Exhibit I: A line graph comparing the yields of the 5 Year U.S. Treasury Yield, Bloomberg U.S. Corporate Index, and ICE BofA AA-BBB Miscellaneous ABS Index from December 2010 through December 2022, where the yields of each index at the end of 2022 were near their highest levels experienced over this timeframe.
4Q Highlights
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Many Happy Returns… On the Returns of High Yields, Recession Concerns, and Issuance
2023 offers fixed income investors opportunities to re-engage the bond market as Treasury yields are at 15-year highs and there are an abundance of credit opportunities outside of traditional benchmarks. We caution that this is not a call on a “top” in rates nor an “all-in” recommendation with credit. Navigating this market will not be easy, as several segments of the credit market appear unattractively valued and a potential recession looms. That said, we believe fixed income investors should increase credit allocations given the substantial positive changes in compensation for credit and liquidity risk.
Investors endured the worst year in bond market history to reach this point. Interest rates rose significantly from historical lows. Fund outflows were large and persistent, in some cases necessitating forced selling of credit instruments by fund managers. Credit spreads widened across sectors and qualities. The conflict in Eastern Europe resulted in impairments to debt instruments tied to both Russia and Ukraine. Even traditionally staid segments of the market, such as short-maturity debt indexes, faced declines. If you held bonds of any maturity or quality, there were few places to hide from negative returns during 2022.
The fourth quarter provided a respite from the otherwise difficult conditions faced during the first nine months of the year. Longer-term interest rates were relatively stable despite 125 basis points1 of Federal Reserve (Fed) rate hikes, and IG corporate risk spreads narrowed. Our fixed income strategies experienced a mix of modest out- and under-performance during the quarter, though a discussion about the quarter’s results feels misplaced without the broader context of 2022.
We remain exceptionally proud of our strategies’ performance in 2022. Many of our strategies outperformed their benchmarks while simultaneously capitalizing on a substantial amount of attractive new opportunities. Our valuation discipline and credit process were tested yet again, and we are happy to report that credit impairments were avoided. Relative performance results may not fully reveal the journey of protecting against the rapid credit revaluation that occurred earlier in 2022, nor the subsequent identification of attractive credits purchased at high yields.
Hello Bond Yields, My Old Friend
At the onset of 2022, we observed the misalignment of bond yields below inflation expectations at comparable tenors across the yield curve. We remarked that those yield levels implied that either inflation would not be a problem, or that the Fed would be able to contain its effects swiftly… neither of which followed. We do not attempt to forecast interest rates, nor do we take active positions on the direction of interest rates. But we are certainly pleased to be able to invest at substantially higher yields than a year ago.
As Exhibit I shows, yields of various IG indexes were well above levels experienced throughout the 2010s. Many investors recall the fruitful returns fixed income strategies earned during the mini cycles of the past dozen years. Those episodes tended to be short-lived and were associated with “snap-backs” of credit valuations from distressed levels to more-normal levels. This environment affords investors the opportunity to earn higher yields in an interest rate regime that may prove to be more sustainable than past pockets of opportunity.
Exhibits II and III illustrate how Treasury yields changed relative to for-ward-looking inflation expectations at the start of 2022 versus now. The return of positive real yields provides a potential tailwind to investors seeking to capitalize on this new yield regime through renewed alloca-tions to fixed income.
Exhibit II: A line graph comparing U.S. Treasury Yields and Consumer Price Index Estimates for various tenures, measured in years, as of 12/31/2021, where Treasury Yields are below CPI estimates at every tenure.
Exhibit III: A line graph comparing U.S. Treasury Yields and Consumer Price Index Estimates for various tenures, measured in years, as of 12/31/2022, where Treasury Yields are above CPI estimates at every tenure.
Recession Concerns Returned, Too
While the prospect of rising rates spooked investors at the start of 2022, a different concern seems prevalent as we start 2023: recession. We believe investors are right to question how credit investments might be impacted during a recession. There are a few observations that give us comfort on how credit can still outperform through an economic slowdown.
First, credit tends to perform well through recessions. Exhibit IV shows that credit indexes performed much better than equity counterparts during the past three recessions as defined by the National Bureau of Economic Research. Performance challenges tend to come before recession hits, similar to what markets observed in 2022.
Exhibit IV: A bar chart showing the performance of various credit indexes – investment grade corporate bonds, bank loans, high yield corporate bonds, nontraditional ABS, and CMBS – compared to an equity index (the S&P 500) during the past three periods of recession, where the credit indexes outperform the stock index in nearly every instance.
