One Day at a Time
Similar to the period following the Great Financial Crisis (GFC), the news media is replete with stories of doom and gloom for Municipal issuers. With each passing day, the pandemic has presented unparalleled public health, economic, and credit challenges, which make for alarming headlines. But acknowledging these challenges and connecting them to widespread municipal debt defaults is something different. What’s good for selling advertising isn’t necessarily good for forecasting credit.1
With long-term default rates of less than one-quarter of one percent, Municipal bonds have always ranked as one of the safest credit sectors. The socioeconomic impacts of coronavirus will surely be felt for years to come. Despite these challenges, there are good reasons behind the historical resiliency of Municipal credit performance. Central to our understanding of state and local governments is the concept of “service solvency”. Municipal entities are meant to exist in perpetuity and to provide services and fund infrastructure that are necessary to the public.
Few would argue about the essentiality of health, safety, and education services and the criticality of our nation’s water and sewer systems, highways, bridges, and airports. Municipal entities do not seek to maximize shareholder value and, in many cases, operate as protected monopolies with pricing power. Freedom from competition with effective liens on income streams and property are powerful credit strengths, as is the discretion to raise rates and fees on services and infrastructure that we cannot live without. In other words, we do not view Municipal credit as brittle… the vast majority can bend without breaking.
Six months have now passed since our lives and financial markets were upended. This past March brought us the most volatile markets we have ever experienced. In fact, if we looked back over the last 30 years at the days with the largest Municipal yield changes, 7 out of 10 of them occurred in March! After this tumultuous spring, the market took some time to recover during the third quarter. September provided a stark contrast to March as the 5-year AAA yield remained unchanged for 17 out of September’s 21 trading days – talk about boring! Fortunately, we are well-equipped to handle boring.
Overall market moves for the quarter as a whole were not much more exciting. The 5-year yield fell from 0.41% to 0.26%, the 10-year from 0.90% to 0.87%, and the 30-year from 1.63% to 1.62%. However, market performance was far better than those meager yield declines would suggest as strong demand for credit-sensitive bonds benefited returns. For the quarter, the intermediate maturity Municipal index generated a return of 1.1%, bringing its year-to-date result to 3.2%. We are pleased to report that our managed portfolios outperformed their benchmarks and added to their relative year-to-date gains. The strong performance of our portfolios’ prepaid natural gas, zero-coupon school district, and state housing finance authority (HFA) bonds played prominent roles.
Ongoing Municipal mutual fund inflows helped to drive credit demand, particularly in the revenue sectors. Similar to the second quarter, investors flocked to the Muni market and added over $25 billion of fresh capital to mutual funds. Before turning negative during the last week of the quarter, net fund inflows had been positive for 19 consecutive weeks – a stark contrast to the spring.
Strong demand for credit usually helps performance but, at the same time, it can limit opportunities. Although our trading volume was down compared to earlier in the year, we still picked up several attractive values, including floating rate notes from the Commonwealth of Massachusetts and Case Western Reserve University. Both of these securities offered over 50 basis points2 of spread despite their high quality and short effective maturities. We also purchased new issues from the State of California and dedicated tax bonds from within New York. These three new issues offered concessions with spreads that were two-to-three times prevailing levels prior to the pandemic. Lastly, we added to our position in Houston Airport, our first purchase in that sector since last year.
Since the onset of the pandemic, we have been attracted to the credit strengths of States and bonds that are supported or backed by state-level revenues. These state-related bonds in areas hard hit by the virus have also offered significantly higher spreads than they should, given their credit resiliency. The pandemic and its associated economic downturn have created major headwinds for the entire Municipal market, but states have received a disproportionate share of the negative press. From Senator Mitch McConnell’s suggestion that states should be enabled to file for bankruptcy, to warnings about the collapse of state finances from record-sized virus-related deficits, to unemployment funds running dry, there have been plenty of headlines for Muni investors to digest. Contrary to the fears that the news media have stoked, we believe it is a strength to be aligned with states. These governments are responsible for some of the nation’s most crucial services, including education and
healthcare. As sovereign entities, states also possess unparalleled revenue raising and expense management flexibility. This is why we view most states as durable credits.3
Many states entered the current economic crisis on strong financial footings. They utilized the decade-long economic expansion to bolster reserves, improve pension funding, and de-lever balance sheets. In fact, state debt as a percentage of gross domestic product (GDP) is at its lowest point since 2006, debt service costs had declined for a sixth straight year, and state rainy day funds ended the year at a record high. While pension liabilities still remain the sector’s Achilles Heel, strong equity returns have allowed states to make significant progress in their funding status and many have enacted reform measures. From this solid starting point, states have many levers they can pull to address the pandemic-related financial stresses.
States possess broad powers to manage operations. These powers include the abilities to cut, delay, or pass down expenditures onto lower levels of government. During the GFC, the initial priority for policy makers was to strengthen the foundation of our banking system through “TARP”, the Troubled Asset Relief Program. The following year, the Obama administration signed a broader stimulus bill known as the American Recovery and Reinvestment Act (ARRA). Neither program granted direct aid to states. Back then, states enacted material social service cuts and layoffs that many economists believe hindered the U.S. economic recovery. The current politicization of a potential aid package for states presents similar risks. We have already seen states make significant spending cuts, delay capital projects, and seek alternative funding sources. We derive great comfort from the ability and willingness of state leaders to react rapidly to the changing economic conditions.
