Value investors, such as BBH, are not easy to please. When markets are rallying, we complain incessantly about the increasingly difficult search for value. When the search gets easier, returns are negative, and we complain that the correction isn’t big enough to get invested. The “Goldilocks” market rarely arrives.
After more than a year of complaining that the hunt for value was getting more difficult, we saw the markets break their winning streak in the third quarter. Both the high yield and investment grade corporate markets produced negative total returns. To add insult to injury, intermediate Treasury yields edged upwards, resulting in negative returns for 3-5 year Treasuries. Longer Treasuries were the only bond sector to produce positive returns.
In this challenging environment, we are very pleased to report positive results for the quarter. Despite being fully invested in credit, our core accounts outperformed significantly, and our more conservative Limited Duration Composite essentially broke even. Given that most sectors in which we were active had underperformed Treasuries, our performance is a result of excellent security selection on the part of our team. Valuation discipline really does make a difference.
Now we turn from total returns to “excess returns”, or the amount by which a particular asset outperforms (or underperforms) a Treasury of the same duration. As you can see in the chart below, drawdowns in each credit sector (red bars) roughly mirrored positive excess returns in the first half of 2014 (blue bars). The sectors are sorted by first half return, illustrating the pattern. Such a uniform market seems to be driven by capital flows moving in typical ‘risk-on/risk-off’ fashion, but our focus on valuation may have provided some cushion on the downside. There also were some exceptions to the pattern. We found many better values in BBB and BB corporate bonds and loans, CMBS and ABS as we moved into 2014, and we have been most heavily invested in those credit sectors as a result. Those sectors not only outperformed in the rally, but kept a bit more of their gains in the pullback.
After a big rally in long rates in the first half of the year, Treasuries were also volatile in the third quarter, with short rates moving up 0.2%-0.3%. Long rates are responding to moderating inflation and concerns about growth and credit quality abroad. We expect rates, even shorter rates, to continue to crawl up the forward rate expectation curve, responding to the Fed’s calendar for ending QE purchases (this month) and normalizing short term rates (second quarter 2015).
Putting these trends together, the third quarter produced mildly positive returns for long Treasuries, but slightly negative returns for shorter Treasuries and credit sectors generally. We expect rates, even shorter rates, to continue to move around as investors discount the Fed’s first moves against economic developments here and abroad.
The corporate bond market, especially high yield, has been very fully valued for most of the year, and we have only found value in a few situations where we think ratings can change, or transactions have offered large concessions.
At times like this, when our valuation work suggests high yield bonds are expensive, loans present better value. Generally speaking, the loans in which we are invested pay spreads well in excess of bonds from the same issuer, even though they are senior to bonds in the capital structure. They have to offer this additional spread because the price upside of a loan is limited. Loans can be refinanced quickly when the company’s standing improves. When we think bond spreads are closer to lows than highs, it makes sense to get paid up-front, rather than hope that rich valuations get even richer. Loans outperformed their bond-brethren substantially as yields increased in the third quarter, as shown in the chart above.
We only added a few corporate bond obligors in the quarter, from the REIT (QTS), life insurance (TIAA-CREF) and equipment rental (URI and Ashtead) sectors. In loans, we participated in the loan financing for Burger King’s acquisition of Tim Horton’s, as well as loans to a company that sterilizes medical devices (Sterigenics) and a rare investment grade loan to aviation finance specialist Aercap Holdings.
Investment Grade Corporate spreads are trading roughly where they were in 2004, 20-30 basis points off their pre-crisis lows. ABS and CMBS spreads are offering better value in historical context. Furthermore, deal structures and collateral valuations are considerably more conservative compared to the pre-financial crisis era. It is no surprise we are finding better value in the structured universe.
There are two other things we like about structured products. First, credit quality often improves over the life of the security, something that does not necessarily happen in corporate credit. Secondly, many ABS repay principal over time, creating cash to reinvest at potentially more attractive spreads. When the corporate environment is pricey, it is useful to have a place that provides yield, improving credit, and a flow of cash for the future.
Our ABS and Finance team was busy, adding bonds from three business lenders (Drawbridge, Pennant Park, and Hana) and two consumer lenders (Progreso and One Main). These are investment grade bonds secured by loan collateral with a long history, and each must have enough equity or credit enhancement to be able to withstand a severe depression loss scenario without impairment. In transactions like this we pay particular attention to the continuity of the team originating credit, as well as their track record through the financial crisis and other times of extreme credit stress. Each company has an outstanding track record in its own specific niches of the lending business.
We also added ABS from tax-lien issuer Alterna Funding, and auto-loan backed securities from Credit Acceptance Corp and Foursight Capital. We invested in a drug royalty-backed securitization, a field that is growing rapidly due to the expanding number of patents owned by universities. We also added a securitization of trade receivables backed by the Korean Export-Import Bank. We are happy to report that the latter is owned by the South Korean Government, and far less politically controversial there than our own Export-Import Bank currently is at home.
In CMBS, we found two new well-structured, diversified transactions (“conduit deals” in bond-speak) and two more concentrated “single-borrower” deals with strong sponsorship and conservative debt coverage. The latter are Blackstone’s refinancing of long-term stay hotels and Brookfield’s refinancing of the Bahamas Atlantis Resort. We also purchased a 2007 conduit transaction where the loans have seasoned particularly well and we expect refinancing to improve our position’s credit protection even further over time.
The September swoon has continued into early October. Over longer periods of time, the yield of our portfolios will weigh more heavily than one quarter’s price return. Thanks to our sell discipline and the regular occurrence of prepayments and maturities, we have been building “reserves”, or cash and Treasuries, in most accounts this quarter, and only reinvest when we find new positions that meet our criteria for durability and value.
Andrew P. Hofer
Head of Taxable Portfolio Management
For informational purposes only.