Performance Table 1: Composite performance as of March 31, 2023, for 3 month, year-to-date, 1 year, 3 year, 5 year, 10 year, and since inception time periods.
1Q Highlights
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Market Environment
Unrelenting monetary policy tightening amid continued strong economic growth lifted rates to cyclical highs early in the quarter until a run on Silicon Valley Bank (SVB) changed the trajectory of rates and prospective monetary policy. To quell depositor concerns about a wider swath of bank runs, the Federal Reserve (Fed) and Federal Deposit Insurance Corporation (FDIC) initiated several programs and plans in early March. The FDIC assured full access to uninsured deposits at SVB and Signature Bank. The Fed introduced a new Bank Term Funding Program (BTFP) allowing banks to pledge U.S. Treasuries, agency debt, agency mortgage-backed securities (MBS), and other qualifying assets – valued at par rather than market value – as collateral for loans.
The Fed has stated that they will separate “financial stability” measures from monetary policy moves. The U.S. Fed hiked the target range of the federal funds rate by 0.25% only 12 days after SVB’s failure. Investors now believe that the Fed’s rate hiking campaign ended as the banking crisis unfolded, and three cuts of 25 basis points1 will unfold by the end of 2023.
Fixed income indexes gained during the quarter as longer-term rates declined (see Exhibit I). Spreads of bonds issued by banks widened, but excess returns in the broader corporate debt markets (investment grade bonds, senior bank loans, and high yield bonds) were positive. Indexes of nontraditional asset backed securities (ABS)2 and collateralized loan obligation (CLO) debt outperformed during the quarter. Agency MBS and commercial mortgage-backed securities (CMBS) underperformed during the quarter. U.S. dollar denominated emerging market bonds also lagged during the quarter.
Exhibit I: Fixed income indexes returns as of March 31, 2023, showing duration, total return, and excess return.
Valuations
Credit valuations remain broadly appealing. According to our valuation framework,3 47% of investment-grade corporate bonds screened as a “buy,” 47% of high yield corporate bonds screened as a “buy,” and 95% of bank loans screened as a “buy.” These figures increased from their respective levels at the start of the year, when 36% of investment-grade corporate bonds, 46% of high yield corporate bonds, and 80% of bank loans screened as a “buy.”
Away from the corporate credit markets, we are finding an abundance of attractively valued opportunities in the structured credit markets, particularly among non-traditional ABS issuances, floating-rate single-asset, single-borrower (SASB) CMBS, and CLO debt (see Exhibit II).
Exhibit II: Fixed income sector outlook as of March 31, 2023, for reserves, structured credit, corporate credit, and other credit categories.
We continue to avoid agency MBS and non-agency residential mortgage-backed securities (RMBS) due to unattractive valuations. In addition, conditions facing each sector may create volatility. Agency MBS faces the Fed’s quantitative tightening program where it is tapering its purchases of MBS. Non-agency RMBS is tied up with regional banks’ exposures, as regional banks own an estimated 30% of the market. Deposit outflows at regional banks could place forced selling pressures and price volatility on non-agency RMBS. Away from the residential mortgage markets, we continue to avoid emerging markets credits due to concerns regarding creditor rights in most countries.
Performance
Sector allocation had the largest impact on outperformance, with contributions stemming from the portfolio’s overweight to ABS, bank loans, and high yield corporate bonds and its corresponding underweight to agency MBS (see Exhibit III).
Exhibit III: Representative account attribution as of March 31, 2023, showing average weight and contribution in basis points.
The portfolio’s duration and yield curve profile contributed to results during the quarter. Agency MBS was not owned in the portfolio but carries a significant weight in the Index. Agency MBS has negative convexity, and its duration fell as interest rates declined and volatility spiked. We manage the portfolio’s duration to replicate the Index’s duration as transactions occur – not to changes in the Index’s day-to-day duration swings – and this contributed as the portfolio’s duration was stable but slightly longer than the Index’s while interest rates fell.
Selection results were also positive during the quarter, and the results were driven by outperformance in high yield corporate bonds and CMBS. Selection in investment-grade corporate bonds detracted, as positions in banks underperformed during the quarter, although the portfolio had no exposures to debt issued by SVB, Signature Bank, or Credit Suisse, and exposures within regional banks were minimal.
Transaction Summary
With the intra-quarter volatility in credit spreads, we were able to buy some attractively priced new credits in both the primary and secondary markets, increase existing positions, and revisit credits that re-entered our buy zone. The new opportunities came from a broad range of industries as the volatility was not contained to just one idiosyncratic sector. Descriptions of a few notable portfolio additions are included below.
