BBH Structured Fixed Income Quarterly Strategy Update – Q3 2024

Portfolio Managers, Neil Hohmann, Chris Ling, and Andrew Hofer provide an analysis of the investment environment and most recent quarter-end results of the Structured Fixed Income strategy.

3Q Highlights

  • The Strategy outperformed the Index during the quarter as its defensive duration profile had a positive impact on relative returns.
  • The Strategy's sector and quality emphases further contributed to results during the quarter as the Strategy emphasized strong-performing segments within its holdings of BDC debt, CMBS, and CLOs.
  • We continue to find durable credits offering attractive value despite weak attractiveness of valuations of credits in indexes.
Performance
As of September 30, 2024

 

Total Return

Average Annual Total Returns

Composite/Benchmark

3 Mo.

YTD

1 Yr.

3 Yr.

5 Yr.

Since Inception

BBH Structured Fixed Income Composite (Gross of Fees)

3.41%

8.23%

12.13%

4.34%

4.32%

4.75%

BBH Structured Fixed Income Composite (Net of Fees)

3.32%

7.95%

11.74%

3.97%

3.96%

4.38%

BBH Structured Fixed Income Benchmark

3.04%

4.97%

8.00%

1.61%

1.98%

2.22%

Past performance is no guarantee of future results
Returns of less than one year are not annualized
BBH Structured Fixed Income Benchmark is a combination of two indices. The Bloomberg US ABS Index was used prior to 11/1/2023; the Bloomberg U.S. ABS ex. Stranded Cost Utility Index is used subsequently. Due to recent changes in the composition of the Bloomberg US ABS Index, the new Bloomberg U.S. ABS ex. Stranded Cost Utility Index more closely reflects the effective duration of the strategy. One cannot invest directly in an index.

Sources: Bloomberg and BBH & Co.

Market Environment

Treasury rates continued to respond to investors’ predictions for forward-looking Federal Reserve (Fed) interest rate decisions during the third quarter. The Fed cut the federal funds rate by 0.50% during the quarter, and investors shifted to predicting more aggressive rate cuts of 75 basis points (bps)1 before year-end. Yields declined across all tenors as Treasury rates reflected expectations of larger and faster rate cuts, while fixed income indexes experienced strong total returns as interest rates declined. Excess returns to credit were overwhelmingly positive as credit spreads in mainstream indexes narrowed from already low levels to their cyclical lows.­

Economic data remained strong during the quarter, with inflationary pressures waning and few signs of recession on the horizon. Headline consumer inflation prints have been declining, but wage growth and job openings remain higher than their historical averages and could still exert upward pressure on inflation. The Chicago Fed National Activity Index remains above its recession indicator.

Corporate default rates remain subdued and continue to be concentrated among CCC-rated issuers, although default rates for all rating categories are below their respective long-term averages. Business loan performance appears healthy, as delinquency rates are low and default rates are declining.

The U.S. consumer appears to be strong, with loan delinquency rates and loan loss rates rising to historically normal levels. Non-prime auto loan and credit card delinquencies and charge-offs are normalizing towards pre-pandemic levels, while other consumer loans are experiencing lower losses due to tightened underwriting standards since 2022. The increases in loss and delinquency rates remain within expected ranges for asset-backed securities (ABS) to withstand losses without risk of impairment to bondholders.

Commercial real estate headlines remain disconnected from property-level dynamics. High quality properties have refinanced and there have been minimal losses on paydowns in commercial mortgage-backed securities (CMBS) deals. Commercial real estate woes have not had an outsized impact on banks’ commercial real estate loan portfolios to date, as delinquency rates and charge-offs have been muted. Office delinquency rates remain elevated as return to office dynamics remain weak and continue to pressure office real estate values.


Exhibit I: Fixed income index returns as of September 30, 2024.

Valuations

Despite the rigorous pace of issuance during the quarter, credit spreads were relatively stable across sectors and qualities. This highlights both the intense demand for credit and the increasing complacency of investors evaluating new issues. We are finding fewer opportunities in traditional segments of the credit markets. Only 1% of the mortgage-backed securities (MBS) market screens as a “buy” candidate according to our valuation framework2, but opportunities within those high-coupon 30-year MBS are hard to source. Traditional segments of the ABS market, such as prime auto and bank credit card securitizations, continue to offer limited appeal to us. Collateralized loan obligation (CLO) debt risk spreads narrowed to levels that suggest general exuberance given still-low corporate default rates.

We continue to find opportunities through our bottom-up process in ABS, with spreads in some select sectors remaining disconnected from their underlying credit risk. Opportunities are appearing in the CMBS market as property- and deal-level dynamics are disconnected from the negative headlines impacting the sector. Debt issued by business development companies (BDCs) continues to offer attractive prospects. There are some compelling opportunities emerging in some CLO reset issuances.

We continue to avoid non-agency residential mortgage-backed securities (RMBS) due to poor technical factors, and weak fundamentals, underpinned by poor housing affordability, low inventory of homes for sale, and stable-to-declining home prices.


Exhibit II: Market outlook by sector as of September 30, 2024.

Performance

Security selection paced relative results during the third quarter. Holdings of floating-rate large loan CMBS, Single Asset Single Borrower (SASB) CMBS, business development company (BDC) debt, and recurring revenue ABS contributed to results. Holdings of cell tower ABS and collateralized fund obligations hindered results during the quarter.

Sector and quality allocations were also additive to relative results during the quarter. The strategy’s exposures to strong-performing segments of the market, including BDC debt and CMBS, was additive to results, while exposures to ABS detracted slightly.

