Performance Table 1: Composite performance as of September 30, 2023, for 3 month, year-to-date, 1 year, 3 year, 5 year, 10 year, and since inception time periods.
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.
Exhibit I: Fixed income indexes returns as of September 30, 2023, showing duration, total return, and excess return.
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.
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.
Exhibit II: Fixed income sector outlook as of September 30, 2023, for reserves, structured credit, corporate credit, and other credit categories.
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.
Performance
Strong selection results paced the portfolio’s performance during the quarter (see Exhibit III). Contributions were diversified among positions in investment-grade corporate bonds, high yield corporate bonds, senior bank loans, and ABS. Subsectors that contributed to selection results included investment-grade corporate bonds issued by life insurers and banks, high yield corporate bonds issued by property and casualty (P&C) insurers and technology companies, senior bank loans to healthcare companies and airlines, CLO debt, and recurring revenue ABS.
Exhibit III: Representative account attribution as of September 30, 2023, showing average weight and contribution in basis points.
The portfolio’s duration contributed to total returns and relative results as shorter duration bonds outperformed 1-3 year Treasuries.
Sector allocation contributed modestly to the portfolio’s performance, as emphases on stronger-performing segments of the ABS and investment-grade corporate bond market proved additive.
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. ONDK 2023-1A A is a small business loan ABS deal brought by OnDeck. The company has a 15+ year history of underwriting small business loans, and the deal is backed by a highly diversified portfolio of loans and lines of credit (LOCs) made to small businesses. We bought the AAA rated notes at a spread of 265 basis points 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.
In the CMBS market, CRSO 2023-BRND A is an SASB 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, 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 0.9 years (see Exhibit IV). High yield and nonrated investments represented 11.6%, were comprised primarily of credits rated double-B, and consisted of a blend of corporate bonds and loans. Yield to maturity was 7.3% and remained elevated versus short-term bond market alternatives. The Fund’s option-adjusted spread (OAS) was 196 basis points over Treasuries; for reference, the longer-duration Bloomberg U.S. Corporate Index’s OAS spread was 121 basis points at month-end.
Exhibit IV: Representative account characteristics as of September 30, 2023, showing credit rating, sector allocation, effective duration, spread during, yield to maturity, and option-adjusted spread.
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.
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.
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 Per- formance 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. Perfor- mance calculated in U.S. dollars.
The objective of our Limited Duration Fixed Income Strategy is to deliver excellent returns in excess of industry benchmarks through market cycles. The Composite includes all fully discretionary fee-paying accounts with an initial investment equal to or greater than $10 million with a duration of approximately 1.5 years. Accounts that subsequently fall below $9.25 million are excluded from the Composite. As of 10/1/2020, the Limited Duration Composite was renamed BBH Limited Duration Fixed Income.
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 Limited Duration Fixed Income Strategy is to deliver excellent returns in excess of industry benchmarks through market cycles. The Composite includes all fully discretionary fee-paying accounts with an initial investment equal to or greater than $10 million with a duration of approximately 1.5 years. Accounts that subsequently fall below $9.25 million are excluded from the Composite. As of 10/1/2020, the Limited Duration Composite was renamed BBH Limited Duration Fixed Income.
Definitions
ICE BofA 1-3 U.S. Year Treasury Index is an unmanaged index that tracks the performance of the direct sovereign debt of the U.S. Government having a maturity of at least one year and less than three years.
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.
“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.
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.
Not FDIC Insured No Bank Guarantee May Lose Money
IM-13661-2023-10-26 Exp. Date 01/31/2024
