Lots to Process: Rates, Valuations, and Governance

The first quarter was one for the bond market history books. Interest rates rose significantly and rapidly, while credit spreads widened, culminating in the worst-performing quarter for bonds in over 40 years. Inflationary pressures remain stubbornly high and yield swings reflected a Federal Reserve (Fed) pivoting to a much more aggressive stance than anticipated. Meanwhile, Russia’s invasion of Ukraine led to credit market weakness and substantial impairments in credits tied to both countries.

We are pleased to report that our fixed income strategies outperformed their respective benchmarks during the first quarter. Although many of our strategies carried higher allocations to credit than their benchmarks, elevated income and favorable selection results buoyed our strategies’ relative results – durable credits with attractive valuations owned in client portfolios outperformed Treasury alternatives despite overall credit market weakness. Portfolios also had less exposure to the most-troubled areas of the market, including segments we deemed to be expensively valued or carrying elevated credit risks.

Our clients’ inboxes are no doubt crowded with historical comparisons of the first quarter rate changes, so we would rather focus on how the bond market has evolved in three short months and how we shifted our clients’ portfolios accordingly.

Credit selection matters

It is no longer enough to say “asset-backed securities are cheap” or “time to pour into high yield” when thinking of valuations in the credit opportunities. Credit markets today are incredibly diverse and nuanced, so investors must evaluate valuation on a bond-by-bond basis. Value opportunities can be highly idiosyncratic and can depend heavily on forces such as supply-demand technicals, investor awareness, index inclusion, ratings reception, and news headlines. Credit spreads widened during the first quarter, and credit markets are more attractive today than they were three months ago. However, valuations do not suggest that every segment of the market is a screaming buy. Selectivity matters.

One might guess that a credit-oriented portfolio without active duration or yield curve positions would underperform a Treasury portfolio when credit spreads widen. Yet we observed some actively managed, credit-oriented bond funds that outperformed in such an environment. Other actively managed, credit-oriented bond funds with heavier exposures to emerging market debt or longer-maturity corporate bonds underperformed during the quarter. As a result, we want to explain where we are finding opportunities and how that has manifested in client portfolios.

Valuations

Heading into the quarter, we found valuations of “on-the-run” corporate bonds (defined as corporate bonds represented in market indexes) wholly unattractive. Our clients’ portfolios held credit positions in niche and non-benchmark segments of the market alongside reserves or Treasuries, depending on the portfolio’s interest rate risk objectives. As the quarter progressed, credit spreads widened, valuations improved, and opportunities emerged – but it was hardly a buyer’s market in corporate bonds. As Exhibit I shows, the percentage of investment-grade corporate bonds that screened as a “buy” candidate increased to only 12% at quarter-end from 2%. However, credit spreads peaked in the middle of March before compressing, and the percentage of the universe that screened as a “buy” candidate reached 28%. We participated actively in “on-the-run” corporate, niche corporate, and structured credit opportunities during this episode, as clients will notice through an uptick in their portfolios’ credit exposures versus last quarter.^[1]

Valuations are only the first step in assessing a credit for purchase. Additional elements include passing a rigorous credit screen for durability through a wide variety of economic circumstances and the ability to source the credits in the marketplace. The past quarter underlined why appropriate credit criteria remain a critical component of a successful investment process.

The conflict in Ukraine is a somber reminder why credit durability matters

We put aside our personal sentiments for a speedy and peaceful resolution in Ukraine to briefly discuss credit implications from the conflict and from the resulting sanctions imposed on Russia.

First, debt issued by Ukrainian- and Russian-domiciled institutions has been removed from indices and written down to negligible values. We are only an outside observer to these debt issues as our clients’ portfolios had no exposure to these instruments. There is over $400 billion of dollar-denominated debt outstanding from Russian and Ukrainian issuers, but we could never satisfy ourselves that these were countries with enforceable debtor’s rights, let alone the type of transparency and governance that we require in our holdings.

Some indirect credit exposure emerged during the quarter as adverse price moves were observed for companies or collateral exposed to Russia or Ukraine. Our client portfolios had small exposure to credits in these impacted industries, that include select energy, aviation, financial companies, and asset-backed securities (ABS). Spreads widened marginally in these credits, but price declines were moderate. It was helpful to have a deep understanding of, and strong transparency into, these credits, as we were able to identify the magnitude of exposures quickly and test ongoing durability. We continue to hold these credits and did not sell exposures in any meaningful manner. Underlying fundamentals remain strong and suggest their durability will allow them to manage through any uncertainty involving such exposures.