The strategy’s term structure exposures had a small but negative impact on results, as the strategy held floating-rate bonds that lagged during the declining-rate environment.


Exhibit III: Attribution as of September 30, 2024.

Transaction Summary

Despite weak attractiveness of valuations of credits in indexes, we continued to find durable credits3 offering attractive value. The purchases were made across a variety of sectors and industries. The table below summarizes a few notable portfolio additions.


Exhibit IV: Notable transactions as of September 30, 2024.

Characteristics

At the end of the quarter, the portfolio’s duration was 1.9 years and continued to approximate that of its benchmark. The portfolio had 88% of its investments in investment-grade credits, while high yield and unrated investments represented 12%. The portfolio’s yield to maturity was 7.2% and remained elevated versus bond market alternatives. The portfolio’s option-adjusted spread was 313 basis points over Treasuries; for reference, the Bloomberg U.S. Corporate Index’s was 89 basis points over Treasuries and the Bloomberg ABS Index’s, a proxy for traditional ABS, was 64 basis points over Treasuries at quarter-end.


Exhibit V: Characteristics as of September 30, 2024.

Conclusion

Credit conditions are disconnected from the U.S. political headlines garnering attention. Inflation, corporate defaults, loan losses, and loan delinquencies have normalized to manageable levels. Risk spreads decreased to cyclical lows, suggesting investor exuberance may be creeping into some deals. The Fed’s rate cuts do not appear to be driven by concerns over a weak economy; rather, the cuts should help to ease restraints imposed on consumers and businesses. Given already strong credit conditions in many sectors, this may be a positive for many borrowers. The biggest risk facing credit investors may not be losses driven by macroeconomic weakness, but rather inattentiveness to valuations and durability during a period of ebullience. We believe the valuation and credit disciplines embedded in our bottom-up process are essential for navigating this environment.

1 Basis point (bps) 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.
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.
3 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. Durable means the ability to withstand a wide variety of economic conditions.

Definitions

Bloomberg US ABS Index is the asset backed securities component of the Bloomberg US Aggregate Bond Index. The index includes pass-through, bullet, and controlled amortization structures. The ABS Index includes only the senior class of each ABS issue and the ERISA-eligible B and C tranche. The Bloomberg U.S. ABS ex. Stranded Cost Utility Index excludes certain stranded cost utility bonds included in the Bloomberg US ABS Index.

An index is not available for direct investment.

“Bloomberg®” and the Bloomberg indexes are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indexes (collectively, “Bloomberg”) and have been licensed for use for certain purposes by Brown Brothers Harriman & Co (BBH). Bloomberg is not affiliated with BBH, and Bloomberg does not approve, endorse, review, or recommend the Strategy. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to the Strategy.

Risks

Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Mortgage-backed and asset-backed securities have prepayment and extension risks.

SASB lacks the diversification of a transaction backed by multiple loans since performance is concentrated in one commercial property. SASBs may be less liquid in the secondary market than loans backed by multiple commercial properties.

Asset-Backed Securities (“ABS”) are subject to risks due to defaults by the borrowers; failure of the issuer or servicer to perform; the variability in cash flows due to amortization or acceleration features; changes in interest rates which may influence the prepayments of the underlying securities; misrepresentation of asset quality, value or inadequate controls over disbursements and receipts; and the ABS being structured in ways that give certain investors less credit risk protection than others.

Below investment grade bonds, commonly known as junk bonds, are subject to a high level of credit and market risks.

Foreign investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards.

The Structured Fixed Income Strategy Representative Account is managed with the same investment objectives and employs substantially the same investment philosophy and processes as the strategy.

The securities discussed do not represent all of the securities purchased, sold or recommended for advisory clients and you should not assume that investments in the securities were or will be profitable.

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.

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 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 failureor business interruption. The Not Rated category applies to Non-Government related securities that could be rated but have no rating from Standard and Poor’s or Moody’s. Not Rated securities may have ratingsfrom other nationally recognized statistical recognized statistical rating organizations.

Brown Brothers Harriman Investment Management (“IM”), a division of Brown Brothers Harriman & Co (“BBH”), claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.

To receive additional information regarding IM, including a GIPS Composite Report for the strategy, contact John Ackler at 212 493-8247 or via email at john.ackler@bbh.com.

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 deductionof the maximum investment advisory fees. Returns include all dividends and interest, other income, realized and unrealized gain, are net of all brokerage commissions, execution costs, and without provision for federal or state income taxes. Results will vary among client accounts. Performance calculated in U.S. dollars.

The objective of our Structured Fixed Income Strategy is to deliver excellent returns in excess of industry benchmarks through market cycles. The Composite is comprised of all fully discretionary, fee-paying structured fixed income accounts over $10 million. Investments are focused on asset-backed securities, commercial mortgage-backed securities, collateralized loan obligations, and corporate debt securities that are primarily investment grade. Non-investment grade securities may be held. Investments are focused on U.S. dollar denominated securities, but non-U.S. dollar securities may be held. The accounts are managed to a duration +/- 2 years of the Bloomberg ABS ex-Stranded Cost Utility Index. Effective December 1, 2022, the composite definition was slightly altered to establish a band around the duration of the Bloomberg ABS ex-Stranded Cost Utility Index.

Standard deviation measures the historical volatility of a returns. The higher the standard deviation, the greater the volatility. The Sharpe ratio is the average return earned in excess of the risk-free rate (the Fed Funds rate).

Brown Brothers Harriman & Co. (“BBH”) may be used 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. 2024. All rights reserved.

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IM-15581-2024-11-06        Exp. Date 01/31/2025

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