Exhibit I: Fixed income indexes returns as of March 31, 2024, showing duration, total return, and excess return.
1Q Highlights
|
| Performance As of March 31, 2024 |
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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) |
1.77% |
1.77% |
7.95% |
3.23% |
3.32% |
2.53% | 4.52% |
BBH Limited Duration Fixed Income Composite (Net of Fees) |
1.71% |
1.71% |
7.68% |
2.98% |
3.06% |
2.31% | 4.30% |
ICE BofA 1-3 Year US Treasury Index |
0.30% |
0.30% |
2.97% |
0.06% |
1.14% |
1.06% | 3.65% |
| 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
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.
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 asset-backed securities (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 commercial mortgage-backed securities (CMBS) related to office properties.
Valuations
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.
Exhibit II: Fixed income sector outlook as of March 31, 2024, for reserves, structured credit, corporate credit, and other credit categories.
Performance
The portfolio’s sector and rating emphases contributed to relative results during the quarter. The portfolio was overweight to strong-performing segments of the credit markets, including ABS, investment-grade corporate bonds, senior bank loans, CMBS, and high yield corporate bonds.
The portfolio’s duration profile contributed to total and relative returns as shorter duration bonds had a positive return and outperformed 1 – 3 year Treasuries during the quarter.
Security selection enhanced results further, and contributions were diversified among sectors. The portfolio experienced favorable selection results from its holdings of investment-grade corporate bonds, senior bank loans, and high yield corporate bonds, while selection of ABS hindered results slightly. Subsectors that contributed to the portfolio’s selection results included investment-grade corporate bonds issued by banks, life insurers, and property and casualty (P&C) insurers, senior bank loans to electric utilities and wirelines, Single-Asset Single-Borrower (SASB) CMBS, and data center ABS. The portfolio’s holdings of collateralized loan obligation’s (CLOs) and high yield corporate bonds issued by technology companies hindered selection results.
Exhibit III: Representative account attribution as of March 31, 2024, showing average weight and contribution in basis points.
Transaction Summary
We continued to find durable credits3 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.
Longtime holding SiriusPoint Ltd is a reinsurance company with a strong and stable European business and a strong capital structure that includes subordinated bonds, safety reserves, and a large equity cushion. We purchased their new issue, 5-year, BBB- rated bonds at a spread of 288 basis points over Treasuries for a yield of 7.1%. KKR’s wholly-owned life insurance subsidiary Global Atlantic brought a new issuance during the quarter. Global Atlantic’s strengths include a strong balance sheet, prudent asset-liability matching, and demonstrated capital support from KKR. We purchased the 5-year, A rated bonds at a spread of 175 basis points over Treasuries for a yield of 5.6%. And Apollo’s wholly-owned life insurance subsidiary Athene issued during the quarter as well, with its credit strengths including its very low leverage, its high risk-based capital ratio, and its exceptional liquidity condition. We purchased the new-issue, 5-year, A+ rated bonds at a spread of 160 basis points over Treasuries for a yield of 5.6%. We found some attractively valued bonds issued by leading banks with strong capital and liquidity positions, including five-year, new-issue, AA- rated bonds of Swedish bank Skandinaviska Enskilda Banken AB offered at a spread of 117 basis points over Treasuries for a yield of 5.5% and four-year, new-issue, A- rated bonds of Banco Santander offered at a spread of 125 basis points over Treasuries for a spread of 5.6%.
In the structured credit sectors, we purchased bonds of a SASB CMBS issuance, DK 2024-SPBX. The loan is secured by a diversified portfolio of 108 self-storage facilities spread across nine states, and the deal had strong structural protections and robust debt service coverage ratios under a variety of scenarios. We purchased the 2-year weighted average life, floating-rate, AAA rated bonds at a spread of 150 basis points over Secured Overnight Financing Rate (SOFR)4 for a yield of 6.8%. We also participated in a personal consumer loan securitization, PPWR 2024-A, brought by Purchasing Power, a specialty online retailer that sells products and services directly to employees of its clients through an employee benefit model which are paid via automatic payroll deductions or allocations. Past ABS issuances brought by Purchasing Power had low and predictable loss levels, the deal had strong structural protections to protect bondholders, and we purchased the AAA rated bonds at a spread of 140 basis points over Treasuries for a yield of 6.0%. BHG 2024-1CON is a small business loan ABS deal brought by Bankers Healthcare Group, a specialty finance company providing commercial and consumer financing to high income, skilled professionals in proven healthcare practices. The deal features robust credit enhancements through overcollateralization and excess spread, and we purchased the AAA rated bonds at a spread of 130 basis points over Treasuries for a yield of 5.9%.
Exhibit IV: Representative account characteristics as of March 31, 2024, showing credit rating, sector allocation, effective duration, spread during, yield to maturity, and option-adjusted spread.
Characteristics
At the end of the quarter, the portfolio’s duration was 0.9 years. Holdings of reserves increased modestly to 14% at quarter-end. The portfolio’s credit sector allocations were little changed quarter over quarter. High yield and nonrated investments declined slightly to 9.5%, were comprised primarily of credits rated “BB,” and consisted of a blend of corporate bonds and loans. The portfolio’s yield to maturity was 6.5% and remained elevated versus short-term bond market alternatives. The portfolio’s option-adjusted spread was 135 basis points over Treasuries; for reference, the longer-duration Bloomberg U.S. Corporate Index’s option-adjusted spread was 90 basis points at quarter-end.
Concluding Remarks
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.
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.
4 SOFR = Secured Overnight Financing Rate, which is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities
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-14653-2024-05-06 Exp. Date 07/31/2024
