The past few weeks of market volatility have no doubt been unnerving. While none of us would ever wish for the circumstances that are often the catalyst for significant market dislocations, experienced investors understand that these dislocations most often produce attractive investment opportunities. At BBH, our approach to investing in volatile markets is to remain disciplined and let valuation and credit durability direct where, when, and to what degree we invest. We find that investors who are forced to liquidate into these markets often unload high quality assets that prove the easiest to sell. We are willing to provide these investors the liquidity to do so at a measured and thoughtful pace. Over the next few weeks, it is our intention to send these commentaries out at the end of each week to keep our clients and partners informed on the developments and opportunities we are uncovering in the U.S. fixed income markets. In particular, the commentary will focus on four segments of the U.S. fixed income markets: Corporate Credit, Structured Fixed Income, Municipal Bonds and TIPS. We hope you and your families remain safe and comfortable throughout the duration of this difficult time.

Corporate Credit

We generally define the universe of corporate credit in which we will invest as bonds and loans rated double-B or higher. In the past few weeks, credit spreads in this universe are 125-350 basis points1 wider. We use a proprietary valuation model to set buy, hold and sell targets for each potential opportunity in the universe. Trading costs, long run default expectations, and a margin of safety calculation reflecting expected volatility differences between sectors and sub-sectors are the primary inputs to the valuation model. Currently, nearly 90% of the corporate credit universe is trading in our defined “buy zone”, up from less than 10% only a month earlier. Liquidity has been poor, meaning trading costs are elevated, but markets are functioning. We have incorporated the higher cost of trading into our valuation model. The spread curve in corporate credit is inverted, meaning credit spreads are wider in shorter maturities than in longer maturities. This is not an unusual occurrence in crisis-driven market events as investors who are forced to sell choose to unload securities with the least price decline (which are found at the short-end of the market as a result of their shorter duration). While we believe the inversion is largely technical in nature (i.e. meaning it is the result of heightened selling pressure), there are sectors facing real fundamental problems, including energy, aviation, tourism/travel, and retail. We have modest exposures in energy-related credits such as power generation and pipelines which we will continue to monitor closely.

Percentage of Bank of America Merrill Lynch U.S. Corporate Index in BBH Buy Zone vs Option Adjusted Spread. Graph illustrating percentage in buy zone versus option adjusted spread of Merrill Lynch US Corporate index. Data as of December 2018 to March 2020.

In what we view as a positive sign, several large issuers came to market this week with maturities ranging from 5-30 years. The issuers in which we participated for our client included Verizon, ExxonMobil, Pepsi, Bank of America and Progressive. The issuance was oversubscribed, indicating demand was strong, which is a reassuring sign that capital markets are still functioning. Investor willingness to buy longer maturities is also a comforting sign indicating confidence that better times lie ahead beyond the current turmoil. We have also been selectively active in shorter maturities using the technical dislocations to add high quality bank paper at yields close to 3%. We’ve learned from prior crisis-driven events to act deliberately, but also at a deliberate pace. Markets trend, and we expect liquidity and sentiment to be uneven for a long while. If conditions worsen, we want to maintain a level of reserves to add opportunities at wider spreads.

Structured Fixed Income

We generally define the universe of structured fixed income in which we will invest as performing asset-backed securities (ABS), commercial mortgage-backed securities (CMBS), collateralized loan obligations (CLO) and secured corporate debt. In particular, we often find the most attractive valuations in non-traditional ABS (ABS other than credit card, prime automobile loans and student loans), single-asset, single-borrower CMBS, and short-tenor CLOs. Loan losses will inevitably rise when the economy becomes challenged, as it is now. Therefore, we only purchase securitized investments that have generous structural credit enhancement, with sound collateral, that are underwritten to stress levels that approximate depression-like conditions. Given this level of protection, we expect our investments in the sector to hold up well in periods of market stress, and so far that has been the case. Spreads in non-traditional ABS and CMBS are generally 100-200 basis points wider since the onset of the market sell-off. Some sub-sectors that are likely to experience elevated stress from the current set of circumstances - including aircraft, personal consumer loans, and shipping container ABS, as well as CMBS securitized by retail properties - have all experienced significantly more widening. While our portfolios are well diversified across sub-sectors, we maintain modest exposure to all the sub-sectors noted above, and we have sufficient room to add as opportunities materialize.

