The Harder They Fall…
At BBH, we are value-oriented investors in the credit markets, and we ask our clients to judge us through a complete credit cycle. As we have endured yet another credit cycle, we are pleased to report that our approach continues to produce very strong results:
- Our Core Fixed Income Composite ranks in the top decile of its competitive universe for 1, 3, and 5 years .
- Our Limited Duration Fund continues to rank in the top decile of its peer group for 1, 3, 5, and 10 years .
- Our new Structured Fixed Income composite ranked in the top five percent of its peer group in its first year .
- All of our credit-oriented fixed income client portfolios outperformed their benchmarks in 2016.
Our track records through this cycle, and the ones preceding it, validate our philosophy and process for outperforming benchmarks and peers in fixed income. We will describe some of these, in the context of the 2014-16 credit cycle, in this Strategy Update:
- Credit market sentiment overshoots both ways – buy the pessimism and sell the optimism.
- Follow the Fundamentals – price trends and ratings changes can distract from the underlying fundamental drivers of businesses.
- Maintain valuation discipline.
- Invest for the long term – hold your positions “with strong hands”.
- Cast a wide net – look for bargains in less traveled parts of the market.
The Credit Cycle Has Ended, Long Live the Credit Cycle!
As of the fourth quarter, cumulative excess returns (returns in excess of comparable-duration U.S. Treasuries) of triple-B credit finally turned positive, marking a complete reversal of a cycle that began in June of 2014. We previously compared this cycle to those in 2001-3 and 2011-12, and this one proved to be a little more drawn out, with the recovery starting after seven quarters. Arguably it was more treacherous, given the nearly 300 investment grade companies downgraded by Moody’s over the course of 2015-2016, and the record 15 energy companies downgraded to high yield in just the first quarter of 2016.
During the difficult quarters of this cycle, as we watched credit spreads widen precipitously, we argued in these pages that unrealistic catastrophes were priced into the real estate, energy-adjacent (pipelines and utilities), emerging market consumer, and consumer finance sub-sectors. We viewed these potential catastrophe scenarios as unlikely given the fundamental data before us. There certainly was some bad news, and some legitimate danger to a few companies, but there were bargains on offer in credits that could survive in a range of downside scenarios. The market came around to our view. The same thing happened in 2011, when fears about Greece and Southern Europe affected even Nordic and American bank obligations. In both of these cycles, credits near the locus of distress began to weaken, and then, in a self-reinforcing pattern, more passive owners crowded the exits, forcing spreads to overshoot.
The Harder They Fall, The Harder They Come Back
Some of the best performers in our portfolio in 2016 were the names that had suffered this treatment in 2015 and early 2016 – in particular from the electric generation, consumer products, aviation, and commercial mortgage-backed securities (CMBS) sectors. Two widely held bonds, Avon and Transalta, appreciated by more than 30% from February lows with only minor fundamental changes at the companies (mostly they just endured, which is enough for creditors). Prices for triple-B rated conduit CMBS retraced a 10% decline from the start of the year, with no explanation for this decline in steady commercial real estate fundamentals and valuations over the year. These are only the latest examples of how an irrational market frames information. When prices are down, every little bit of negative news is amplified into a disaster. When prices are up, investors tend to only see the positives.
It’s extraordinarily hard to stay on course through the fog created by Mr. Market. We rely on our guiding principles. For example, we maintain our valuation discipline and hold our credits “with strong hands”, for the long term. For the former, we use very well-defined pricing boundaries to guide us to credits that are likely to be undervalued. The latter is a function of how we underwrite when we originate a position. We try hard to think through the behavior of a credit not just in the economic environment we anticipate, but in an environment that particularly stresses credits of the type we are considering; i.e. a severe recession, a drop in commodity prices, a decline in international trade, or perhaps the loss of a patent or proprietary business line. We avoid credits that we believe cannot withstand severe stresses. Like practice drills for emergencies, anticipating the stress beforehand helps us to maintain a more centered, long-term outlook when a stress scenario actually materializes, just as it did for energy and emerging market-related credits in this last cycle. We try very hard to separate the fundamental news that affects a credit’s durability from the price action. We are occasionally accused of stubbornness, but without the conviction of our process to hold these names with strong hands, this year’s performance might not have been so strong.