F&G Global Funding is a life insurance company specializing in annuities and is owned by Fidelity National Financial. The company has strong capital ratios, low leverage, and a predictable liability structure. The new issue 5-year investment-grade rated BBB- notes offered a spread of 370 bps over Treasuries. We purchased Blackstone Mortgage Trust, the second largest publicly traded mortgage real estate investment trust (REIT) which has a diverse mortgage portfolio, varied funding sources and a strong history of underwriting performance. The discounted 4-year secured BB rated notes were purchased at a spread of 395 bps over Treasuries. We purchased bonds issued by HSBC, Intel, Dell Technologies, and Charter Communications as more attractive pricing emerged for these durable credits.4
MCFCL 2023-1A C is an A rated tranche of a middle-market CLO from Madison Capital Management, a wholly owned subsidiary of New York Life. The Class C note subordination protection is solid, and it came offered at a spread of 420 bps over SOFR.5
AESOP 2023-4A A is a AAA rated tranche of a rental fleet ABS from Avis Budget Rental Car Funding AESOP LLC. With strong subordination protection and demonstrated durability through the challenges of COVID, we purchased the notes, with an expected weighted average life of 5 years, at a spread of 190 bps over Treasuries.
NFMOT 2023-1A A2 is a AAA rated tranche of an auto floorplan ABS from NextGear Capital, a subsidiary of the Cox Automotive group of companies. With strong structural protections, very low historical losses, high asset recoveries, and strong management, we purchased the A2 notes at a spread of 110 bps over Treasuries with an expected 3 years average life.
We purchased COLO 2023-1A A2, a data center ABS deal brought by DataBank. DataBank’s core business is colocation, the leasing of space, power, and cooling to high quality tenants under multi-year contracts. The A2 notes have a 5-year expected life, are rated A- with 2.65x debt coverage ratio for contracted cash flows and came at a spread of 295 basis points over Treasuries. Vantage Data Center brought VDC 2023-1A, a data center ABS deal, to market during the quarter, and we purchased the A- rated A2 notes at a spread of 286 bps to Treasuries. Vantage is managed by seasoned executives in the internet infrastructure industry, and there is strong growth and demand for leasing hyperscale data centers from cloud computing, software as a service, and information technology outsourcing. The notes carry a strong debt service coverage ratio with long-term, contractual leases.
Characteristics
At the end of the month, the Strategy’s duration was 6.2 years and continued to approximate that of its benchmark (see Exhibit IV). High yield investments represented 17.5%, were comprised primarily of credits rated “BB,” and consisted of a blend of corporate bonds and loans. The Strategy’s yield to maturity was 6.8% and remained elevated versus bond market alternatives. The Strategy’s option-adjusted spread (OAS) was 302 basis points; for reference, the Bloomberg U.S. Corporate Index’s OAS was 138 basis points at month-end.
Exhibit IV: Representative account characteristics as of March 31, 2023, showing credit rating, sector allocation, effective duration, spread during, yield to maturity, and option-adjusted spread.
Conclusion
Volatile market conditions serve as a reminder of risks assumed, elevate certain risks to the forefront, and create opportunities for well-positioned investors. The current state of valuations and fundamentals in the credit markets suggest that careful selection will be paramount for attaining the still-attractive yields offered in the fixed income markets, particularly as volumes of new issuances are set to rebound. We remain prepared, selective, diligent, and patient in evaluating credits that come to market. We hope that this insight into the Strategy’s composition and performance is useful as we navigate macroeconomic uncertainties.
Performance Table 2: Representative account performance as of March 31, 2023, for the first quarter, 1 year, and since inception time periods.
1 A unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.
2 Traditional ABS include prime auto backed loans, credit cards and student loans (FFELP). Non-traditional ABS include ABS backed by other collateral types.
3 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.
4 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.
5 SOFR = Secured Overnight Financing Rate, which is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.
The securities 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.
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 speculative in nature and are vulnerable to the possibility of issuer failure or business interruption.
Purchase and sale information provided should not be considered as a recommendation to purchase or sell a particular security and that there is no assurance, as of the date of publication, that the securities purchased remain in a portfolio or that securities sold have not been repurchased.
Opinions, forecasts, and discussions about investment strategies are as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are not intended to be and should not be interpreted as recommendations.
RISKS
Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, maturity, call and inflation risk; investments may be worth more or less than the original cost when redeemed. Bond prices are sensitive to changes in interest rates and a rise in interest rates can cause a decline in their prices. Mortgage-backed securities have prepayment, extension, and interest rate risks.
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.
The Strategy invests in derivative instruments, investments whose values depend on the performance of the underlying security, assets, interest rate, index or currency and entail potentially higher volatility and risk of loss compared to traditional bond investments.
Foreign investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging market securities can be significantly more volatile than the prices of securities in developed countries, and currency risk and political risks are accentuated in emerging markets.
The Strategy may engage in certain investment activities that involve the use of leverage, which may magnify losses.
A significant investment of assets in one or more sectors, industries, securities and/or durations may increase its vulnerability to any single economic, political, or regulatory developments, which will have a greater impact on returns.
Illiquid investments subject the investor to the risk that she may not be able to sell the investments when desired or at favorable prices.
Portfolio Characteristics are of the Representative Account. The Representative Account is managed with the same investment objectives and employs substantially the same investment philosophy and processes as the Strategy.
One basis point or bp is 1/100th of a percent (0.01% or 0.0001).