Second, credit spreads rose during 2022. While spread widening may have many causes, one cause was surely concern about a looming recession. Credit market valuations suggest there is less complacency in the market, and therefore market participants may already be pricing in the prospect of an economic downturn.
Third, we stress test the credits we buy and hold to make sure they can survive the most severe conditions their industries have faced. It is difficult to forecast exactly how a recession might impact individual industries, but our process of stressing to an extreme environment gives us reasonable expectation that credits owned can navigate a difficult economic environment.
Regardless of whether a recession occurs, the road ahead is likely to be choppy as credit valuations can be impacted by concerns about the economy, a credit’s industry, a security-specific concern, or by fund flows necessitating forced selling. We believe our process of making these decisions on a bond-by-bond basis with the benefit of defined valuation and credit criteria is imperative to optimizing investment experiences.
Credit Valuations – Corporate Spread Narrowing Requires Thinking Beyond Bond Benchmarks
Corporate bond spreads rose from historically low levels in 2022 and remained near their longer-term medians by year-end. As corporate bond spreads narrowed during the fourth quarter, our valuation framework2 identified fewer corporate bonds that screen as “buy” candidates. Our valuation framework identifies only 36% of the IG index and 46% of the high yield corporate bond index that meet our criteria for a new purchase. These levels are down from 65% for the IG corporate bond index and 62% for the high yield corporate bond index at the end of the third quarter.
Outside of mainstream benchmarks, we are finding an abundance of attractively-valued credits. Valuations of nontraditional ABS, SASB CMBS, and bank loans remain broadly attractive, as their spreads widened during the fourth quarter and remain at levels typically seen during recessions. Valuations of corporate bonds that do not meet index inclusion criteria due to their issuance size, structure, or the number of credit ratings assigned continue to offer outsized yields relative to their underlying quality.
We believe the state of credit valuations has two implications for investors. First, although yields are at decade-plus highs, careful attention must be paid to credit valuations, and investing passively in credit might yield disappointing results. Second, credit diversification, including diversification beyond the traditional segments that dominated benchmarks, may be appealing as a portfolio diversifier to traditional stock and bond portfolios.
Better Days Ahead for Credit Issuance, Too
Bond prices were not the only thing to decline in 2022; issuance volumes declined across corporate and structured credit markets. High grade corporate bonds experienced a 16% decline in volume while high yield corporate bonds and bank loans experienced 76% and 63% slowdowns, respectively. CMBS volumes declined 36%, while new issues of CLOs decreased 31% from 2021 volumes. ABS volumes proved resilient, declining only 8% from 2021’s record pace despite the challenging environment that persisted.
Meanwhile, bond fund flows went in one direction in 2022: negative. The scale and persistence of outflows were unprecedented and contributed to both widening credit spreads and slowdowns in issuance volumes. Higher yields should combine with a Fed nearing the end of its tightening campaign to attract buyers in the not-too-distant future. The first few trading sessions of 2023 provided hope that this may have already begun. There was a heavy supply of issuance during the (usually) slow holiday week following the New Year holiday.
Our Activity
At the start of 2022, our concern was that valuations were broadly unattractive, and that our investor’s patience would be tested as their portfolios accumulated reserves. Those concerns were illustrative of a market at the peak of its cycle, and they proved correct as credit spreads began to widen in January and reached their 2022 peaks in mid-October. Client portfolios were protected against the widening of spreads from historically low levels and from credit impairments that occurred due to the Russia/Ukraine conflict.
The above positioning also allowed us to spend reserves and buy attractively-valued credits. This process unfolded throughout the year, and portfolios are now holding minimal levels of reserves. We were active purchasers of a variety of IG corporate bonds, high yield corporate bonds, and senior bank loans, with the heaviest activity in debt issued by banks, life insurers, and electric utilities. We purchased bonds of 20 distinct nontraditional ABS deals, including subprime auto ABS, CLOs, personal consumer loan ABS, large and small ticket equipment ABS, as well as SASB CMBS.
Our strategies’ relative performance was mixed as this process played out, similar to past episodes when spreads widened to attractive levels and brought an abundance of opportunities. We are happy our strategies outperformed during a time when spreads widened from historically low levels. While performance can be choppy as we scale into credit positions, we believe the current environment affords our clients the benefit of having their portfolios fully invested into carefully selected and attractively-valued credits.
Remain Disciplined on This Trip Around the Sun
It is hard to look back at the negative returns of 2022 and see the virtues associated with disciplined valuation and credit processes. Broad-based negative returns may have masked instances of credit impairments, painful credit valuations, or outcomes of more-positive changes to credit positioning. However, an era of higher yields and credit spreads, amid increased recession concerns and the prospect of heavier issuance, requires investors to balance an opportunistic mindset with appropriate caution. Individual bond selection is the best approach to stay vigilant over the long term. We look forward to our conversations as we navigate 2023 with you.