Casting a Wide Net
Many of our credits were actually far from the center of the storm. Performance also came from less volatile sectors, and demonstrated how casting a wide net across multiple sectors can extract a few gems. Technology, for instance, was a standout sector. Our high conviction in Dell paid off as the company raised a large financing to buy EMC. Similarly, we participated in Western Digital’s merger with Sandisk. Our ability to invest across bonds and loans gave us large position sizes and a substantial performance impact even in larger accounts.
Municipal bonds were also a stealthy standout in performance over the past few years. While corporate bonds were swooning in early 2016, Municipals bonds staged a huge rally (at least up through election day), producing equity-like returns even in pre-tax terms. We occasionally invested in a handful of more controversial names, like those with structures that offer high credit quality but repel mutual funds and more passive municipal investors. Examples of these include bonds from our Detroit and Philadelphia School District, which enjoy critical credit support from their state governments. Among shorter investments, “broken” auction-rate bonds that we purchased over the last few years at substantial discounts to par are being redeemed at a rapid pace, thanks to the increase in the London interbank offering rate (LIBOR), to which their floating rates are pegged.
This is a sector in which we are still finding value: At the short end of the curve, there are very high quality municipal floaters priced off of LIBOR that offer money market yields well above U.S. Treasuries and repurchase agreements. In fixed coupons, the municipal/Treasury ratio is unusually wide, creating an opportunity for compression of municipal bond spreads.
High Yield and Floating-Rate Loans – Record Market Performance
The performance of high yield credit in both bonds and floating-rate loans was truly remarkable this year. Our client portfolios that could participate in these sectors benefitted particularly from our ability to cast a wider net for opportunities. The JP Morgan High Yield BB Index returned 12.4% and the JP Morgan BB/B Floating-Rate Loan Index performed well at 8.6%, with the total high yield and loan indices returning 18.9% and 9.8% for 2016, respectively. This level of performance marks the best returns for high yield since 2009 and the third best return in two decades. Fixed income investors continued to seek out the higher yields in the below investment grade sector to offset low global bond yields. The fundamental data for high yield companies has remained solid and default rates are trending lower again. The recent rise in interest rates, including LIBOR, has brought significant investor attention to the benefits of floating-rate loan investments, which should be expected to continue into the new year. We highlighted this sector in our August 2016 Fixed Income Strategy Insight.
Another sector where we’ve been pointing out significant value is CMBS. Single-asset CMBS, secured by a single high quality property or portfolio, have contributed substantially to account performance throughout the year. In the second half of 2016, we also witnessed a strong recovery in multi-loan conduit CMBS. Earlier in the year we saw triple-B conduit CMBS trade as high as 8% over comparable U.S. Treasuries, but by year-end, they had compressed to about 6% over U.S. Treasuries. A meaningful rally also took place in the highest quality tranches, with triple-A CMBS rallying over
60 basis points (bps) by year-end from their widest spreads of 160 bps in February. At as much as 25% of our portfolio values, the CMBS rally provided a substantial tailwind to fourth quarter performance.
Commercial real estate fundamentals remain solid. Property valuations showed healthy increases throughout 2016 and, with the strength in U.S. labor markets, commercial vacancies continue to decline. Two trends in CMBS fundamentals should also continue to support this sector. First, all issuance from here on will have to comply with new risk retention rules, requiring the entities selling loans into CMBS to retain 5% of the risk. The industry launched a handful of deals in the second half of last year that complied, and they have gone extremely well, pricing at a premium over non-compliant legacy issuance. Secondly, as the market digests the refinancing of the last $100 billion of pre-crisis loans, we expect the demand/supply balance in the sector to change more favorably, helping spreads to return to long-term normal levels. Recent supply remains subdued by historical standards, which should also help prices recover.
ABS – What Rate Sell-Off?
With the improving outlook for the U.S. economy, heightened inflation concerns, and more Fed rate hikes on the horizon, U.S. Treasury yields rose substantially from June 30 to December 31, with 2- and 10-year yields up by 53 bps and 88 bps, respectively. Most of this move followed the U.S. election.
