Market Whiplash Opens a Brief Window for Credit Opportunities

You could get whiplash watching these markets. Just three months ago we wrote about the pessimistic tone in credit and equities and suggested that it felt, to us, like an overreaction. Since the beginning of the year, credit and equity markets recovered in a sharp V-shape, with the fourth quarter’s laggards leading the way in a massive rally. The Federal Reserve’s (Fed) tone went from hawkish to dovish, and the market-discounted likelihood of a Fed cut in the year ahead now stands at 65%. The only consistent elements since last quarter are a) slowing global growth and b) lower rates and bearish signals from the rates market. The magnitudes of the fourth quarter’s swoon and the first quarter’s rally doesn’t make much sense to us. However, exaggerated market movements are the most important and exploitable premise of our valuation-driven approach.

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If it weren’t for Treasury rates, it would be like the fourth quarter downdraft never happened. It’s difficult to craft a consistent story about the markets over the last six months without suggesting that the Fed’s dovish turn has determined the appetite for risk.1

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Around March 22, the spread between 3-month and 10-year Treasury obligations dropped below zero, spurring speculation about recession and rate cuts. Inverted yield curves typically precede recessions and may expose a tight Fed policy stance too late into the cycle. Accompanying this Quarterly Strategy Update is a “Frequently Asked Questions” BBH Strategy Insight on the subject of inverted yield curves, prepared by our colleague Jorge Aseff, which will take you through the historical pattern of yield curve inversions, their aftermath, and some historical and model-based implications for recession risk and appropriate monetary policy levels.

Unfortunately, even if investors accept the inversion of the curve as both marking the end of tightening and predicting recession, they still tend to impose their preferred narrative onto any specific circumstances. We present below a group of stories that could be told, compiled into a two-by-two matrix by their implications for rates and credit markets:

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As you can see, even if you accept that the inverted curve implies heightened recession risk, that does not necessarily lead to a simple conclusion about rates and spreads. Indeed, even if you think the Fed is overreacting, it is still possible to make diametrically opposed predictions about what is likely to happen as a result (boxes 2 and 4). If you think the Fed has been right to back off its tightening schedule, the outlook for rates and credit depends on whether they shifted their policy stance in time to ward off a severe recession (boxes 1 and 4). But it is fair to say that inverted yield curves have historically predicted recessions 18 months ahead, and that spreads widen in recessions.

One thing is for sure – investors are actively penalized today for taking on duration risk. An inverted curve forces investors to pay for their conviction that rates will go down. It is interesting to us that fundamental indicators have pushed up the risk of any recession to about one-third according to the Federal Reserve Bank of New York’s model, but spreads and the stock market seem to be asking – what recession?. The Treasury market remains the Gloomy Gus of financial markets.

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As a reader of our Quarterly Updates, you know that we do not make macroeconomic forecasts. Hopefully the discussion above gives you a sense of why we think it is difficult to add value doing so, even with some historical insight. We prefer to look for investments that other investors are underpricing, and that are likely to be durable through a variety of economic circumstances. We were able to take advantage of a handful of opportunities that popped up in the uncertainty around year-end, but valuations never rose to the levels in previous credit cycles, such as 2015-16 or 2011-12. So, you will not be surprised that after six months in which valuations moved from poor to mediocre and back to poor, we still hold ample reserves and a conservative level of corporate spread duration in our diversified accounts.

We would certainly prefer not to experience a recession and its attendant spread widening, but if it came, we feel it would bring us an abundance of opportunities that are sorely lacking in today’s market.

We would characterize the corporate bond market as broadly overvalued with small patches of opportunity. In September of 2018, 4% of the investment grade universe passed our valuation criteria for purchase, and at year-end it was 27%. As we close the quarter it is around 9%.2

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However, the averages do not tell the whole story (thank goodness, they never do). Indiscriminate selling from overseas and out of Exchange-Traded Funds (ETFs) provided a few opportunities to add to existing positions, and locate a few new credits to inlcude in accounts, both at very attractive levels. The loan market suffered some severe forced fund liquidations in December, with prices dropping four dollars at year-end, giving us excellent entry opportunities on several higher-rated credits we already liked. Our Limited Duration and Core Fixed Income strategies added around 0.4 years of corporate spread duration over the last six months, and loan-eligible accounts added significantly more than that. Once again, our valuation discipline has helped position us well through this mini credit cycle.

One example of overseas selling was Sirius Group, a newly public, global insurance company that has a decades-long operating history. Sirius is now majority-owned by a Chinese private equity investor, and when the company issued debt in 2016 (BBB-rated at 4.6% yield to maturity [YTM]) much of it was spoken for in Asia before it even became available here. Several large Asian investors came under stress and decided to sell this unfamiliar bond in December, finding little demand. Bonds dipped to $85. We believe its fair value is close to par and added to positions across accounts at average yields at purchase of 7%. As of quarter-end we are seeing domestic bids approaching the mid-$90s, and we expect the price to continue to increase as U.S. public ownership seasons and ownership broadens.