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 W. 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 reflects the deduction of 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 Core Plus Fixed Income Strategy is to deliver excellent after-tax returns in excess of industry benchmarks through market cycles. The Representative Account is managed with the same investment objectives and employs substantially the same investment philosophy and processes as the strategy. The Composite included all fully discretionary, fee-paying core fixed income accounts over $10 million that are managed to a duration of approximately 4.5 years and are invested in a broad range of taxable bonds. Accounts that subsequently fall below $9.25 million are excluded from the Composite.
Definitions
BDC Corporate is computed as an equal-weighted index of corporate bonds issued by business development companies (BDCs) that BBH holds with at least one year until legal, final maturity.
JP Morgan CLO Index (JPM CLO) is a market value weighted benchmark tracking U.S. dollar denominated broadly-syndicated, arbitrage CLOs. The index is comprised solely of cash, arbitrage CLOs backed by broadly syndicated leveraged loans. All CLOs included in the index must have a closing date that is on or after January 1, 2004. There are no weighted average life (WAL) limitations. There are no minimum tranche size restrictions.
JP Morgan Other ABS Index (Non-Tradional ABS), is an index that represents ABS backed by consumer loans, timeshare, containers, franchise, settlement, stranded assets, tax liens, insurance premium, railcar leases, servicing advances and miscellaneous esoteric assets of the The J.P. Morgan Asset-Backed Securities (ABS) Index. The JP Morgan Asset-Backed Securities (ABS) Index is a benchmark that represents the market of US dollar denominated, tradable ABS instruments. The ABS Index contains 20 different sub-indices separated by industry sector and fixed and floating bond type. The aggregate index represents over 2000 instruments at a total market value close to $500 trillion dollars; an estimated 70% of the entire $680 billion outstanding in the US ABS market.
Morningstar LSTA Leveraged Loan Index (the Index) is a market value-weighted index designed to measure the performance of the U.S. leveraged loan market based upon market weightings, spreads and interest payments. Facilities are eligible for inclusion in the indexes if they are senior secured institutional term loans with a minimum initial spread of 125 and term of one year. They are retired from the indexes when there is no bid posted on the facility for at least 12 successive weeks or when the loan is repaid.
Bloomberg US Aggregate Bond Index is a market value-weighted index that tracks the daily price, coupon, pay-downs, and total return performance of fixed-rate, publicly placed, dollar-denominated, and non-convertible investment grade debt issues with at least $300 million paramount outstanding and with at least one year to final maturity. The index is not available for direct investment.
The Bloomberg US Corporate Bond Index represents the corporate bonds in the Bloomberg Barclays U.S. Aggregate Bond Index, and are USD denominated, investment-grade (rated Baa3 or above by Moody's), fixed-rate, corporate bonds with maturities of 1 year or more.
Bloomberg Taxable Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term taxable bond market. To be included in the index, bonds must be rated investment-grade (Baa3/BBB- or higher. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate and must be at least one year from their maturity date.
Bloomberg US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Must have at least one year to final maturity regardless of call features and must have at least $250 million par amount outstanding.
Bloomberg US Long Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market whose maturity is 10 years or longer. It includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers.
Bloomberg Emerging Markets USD Aggregate Index includes USD-denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. Bonds must have at least one year to maturity and a minimum issue size of $500 million. Both investment-grade and high-yield bonds are permitted. Debt from sovereign, agency (government owned, government guaranteed, and government sponsored entities), local authority, and corporate issuers are eligibility. Bloomberg US 1-3 Year Treasury Bond Index is an index of fixed rate obligations of the U.S. Treasury with maturities ranging from 1 to 3 years.
Bloomberg US Corporate High Yield Index (BBG HY Corp) is an unmanaged index that is comprised of issues that meet the following criteria: at least $150 million par value outstanding, maximum credit rating of Ba1 (including defaulted issues) and at least one year to maturity.
Bloomberg US Intermediate Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers that have between 1 and up to, but not including, 10 years to maturity.
Bloomberg US TIPS Index includes all publicly issued, U.S. Treasury inflation-protected securities that have at least one year remaining to maturity, are rated investment grade, and have $250 million or more of outstanding face value.
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.
Bloomberg US MBS Index tracks fixed-rate agency mortgage backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The index is constructed by grouping individual TBA-deliverable MBS pools into aggregates or generics based on program, coupon and vintage.
Bloomberg Non-Agency CMBS Index (Non-Agency CMBS) is the Non-Agency CMBS components of the Bloomberg US Aggregate Bond Index, a market value-weighted index that tracks the daily price, coupon, pay-downs, and total return performance of fixed-rate, publicly placed, dollar-denominated, and non-convertible investment grade debt issues with at least $300 million par amount outstanding and with at least one year to final maturity.
Duration is a measure of the portfolio's return sensitivity to changes in interest rates.
An index is not available for direct investment.
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, 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. 2023. All rights reserved.
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IM-12745-2023-04-24 Exp. Date 07/31/2023