1 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.
Gross of fee performance results for the composites do not reflect the deduction of investment advisory fees. Actual returns will be reduced by such fees. Net of fees performance reflects the deduction of the maximum investment advisory fees. Performance is calculated in U.S. dollars.
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.
* Returns are not annualized
On 12/31/2021, the BBH Core Fixed Income Composite was renamed the BBH Core Plus Fixed Income Composite. On 7/11/2022, the BBH Unconstrained Credit – Fixed Income Composite was renamed the BBH Multisector Fixed Income Composite.
BBH Limited Duration Fixed Income Composite inception date is 1/1/1990, BBH Multisector Fixed Income composite inception date is 5/15/2014, BBH Structured Fixed Income Composite inception date is 1/1/2016, BBH Intermediate Duration Fixed Income Composite inception date is 7/1/1985, BBH Municipal Fixed Income Composite inception date is 5/1/2002, BBH Core Plus Fixed Income Composite inception date is 1/1/1986, BBH Inflation-Indexed Securities Composite inception date is 4/1/1997, BBH Intermediate Inflation-Indexed Securities Composite inception date is 11/1/2004.
The BBH Structured Fixed Income Benchmark is a combination of two indices. The Bloomberg US ABS Index was used prior to 11/1/2023; the Bloomberg U.S. ABS ex. Stranded Cost Utility Index is used subsequently. Due to recent changes in the composition of the Bloomberg US ABS Index, the new Bloomberg US ABS ex. Stranded Cost Utility Index more closely reflects the effective duration of the strategy.
Index Definitions
BDC Corporate is computed as an equal-weighted index of corporate bonds issued by business development companies (BDCs) that BBH holds with at least one year until legal, final maturity.
The BofA Merrill Lynch US Corporate Index tracks the performance of USD denominated investment grade corporate debt publicly issued in the U.S. domestic market.
ICE/BofA 1-5 Year US Fixed Rate CMBS Index consists of USD denominated, fixed rate commercial mortgage-backed securities (CMBS). The Index is comprised of CMBS tranches where the issues are rated investment-grade using an average of Moody’s, S&P, and Fitch and have durations greater than 1 year but less than 5 years when the index is constituted. To be eligible for inclusion, CMBS issues must have a minimum original deal size of $250 million, at least $50 million current outstanding for senior tranches and $25 million for mezzanine and subordinated tranches, and at least 10% of the original deal size must be currently outstanding.
ICE BofA US Fixed-Rate Miscellaneous Asset-Backed Securities (ABS) Index is a subset of the ICE BofA US Fixed-Rate ABS Index, ex securities collateralized by auto loans, home equity loans, manufactured housing, credit card receivables and utility assets. Securities are publicly issued, USD, with an IG rating based on an average of Moody’s, S&P and Fitch.
JP Morgan CLO Index (JPM CLO) is a market value weighted benchmark tracking U.S. dollar denominated broadly-syndicated, arbitrage CLOs. The index is comprised solely of cash, arbitrage CLOs backed by broadly syndicated leveraged loans. All CLOs included in the index must have a closing date that is on or after January 1, 2004. There are no weighted average life (WAL) limitations. There are no minimum tranche size restrictions.
JP Morgan Other ABS Index (Non-Tradional ABS), is an index that represents ABS backed by consumer loans, timeshare, containers, franchise, settlement, stranded assets, tax liens, insurance premium, railcar leases, servicing advances and miscellaneous esoteric assets of the The J.P. Morgan Asset-Backed Securities (ABS) Index. The JP Morgan Asset-Backed Securities (ABS) Index is a benchmark that represents the market of US dollar denominated, tradable ABS instruments. The ABS Index contains 20 different sub-indices separated by industry sector and fixed and floating bond type. The aggregate index represents over 2000 instruments at a total market value close to $500 trillion dollars; an estimated 70% of the entire $680 billion outstanding in the US ABS market.
Merrill Lynch 1-3 Year US Treasury Index is an index of fixed rate obligations of the U.S. Treasury with maturities ranging from 1 to 3 years.
Morningstar /LSTA Leveraged Loan Index (the Index) is a market value-weighted index designed to measure the performance of the U.S. leveraged loan market based upon market weightings, spreads and interest payments. Facilities are eligible for inclusion in the indexes if they are senior secured institutional term loans with a minimum initial spread of 125 and term of one year. They are retired from the indexes when there is no bid posted on the facility for at least 12 successive weeks or when the loan is repaid.