Investment Grade credit markets were hammered by this rate sell-off over the second half of 2016. The Barclays Capital U.S. Credit Index (Barclays Credit) lost -1.9% since June. Performance in November was a tough -2.9%.
Shorter credit indexes also underperformed. Traditional Asset-Backed Securities (ABS), as tracked by the Barclays Capital U.S. ABS Index (Barclays ABS), posted a -0.5% return over the second half of the year and a -0.5% return in November. The broader Barclays Capital U.S. 1-3 Year Credit Index (Barclays 1-3Yr Credit), has been flat since June and dropped -0.4% in November. So benchmark ABS and short corporates both suffered in the sell-off.
However, non-benchmark ABS and CMBS, with short rate duration and a sizable carry advantage over U.S. Treasuries, posted healthy returns during both of these intervals of soaring rates. This is apparent in the returns for BBH’s Structured Fixed Income strategy. During a dismal November for bonds, the Structured Strategy produced a positive 0.1% return, and over the longer interval of rising rates that began in July, the strategy has returned over 2.4%. Our typical 25% to 30% holdings of ABS across credit-oriented accounts provided a solid boost to fourth quarter performance as bond indices posted negative returns.
This steady return performance is partly due to the short rate duration of ABS, which limits price declines when rates rise. The rate duration of our Structured Strategy is only 1.8 years. Any minor declines in bond prices are more than offset by the high running yield of our nontraditional ABS holdings.
Issuance within non-benchmark ABS sectors was a record $111 billion in 2016, representing 62% of total ABS issuance. This ongoing expansion of the nontraditional ABS market was particularly notable last year in the personal consumer loan and aircraft ABS sub-sectors. Attractive additions in the fourth quarter included triple-B rated aircraft ABS from leasing industry leader Airlease at 430 bps over U.S. Treasuries. We also participated in 25-year veteran lender Lendmark’s single A-rated personal consumer loan ABS transaction at 365 bps over U.S. Treasuries.
Corporates Getting Rich
We have certainly enjoyed the rally in corporate bond spreads, but we have found it increasingly hard to find issuers that fit our valuation criteria. As of the end of December, only 18% of the investment grade corporate bond universe exceeded our spread hurdle. The last time that number was so low was 2014, when this last cycle began.
Furthermore, the issues that are too expensive are far too expensive, as illustrated in the accompanying distributional exhibits of excess return potential from our valuation work.
As you can see, only a few issuers meet our valuation criteria (green). Names that don’t are at valuations that we would judge are more likely to produce negative than positive excess returns if valuations revert to mean levels (visible in the broad left tail in the bar graph, and the depth of the red dots in the sector graph). This isn’t an environment in which we are willing to commit a lot of new capital. We did, however, find a few new corporate names, such as Sirius International Group, a reinsurance company returning to the public markets, and the new Sprint Spectrum bonds, which are secured by valuable cellular spectrum rights. We also found some short, LIBOR-based instruments from banks and AT&T, and rolled and extended several existing positions, such as Freeport-McMoran, Alliance Data Systems, and Ares Capital. However, as the credit market tightens, our valuation discipline is forcing us to trim our corporate exposure.
A “Yuuuge” Move In Rates
The big story of the fourth quarter was the rapid rise of interest rates after the election. The fourth quarter took rates above levels where they began the year. The Barclays Capital U.S. Aggregate Index (Barcap Aggregate), which had YTD returns climb as high as +5.9% in July, ended the year at +2.65%, below even our very short Limited Duration Fund (+2.77% after fees).
We have been saying through the last two years that market sentiment on credit was too negative, that real estate, even retail real estate, was doing reasonably well, that rates were not a particularly good value, and that patience in the under-loved segments of the credit markets would ultimately be rewarded. This was one of the longer credit cycles we’ve seen, so patience is exactly what it took, but we are very pleased that, once again, leaning against the overwrought moods of Mr. Market produced excellent returns for our clients.
We’ve enjoyed visiting with you through this time, and are gratified with the confidence you have shown in our process.
Andrew P. Hofer
Neil Hohmann, PhD