BNP Paribas issued 4.7% YTM 2025 A-rated bonds at the beginning of the year, and because of market conditions had to issue at a large concession. We participated in the deal and were able to pick up these bonds at a spread of 235 basis points* (bps). They are currently trading at a spread of 146 bps.

Asset-Backed Securities

Unlike the Corporate sector, prices in the Asset-Backed Securities (ABS) sector experienced little turbulence in the fourth quarter, and a correspondingly modest recovery in the first quarter. Price volatility in the ABS market is typically lower than other credit sectors because of their short rate and spread duration, their strong historical credit performance, their tendency to de-lever as they season, and their stable insurer investor base. Nevertheless, BBH was able to take advantage of wider spreads on several attractive first quarter ABS purchases.

Hercules Financial (4.8% YTM A) issued its fourth securitization. Hercules is a business development company (BDC) lender, founded in 2003 and listed on the New York Stock Exchange. The firm specializes in lending to late-stage life sciences and tech firms, with a very low historical loss rate on its low loan-to-value (LTV) loan portfolio. Hercules did experience some unwelcome news as founder and CEO Manuel Henriquez stepped down in March after being implicated in the college admissions scandal. Hercules, however, has a deep bench of talent and long-standing CIO Scott Bluestein quickly stepped into the chief executive role. The bonds have been unaffected by the shuffle.

America Car Center (ACC) (4.1% YTM BBB), founded in 2000, brought its inaugural ABS transaction last April. The company has a unique business model, underwriting automobile leases rather than loans, for the purchase of low-mileage used vehicles. Consistently profitable over its history, ACC’s credit performance benefits from structural protections built into its leases (resulting in vehicle turn-in rates of only 1.5%), and there is a sizable equity and subordination beneath the notes. We have analyzed the company for more than a year and participated this quarter in the company’s second securitization.

Finally, Stack Infrastructure, Inc. (4.6% YTM A) issued its first ABS transaction, secured by the company’s geographically diversified real estate portfolio of data centers. The collateral securing the transaction consists of the bulk of Stack’s holdings, 6 of 8 data centers located in the largest data markets: Northern Virginia, Silicon Valley, Dallas-Fort Worth, and Chicago. Stack builds and leases data center space with power and cooling to tenants under long-term contracts. The tenants own and maintain their equipment, pay the power costs, and have fixed “take-or-pay” contracts.

Floating-Rate Loans

We have been invested in the secured-term loan of Helix Generation for a few years. Helix owns a critical electrical generation asset in New York City. In the fourth quarter downdraft, the market price for this loan dropped to a very attractive price in the low-$90s. We were able to increase our investment at a price of $93 (7.7% YTM), and it has since traded back up to $97.

In addition to adding to Helix, we entered new positions in Tivity Health (8.2% YTM B+) and Power Solutions (6.3% YTM BB). A leading provider of fitness, health improvement, and weight management programs, Tivity has a rating we think is upwardly mobile due to its strong cash generating businesses, and the high likelihood of rapid debt reduction. It carried a yield of over 8%at purchase. Power Solutions is a leading global supplier of lead-acid automotive batteries for virtually every type of passenger car, light truck and utility vehicle. The company serves both automotive original equipment manufacturers (OEMs) and the general vehicle battery aftermarket and supplies advanced battery technologies to power start-stop, hybrid, and electric vehicles.

These are representative of the types of opportunities we look for – we did not make any difficult macro predictions, we just worked harder to understand a credit that was being overlooked. As often happens, a good value got better (i.e. the price went down further) and detracted from performance in the fourth quarter before contributing significantly in the first quarter.

Conclusions

We have been watching earnings and economic data taper downward gently, and have seen financial markets go full risk-off and risk-on in successive quarters. Without trying to predict and ride the overall trend, we have taken careful advantage of excellent investments that were shaken loose as investors re-positioned, emerging well ahead of where we started in September. We remain confident in our positioning even if the economic environment deteriorates. Staring at financial data and trying to predict rate and credit trends would only have distracted us from the simple and unglamorous work of turning over stones and finding real, actionable, durable opportunities.

Warmer weather is creeping up on us here in the Northern Hemisphere, and not a moment too soon. We wish all of you a profitable second quarter and look forward to meeting with many of you in person.

 

Andrew P. Hofer
Portfolio Co-Manager

               

Neil Hohmann, PhD
Portfolio Co-Manager


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,
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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.