Performance Table: Performance as of September 30, 2023.
3Q Highlights
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Market Environment
U.S. Treasury rates rose during the third quarter. The U.S. economy appears to be on strong footing, and investors are capitulating to the view that the Federal Reserve (Fed) will need rates to be “higher for longer.” The Fed hiked the target range of the federal funds rate by 0.25% to 5.25%-5.50% at its July meeting. The Fed’s next announcement is scheduled for November 1st. In addition, the Fed continued its campaign of shrinking its portfolio of assets acquired through open market operations by a maximum of $95 billion per month.
On a duration-adjusted basis, nearly every credit index earned positive excess returns during the quarter, though agency mortgage-backed securities (MBS) were a noteworthy underperformer (see Exhibit I). Indexes tied to floating rate investments and with shorter durations experienced positive total returns despite the rise in rates. Long maturity corporate bonds (those with 10+ years until maturity) also had strong excess returns during the quarter.
Year-to-date, all credit indexes had positive excess returns except for agency MBS. Non-agency commercial mortgage-backed securities (CMBS) slightly outperformed comparable duration Treasuries despite negative headlines regarding commercial real estate (CRE). Indexes of investment-grade corporate bonds, senior bank loans, high yield corporate bonds, nontraditional asset-backed securities (ABS), and collateralized loan obligation (CLO) debt posted strong excess returns.
Exhibit I: Fixed income index returns for various indexes as of September 30, 2023, displaying duration, total return, and excess return.
Valuations
The strong recent performance of credit instruments has caused valuations to weaken. According to our valuation framework,1 the number of investment-grade corporate bonds that screened as a “buy” decreased to 32% and the number of high yield corporate bonds screened as a “buy” decreased to 33% while over 90% of bank loans screened as a “buy.” Within the investment-grade corporate bond market, we find most opportunities in short and intermediate duration segments of single-A rated and triple-B rated bonds, as well as nontraditional issuances that do not meet index inclusion criteria but offer compelling valuation while meeting our credit criteria. In the high yield corporate bond market, there are many opportunities among smaller issuers in the double-BB and single-B rated markets. However, our valuation framework identifies plenty of “hold” and “sell” candidates in those ratings categories, so there are numerous value traps and valuation-sensitive selection remains imperative.
In the structured credit markets, we are finding an abundance of attractively valued opportunities as we observe a continuing disconnect between wider credit spread levels and solid credit performance (see Exhibit II). Issuances of select non-traditional ABS, Single-Asset, Single-Borrower (SASB) CMBS, and CLO debt have come with attractive compensation and strong durability and structural protections. Opportunities are emerging in parts of the agency MBS market as valuations improve, and we are prepared to add positions.
Non-agency residential mortgage-backed securities (RMBS) continue to suffer from lower durability, thin credit enhancement, and prepayment risk. We continue to avoid emerging markets credits due to concerns regarding creditor rights in most countries.
Exhibit II: Market outlook by sector as of September 30, 2023, broken-down by reserves, structured credit, corporate credit, and other credit categories.
Performance
Favorable selection results had the largest impact on the portfolio’s relative performance during the quarter (see Exhibit III). Positions in senior bank loans to healthcare, airline, and consumer cyclical services companies had notable contributions during the quarter. Holdings of high yield corporate bonds issued by property and casualty (P&C) insurers and technology companies enhanced relative results further. The portfolio’s positions in SASB CMBS also proved additive, as well as the portfolio’s positions in investment-grade corporate bonds issued by business development companies (BDCs).
Exhibit III: Attribution as of September 30, 2023, showing average portfolio weight and gross contribution displayed in basis points.
Sector allocation also influenced performance favorably during the quarter. The portfolio benefitted from its emphases on stronger performing credit sectors, including investment grade corporate bonds and nontraditional ABS, and its avoidance of agency MBS.
The portfolio’s duration and yield curve profile contributed to results. Agency MBS was not owned in the portfolio but carries a significant weight in the Index. Agency MBS has negative convexity, and its duration can change day-to-day with changes in interest rates and interest rate volatility. 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 lower than the Index’s while interest rates rose.