The ultimate impact to exposed credits remains uncertain. It will depend on the management of Russian and Ukrainian operations and will only become known over a longer horizon. Well-capitalized and well-managed global companies will likely weather the storm, although asset write-downs may result in some credit rating downgrades.

The challenging events of the last few months underscore two cornerstones of our approach. First, research a credit’s durability, leverage, management, and transparency. These facets are essential to identifying strong companies and asset pools that are well positioned to weather the environment ahead. Second, invest with a margin of safety. This means commanding a higher spread as compensation for unavoidable volatility and cushion against severe economic stress.

Credit issuance was mixed in Q1

It may seem that Q1 was a ripe environment for an active manager to identify and invest in many new opportunities. Maintaining selectivity on valuation and credit criteria has been crucial, and it metered our pace of purchase. An additional limitation was issuance which was a mixed bag for the credit markets during the quarter. Corporate credit issuance slowed in February when rising rates combined with uncertainties from the onset of the Russian/Ukrainian conflict. Issuance rebounded strongly in March, but first quarter new issue volumes remained below trend, particularly for loans and high yield bonds. Asset-backed security issuance was strong, and it continued to be carried by issuances of non-traditional collateral. Commercial mortgage-backed securities (CMBS) experienced another quarter of robust issuance that saw newer structures, such as single-asset single-borrower (SASB) and commercial real estate collateralized loan obligations (CRE CLO’s), outpace issuance of traditional conduit structures. We remained prepared to exploit credit opportunities in traditional and non-traditional segments of the market, and we were active buyers of durable credits at attractive valuations in these higher issuance market segments.

What did we do?

As attractively valued opportunities emerged during the quarter, we were ready to deploy capital from our clients’ portfolios. Our client accounts generally experienced declining balances of cash and Treasuries that were used to purchase both “niche” and “on-the-run” credits. We believe that “niche” opportunities can emerge in almost every market, while “on-the-run” credits tend to be mainstream, liquid deals that dominate indexes and present good value opportunities only episodically. More of our purchases were concentrated among “niche” segments of the credit markets, as only a few “on-the-run” credits presented attractive valuations. Overall, we took advantage of these higher spread opportunities to increase spread duration (sensitivity to credit spreads) in our portfolio by 20-30% over last fall’s levels.

In the first quarter, we found improved valuations in several types of non-traditional ABS that offer unusually attractive compensation, including collateralized loan obligations (CLO’s), recurring revenue ABS, small business loan ABS, personal consumer loan ABS, servicer advance ABS, and venture debt ABS. In the commercial mortgage-backed securities (CMBS) market, we purchased fixed- and floating-rate, single-borrower securitizations that offered compelling valuations for client portfolios.

We also identified several attractively valued “on-the-run” corporate debt opportunities due to issuance that coincided with wider spread levels, and “niche” opportunities of less-familiar issuers or smaller sized issues. Our corporate debt purchases included bonds and loans issued by banks, business development companies (BDC’s), health care companies, media entertainment companies, and property and casualty insurers.

Looking forward, we are cautiously optimistic for bond investors

Given the boost in rate and spread compensation, we are proceeding with a mix of optimism and caution. Higher bond yields provide a tailwind to forward-looking returns. However, credit valuations still command a selective approach as the majority of the investment grade and high yield corporate markets are still too richly valued to purchase based on our time-tested valuation criteria. We remain confident that our disciplined investment process will continue to serve our clients well as we navigate what is likely to be a more volatile period ahead.

We look forward to our upcoming client meetings, and thank you for the trust placed in us.

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.

The Core Plus Fixed Income Representative Account is managed with the same investment objectives, employs substantially the same investment philosophy as the strategy.

* Returns are not annualized

On 12/31/2021, the BBH Core Fixed Income Composite was renamed the BBH Core Plus Fixed Income Composite.

BBH Limited Duration Fixed Income Composite inception date is 1/1/1990, BBH Unconstrained Credit – 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.

Index Definitions

The BofA Merrill Lynch U.S. Corporate Index tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market.

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.

Bloomberg US 1-3 Year Treasury Bond Index is an index of fixed rate obligations of the U.S. Treasury with maturities ranging from 1 to 3 years.

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, US dollar-denominated, fixed-rate treasuries, government-related, and corporate securities.

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.

“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 Unconstrained Credit – 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 includes all fully discretionary fee-paying accounts with an initial investment equal to or greater than $10 million that are managed to the Structured Fixed Income strategy. The target duration may range from 2 to 6 years. Investments are focused on asset-backed and related structured fixed income securities. Holdings are primarily investment grade but non-investment grade securities may be held. Investments may include non-dollar fixed income.

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.