Option Adjusted Spread chart illustrating spread of February 29th and March 17th

Secondary market activity picked up noticeably this week and we were active. We added a high-quality position securitized by personal consumer loans at a spread of 400 basis points and selective prime auto and triple-A rated CMBS at spreads near or exceeding 200 basis points. As with corporate credit, we intend to invest at a measured pace while conditions remain challenged. For example, while our valuation work is indicating buy signals on aircraft-related securitized debt, we are remaining patient as uncertainties surrounding government assistance to the industry could lead to a wide dispersion of short-term outcomes.

Municipal Bonds

We generally define the universe of municipal bonds in which we will invest as general obligation and revenue bonds rated single-A or higher. Most lower rated-issuers do not meet the durability requirements of our credit criteria. Strong investor preferences persist in the municipal bond market which can both distort valuations and create opportunity. These preferences include state specificity, coupon bearing securities, fixed rate debt and debt with little or no structure such as call features. As a result, revenue bonds, zero-coupon bonds and bonds with call features often trade at yield concessions to coupon bearing, non-callable general obligation debt. Municipal bonds initially held up well as the current crisis-driven market ensued, appearing as a possible haven for investors. Confidence in the sector quickly eroded as the risk selloff intensified, driving municipal bond rates and spreads significantly higher. Since that point, municipal bond rates have risen 100 basis points across the curve with credit spreads out 75-150 basis points. As with taxable credit sectors, certain sub-sectors most sensitive to the current circumstances – airports, pre-paid natural gas, and travel/tourism – have experienced spread widening in excess of 150 basis points.

As a result of the significant rise in municipal bond rates, municipal bond ratios to U.S. Treasuries have risen to well over 200% in short maturities and 150+% in longer maturities. Ratios in excess of 200% are highly unusual and historically do not persist for long. Most of our activity in institutional accounts this week has been in short maturity, high quality bonds. We will purchase municipal bonds for institutions that are generally tax exempt when the spreads to Treasuries are attractive, much as we would for a corporate bond. Given challenging liquidity conditions in the municipal bond market, the team is maintaining reserves which has been made more palatable by a significant increase in yields on variable rate demand notes (VRDNs). VRDNs are high quality money market instruments which would typically offer yields around the Fed Funds rate. This week yields on some VRDNs in which we invest are at or above 5%, an indication of the challenged liquidity environment. We have seen liquidity-driven dislocation in the municipal bond market in previous periods of stress, and they have created some of the most attractive opportunities we have sourced in the sector. Stay tuned.

Municipal to treasury ratio chart, illustrating 2-year ratio versus average. Data as of December 2004 to December 2019.

U.S. TIPS

Investors strategically own TIPS to provide protection in periods of unanticipated inflation. With a significant economic contraction likely and with an oil price war unfolding, investors today are surely not worried about near-term inflation. In fact, deflation concerns may become more prominent. But longer-term, amid record amounts of monetary stimulus and substantial fiscal stimulus in development, some investors are looking beyond this crisis period to a time when more normal inflation levels will be restored. This is not at all what is being reflected in today’s TIPS market which has rarely been cheaper.

10-year breakeven inflation rate chart. Data as of December 2018 to March 2020.

 

BBH takes a “pure play” approach to TIPS investing, which is to say that we seek outperformance by exploiting inefficiencies in the TIPS market, without turning to other sectors for added return. The best indicator for TIPS demand, and market expectations for inflation, is the breakeven inflation rate. This rate is measured as the yield difference between the real yield for TIPS and the nominal yield of a similar-maturity U.S. Treasury note. Today’s 10-year breakeven inflation rate of 0.7% essentially says that investors expect CPI to average only 0.7% over the next 10 years. As shown in the accompanying table, breakeven inflation rates have not been this low since the Global Financial Crisis (GFC) in 2008. We believe that the current breakeven inflation rate reflects market dislocations and distress, rather than a long-term inflation outlook, which was also the case in 2008. Demand for TIPS is likely to remain weak as the news flow validates an economic contraction. Concerns for a significant increase in deficit spending are impacting nominal U.S. Treasuries as well as TIPS. It has been novel to see U.S. Treasury rates actually increase over the last several days in the face of “risk off” trading. Breakeven inflation rates below 1% have historically rewarded patient investors who can hold TIPS in place of nominal U.S. Treasuries. Considering current market conditions, we are not opportunistically adding TIPS exposure at this time to fixed income accounts not dedicated to TIPS investing. For investors that maintain a strategic allocation to the asset class, we believe current levels will offer long-term value and we counsel patience. We also believe that today’s increased market volatility will bring a more fertile environment for our active management strategies.

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, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.IM-07712-2020-03-19

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