores the importance of a valuation discipline at the security level while evaluating opportunities.

High Yield Credit

Valuations of high yield (HY) corporate bonds also weakened notably during the fourth quarter; 24% of the ICE BofA U.S. High Yield Index screened as a “buy” candidate, down from 33% at the start of the quarter. The average spread of the Bloomberg U.S. Corporate High Yield Index was 323 basis points2 – its lowest level since December 2021. Senior bank loan valuations remain more attractive, and the decline in index spreads has been less pronounced.

Several indicators suggest HY issuers are facing less worrisome conditions than was predicted last year. The number of individual issuers and the amount of debt issued considered to be facing distressed conditions decreased through 2023 to its lowest levels at year-end. The par-weighted observed default rate was 3.0% of par value in 2023, slightly below its long-term average of 3.1%, with these defaults concentrated among debt rated CCC and lower. HY bond issuance surged 64% from 2022’s subdued volumes, while senior bank loan issuance increased 4% year-over-year. The decline in longer-term interest rates and the narrowing of credit spreads also impacted borrowing costs favorably.

Two interesting trends emerged from default activity in 2023. First, the number of defaulted issuers surged while the dollar volume of defaults was relatively normal. Smaller issuers with only loans outstanding were attributable for the uptick in the number of defaults in 2023, while the overall dollar volume of default was driven by relatively few defaults of larger companies with both bonds and loans outstanding. Second, recovery rates have been noticeably weaker than historical experience. The average recovery rate for defaulted loans was only 38% compared to a long-term average of 65%, and recoveries of loan-only issuers lagged recoveries from joint issuers of loans and bonds significantly. Lower loan recovery rates could be partly responsible for the continuing attractiveness of loan valuations.

ABS

ABS issuance once again proved resilient, with volumes up 5% in 2023 over a record 2022. That issuance occurred amid higher short-term rates and pockets of credit volatility, demonstrating the continued importance of ABS as a financing source for non-bank lenders. The secular trend of tightening bank regulation and the retreat of bank lending has led to rising ABS issuance as borrowers diversify financing away from the traditional banking and corporate debt channels. That shift intensified with the regional bank volatility earlier in 2023, manifested in a resumption of bank-issued auto loan ABS as well as issuance secured by new types of assets and loans.

Valuations of nontraditional ABS remain attractive, and we continue to observe an encouraging disconnect between credit spread levels and strong underlying credit performance. Credit enhancements remain healthy, loss rates are minimal, and delinquency rates remain low.

In past credit spread cycles, nontraditional ABS has represented a larger part of our clients’ credit exposure when corporate valuations weaken, and looking ahead, we expect that might again be the case. We expect issuance, valuations, and fundamentals to be supportive of investments in carefully selected deals. We continue to focus on our bottom-up credit research and pay careful attention to durability, credit enhancements, and management experience as opportunities arise.

CMBS and Comercial Real Estate

Non-agency CMBS issuance cratered 55% in 2023 amid specific concerns over office properties and general unease that higher interest rates, select credit weakness, and the fallout from regional bank weakness might leave issuers unable to refinance maturities. Just like looming maturities in other sectors, we expect the market will be open for high quality issuers to come to market at advantageous terms for investors. We stand ready to apply our rigorous credit research to opportunities that may emerge in a sector where generalized fears do little justice to bond level dynamics and durability.

Our clients’ portfolios have maintained small levels of CMBS with office exposure. This limited exposure invariably underscores the breadth of opportunity and credit strength available within a diverse office property sector. For example, we hold bonds of a Single-Asset, Single-Borrower (SASB) deal secured by a portfolio of film studios with adjacent office properties that performed very well through the COVID-19 pandemic. Another holding is secured by a portfolio of medical office properties where occupancy levels remain above 90%. There are also holdings secured by several flagship office properties with desirable locations, robust occupancy rates, well-capitalized anchor tenants, and long leases such as loans secured by New York City offices at One Bryant Park, 200 Park, and 1166 Avenue of the Americas.

Residential Mortgage-Backed Securities

Last quarter, we wrote about how opportunities were emerging in parts of the agency mortgage-backed securities (MBS) market amid improved valuations. Spreads of the Bloomberg MBS Index narrowed significantly during the quarter, and the opportunity set narrowed significantly in tandem. Exhibit II shows our valuation framework’s assessment of the 30-year Uniform MBS (UMBS) market by coupon cohort. It shows the market screens unattractively for every coupon except the highest ones that are also the smallest segments of the universe. In the 15-year universe, no coupon cohort meets our valuation criteria. We are remaining patient for opportunities to emerge at appropriate valuations.


Exhibit II: A chart displaying BBH’s valuation framework output of the Bloomberg 30 Year Uniform MBS index, by coupon rate, as of 12/31/2023, where the market screens unattractively for every coupon except the highest ones that are also the smallest segments of the universe.

Challenges continue to loom in the non-agency residential mortgage-backed securities (RMBS) market. Home prices continued to rise as low inventory offset weak affordability. Non-agency RMBS issuance declined 57% in 2023 versus 2022’s volumes. Segments of the non-agency RMBS market still exhibit thin credit enhancement and uncompensated prepayment risk. In addition, lenders are reporting higher delinquency rates in non-qualifying mortgages (non-QM) as borrowers delay payments amid higher refinancing rates. For these reasons, we continue to see very limited opportunity in the non-agency RMBS market.

Collateralized Loan Obligations

Spreads of collateralized loan obligation (CLO) debt narrowed toward the end of the year amid the general tightening of leveraged credit spreads coupled with reduced expectations of a recession and defaults. Improved market conditions for leveraged borrowers helped facilitate stronger issuance volumes during the fourth quarter, with stronger new issue and refinancing volumes. Within that issuance lift is a strong shift towards middle market, or private credit, CLOs. It was the second largest issuance year ever for middle market CLOs, with $31 billion issued, comprising 24% of total U.S. CLO issuance. CLO managers may continue to benefit from the interest of borrowers seeking to refinance debt obligations.

Many borrowers are attracted to lending from a CLO manager despite higher loan rates and tighter documents. Reasons include certainty and simplicity of execution, avoidance of expense, attainment of public credit ratings, achievement of multiple debt capital structures within a single transaction, and reduced disclosures versus private loan issuance. With money flowing to private capital and borrowers looking to refinance debt obligations opportunistically, we believe that CLO issuance will persist, and further opportunities will emerge. Our focus remains on finding securities issued by best-in-class managers and with thick credit enhancements.

Business Development Companies

We expect issuance of business development companies (BDC) debt to be strong in 2024, with roughly $6 billion of maturities due. Fundamentals have been resilient. Non-accruals and nonperforming loans in BDCs remain low despite higher loan costs, and interest income remains strong on floating rate loans. We monitor closely whether elevated loan rates may boost non-accruals. We believe BDCs with larger scale are better positioned to weather an adverse environment given their greater flexibility to refinance existing loans and a greater capacity to restructure underperforming loans.

The BDC market has also been growing with new entrants coming to market. New entrants are increasing competition for middle market direct lending. Issuer selection is of paramount importance given the combination of growth in the sector, upcoming maturities needing to be refinanced, and the potential for higher rates to push both interest income and nonperforming loans higher. We continue to emphasize durability when evaluating prospective BDC credits and pay close attention to each issuer’s underwriting consistency, percentage of true first-lien loans, dividend coverage, asset coverage, diversity in funding, and access to liquidity.

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. We look forward to our engagements with you in 2024 and beyond.

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 points (bps) is a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.

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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