Turning to Houston Airport, the securities we purchased are known as General Aviation Revenue Bonds, or “GARBs”, which we view as a resilient structure. Like our other airport credits, we consider Houston Airport as a tolling utility. The bonds are backed by contract payments from the airlines for the privilege of flying to and from the airport. From a competitive standpoint, Houston Airport holds a monopoly on its service area and features a robust balance sheet with strong reserves and low leverage.
When the pandemic hit, Houston, and the rest of the country, saw air travel drop an astonishing 95%. By last month, Houston had rebounded to about 40% relative to the prior year. Although we do not expect a full recovery for up to five years, our bonds still possess multiple layers of protection, notwithstanding the Federal aid it received via the Coronavirus Aid, Relief, and Economic Security Act (CARES). First, if air-travel is to occur, the charges that back our bonds must be paid. Second, Houston Airport has over two years of cash on hand for operations that it can use to service its debt. Lastly, our bonds feature a debt service reserve that also helps protect against the risk of further interruption for up to an additional year.
We are now well into the Fall with the return of in-person schooling and an uncertain outlook for a second wave of the virus. Hyper-partisan politics which threatens a state aid package and an upcoming presidential election only add to the existing economic uncertainties. Despite these challenges, we believe that the vast majority of Municipal issuers have the flexibility and resources available to see them through to the other side of the pandemic. Not all issuers will remain unscathed and our job is to protect our clients’ capital by avoiding them. Nursing homes, student housing, non-essential infrastructure, and projects reliant upon growth are examples of sectors in which we do not invest and are very exposed in the current environment. Many may face the real threat of insolvency. These are a few examples of credits that you will not find in a BBH-managed muni portfolio.
As you know, capital protection is our first objective and given today’s environment – it is more important now than ever to invest in durable, well-managed, and appropriately structured credits that we fully understand. The credits in which we invest possess layers of protection, that serve as margins of safety.4 This can be achieved in many ways, such as from operating flexibility, balance sheet strength, price autonomy, protective covenants, and reserve accounts, among others. A BBH-managed Muni portfolio is built one bond at a time with durable credits meant to withstand a wide range of economic and political environments.
Prior to this year, we did not conduct our credit research with a pandemic explicitly in mind, but we always questioned ourselves on what can go wrong to find each bond’s potential weak spots and their associated mitigants. Our large exposures to states, state-supported school districts, and state HFAs form the core of our active Municipal strategy. Our other holdings also finance essential services or critical infrastructure and possess numerous credit strengths to help preserve the value of our clients’ portfolios.
There are many reasons to worry, but we don’t want your Muni portfolio at BBH to be one of them. Like you, our families have all been disrupted by the pandemic and it is going to be a while until we return to normal. Until then, we will take it one day at a time.
We hope you and your families stay safe.
There is no assurance that a portfolio will achieve its investment objective or that the strategy will work under all market conditions. The value of the portfolio can be affected by changes in interest rates, general market conditions and other political, social and economic developments. Each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.
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.
Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax.
The Strategy also 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 stock or bond investments.
As the Strategy’s exposure in any one municipal revenue sector backed by revenues from similar types of projects increases, the Strategy will become more sensitive to adverse economic, business or political developments relevant to these projects.
The Representative Account is the account whose investment guidelines allow the greatest flexibility to express active management positions. It is managed with the same investment objectives and employs substantially the same investment philosophy and processes as the proposed investment strategy.
The BBH Intermediate Municipal Strategy is comprised of fully discretionary, fee-paying municipal fixed income accounts over $5 million that are managed to an average duration of approximately 4.5 years. Accounts are benchmarked to the Bloomberg Barclays 1-10 Year Municipal Blend Index. On 10/1/2020 the BBH Intermediate Municipal Strategy was renamed the BBH Municipal Fixed Income Strategy.
Bloomberg Barclays 1-10 Year Municipal Bond Index is a component of the Barclays Municipal Bond index, including bonds with maturity dates between one and 17 years. The Bloomberg Barclays Municipal Bond Index is considered representative of the broad market for investment grade, tax-exempt bonds with a maturity of at least one year. One cannot invest directly in an index.
For purpose of complying with the GIPS® standards, the firm is defined as Brown Brothers Harriman Investment Management (“IM”). IM is a division of Brown Brothers Harriman & Co. (“BBH”). IM claims compliance with the Global Investment Performance Standards (GIPS®). To receive a list of composite descriptions of IM and/or a presentation that complies with the GIPS standards, contact John W. Ackler at (212) 493-8247, or via email at firstname.lastname@example.org.
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 reflect the deduction of the maximum investment advisory fees. Performance calculated in U.S. dollars.
Holdings are subject to change.
Credits: 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.
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.
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. References to specific securities, are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.
Past performance does not guarantee future results, and current performance may be lower or higher than the past performance data quoted. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost.
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. 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. 2020. All rights reserved.
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IM-08547-2020-10-12 Exp. Date 01/31/2021
1Previously called the BBH Intermediate Municipal Strategy
2Basis 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
3Obligations 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.
4 With respect to fixed income investments, a margin of safety exists when the additional yield offers, in BBH’s view, compensation for the potential credit, liquidity and inherent price volatility of that type of security and it is therefore more likely to outperform an equivalent maturity credit risk-free instrument over a 3-5 year horizon.