Transaction Summary
We purchased bonds from a variety of sectors and industries during the quarter. Purchases included bonds from ABS secured by data center leases and revenues, small ticket equipment loans, personal consumer loans, and small business loans, corporate bonds issued by banks, a life insurer, and a construction machinery company, a loan to a healthcare company, and bonds from an SASB CMBS deal. Descriptions of a few notable portfolio additions are included below.
We bought bonds from several ABS issuances amid heavy volume. VDCR 2023-1A A2A is a data center ABS brought by Vantage Data Centers, a leading owner, developer, and operator of large hyperscale data centers in North America. The collateral consists of eight data centers in Northern Virginia, Montreal, and Quebec City. We purchased the A- rated bonds at a spread of 285 basis points2 over Treasuries. Aligned Data Centers issued its third deal secured by data center revenues, ADC 2023-1A. The securitization portfolio consists of six wholesale data centers and the associated leases, with contractual cashflows generated from leases to 32 hyperscale, large, enterprise, carrier companies. We bought the A- rated notes at a spread of 250 basis points over Treasuries. Adams Outdoor Advertising issued its fifth securitization secured by a portfolio of billboard assets and the revenue generated from leasing its space, ADMSO 2023-1. The collateral includes 9,983 billboards with no client or industry accounting for more than 3% and 12% of the pool, respectively. We bought the 4.1 year duration, A- rated notes at a yield of 7.1% and a spread of 310 basis points over Treasuries.
CRSO 2023-BRND A is an SASB CMBS deal secured by The Americana at Brand, a lifestyle luxury retail center located in Glendale, California that is 99.4% leased by 75 tenants. The property demonstrates low loan-to-value (LTV) ratios and strong operating performance. The triple-A rated notes carry a 5 year weighted average life, and we purchased the bonds at a yield of 7% and a spread of 270 basis points over Treasuries.
In the corporate credit market, NRG Energy Inc is the third largest publicly traded merchant power generation company and the largest power marketer in the U.S. NRG’s credit strengths include low leverage, significant liquidity, diverse exposure to different wholesale power markets, and a physical hedge against wholesale power dynamics through its retail power and gas marketing platform. We bought the new issue, 5 year, BBB- rated secured notes at a yield of 7.5% and a spread of 310 basis points over Treasuries. Corebridge Financial Inc is a life insurance company that was spun off from AIG, and the company benefits from significant scale and diversification. Their credit strength is derived from an excellent balance sheet, brand recognition, diverse product mix, excellent liquidity, and strong underwriting. We bought the new issue, 5 year, A+ rated notes at a spread of 149 basis points over Treasuries.
Characteristics
At the end of the month, the portfolio’s duration was 6.1 years and continued to approximate that of its benchmark (see Exhibit IV). High yield investments represented 15.8%, were comprised primarily of credits rated double-B, and consisted of a blend of corporate bonds and loans. Yield to maturity was 7.6% and remained elevated versus bond market alternatives. The portfolio’s option-adjusted spread (OAS) was 265 basis points over Treasuries; for reference, the Bloomberg U.S. Corporate Index’s OAS was 121 basis points over Treasuries at month-end.
Exhibit IV: Characteristics as of September 30, 2023, including credit rating and sector allocation for both the portfolio and benchmark.
Conclusion
Higher interest rates will offer the potential to bring higher returns for credit investors. We caution that a strong economy should not be the basis for investor credit decisions. Higher-for-longer interest rates will eventually weigh on many borrowers. Instead, we focus on durable credits3 which is a hallmark of our process. Thank you for your continued trust, and we look forward to our conversations over the coming weeks.
1 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.
2 Basis point (bps) is a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.
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.
Totals may not sum due to rounding.
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.
Definitions
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, dollardenominated, 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.
Duration is a measure of the portfolio’s return sensitivity to changes in interest rates.
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
Investors should be able to withstand short-term fluctuations in fixed income markets in return for potentially higher returns over the long term. The value of portfolios changes every day and can be affected by changes in interest rates, general market conditions, and other political, social, and economic developments.
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.
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.
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..
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. 2023. All rights reserved.
Not FDIC Insured No Bank Guarantee May Lose Money
IM-13663-2023-10-26 Exp. Date 01/30/2024