S&P 500 is a market-capitalization-weighted stock market index that tracks the stock performance of the 500 largest U.S. public companies.
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.
Intermediate Aggregate (AA) represents securities in the intermediate maturity range of the Bloomberg Aggregate Index.
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.
Bloomberg Intermediate Gov/Credit Index is a broad-based flagship benchmark that measures the non-securitized component of the US Aggregate Index with less than 10 years to maturity. The index includes investment grade, USD denominated, fixed-rate treasuries, government-related, and corporate securities.
Bloomberg US 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 US Intermediate Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers that have between 1 and up to, but not including, 10 years to maturity.
Bloomberg US Corporate High Yield Index (BBG HY Corp) is an unmanaged index that is comprised of issues that meet the following criteria: at least $150 million par value outstanding, maximum credit rating of Ba1 (including defaulted issues) and at least one year to maturity.
Bloomberg US TIPS Index includes all publicly issued, U.S. Treasury inflation-protected securities that have at least one year remaining to maturity, are rated investment grade, and have $250 million or more of outstanding face value.
Bloomberg US ABS Index is the asset backed securities component of the Bloomberg US Aggregate Bond Index. The index includes pass-through, bullet, and controlled amortization structures. The ABS Index includes only the senior class of each ABS issue and the ERISA-eligible B and C tranche. The Bloomberg US ABS ex. Stranded Cost Utility Index excludes certain stranded cost utility bonds included in the Bloomberg US ABS Index.
The Bloomberg Non-AAA ABS Index (Non-AAA Traditional ABS) is non-AAA ABS components of the Bloomberg US Aggregate Bond Index, 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 MBS Index tracks fixed-rate agency mortgage backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The index is constructed by grouping individual TBA-deliverable MBS pools into aggregates or generics based on program, coupon and vintage.
Bloomberg Non-Agency CMBS Index (Non-Agency CMBS) is the Non-Agency CMBS components of the Bloomberg US Aggregate Bond Index, 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®” 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.
Composites Description
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.
The objective of our Multisector Fixed Income Strategy is to deliver excellent returns in excess of industry benchmarks through market cycles. The Composite includes all fully discretionary fee-paying with an initial investment equal to or greater than $10 million that are managed using the Unconstrained Credit – Fixed Income strategy. Accounts are invested in a broad range of taxable bonds, with the duration target approximately 4.5 years. Investments are primarily investment grade securities. Account guidelines are not materially restrictive. Account that subsequently fall below $9.25 million are excluded from the Composite.
The objective of our Structured Fixed Income Strategy is to deliver excellent returns in excess of industry benchmarks through market cycles. The Composite is comprised of all fully discretionary, fee-paying structured fixed income accounts over $10 million. Investments are focused on asset-backed securities, commercial mortgage-backed securities, collateralized loan obligations, and corporate debt securities that are primarily investment grade. Non-investment grade securities may be held. Investments are focused on U.S. dollar denominated securities, but non-U.S. dollar securities may be held. The accounts are managed to a duration +/- 2 years of the Bloomberg ABS ex-Stranded Cost Utility Index. Effective December 1, 2022, the composite definition was changed slightly altered to establish a duration band around the duration of the Bloomberg ABS ex-Stranded Cost Utility Index.
The objective of our Intermediate Duration Fixed Income Strategy is to deliver excellent returns in excess of industry benchmarks through market cycles. The Composite included all fully discretionary fee-paying fixed income accounts over $5 million that are invested in governments and corporates, with a duration of approximately 2 years. Accounts that subsequently fall below $4.5 million are excluded from the Composite.
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.
The objective of our Core Fixed Income Strategy is to deliver excellent after-tax returns in excess of industry benchmarks through market cycles. The Composite included all fully discretionary, fee-paying core fixed income accounts over $10 million that are managed to a duration of approximately 4.5 years and are invested in a broad range of taxable bonds. Accounts that subsequently fall below $9.25 million are excluded from the Composite.
The objective of our Inflation-Indexed Fixed Income Strategy is to deliver excellent returns in excess of industry benchmarks through market cycles. The Composite included all fully discretionary, fee-paying domestic accounts over $10 million with an emphasis on U.S. inflation indexed securities. May invest up to approximately 25% outside of U.S. inflation indexed securities, and a duration of approximately 7-9 years. Accounts that subsequently fall below $9.25 million are excluded from the Composite.
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.
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. 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-12263-2023-01-20 Exp. Date 04/30/2023
