Exhibit I: A graph comparing the duration and spread of various segments of the municipal bond market, where off-the-run bond structures may provide additional yield without more risk.
Q1 2024 Highlights
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One
Our search for durable and attractively valued municipal bonds continues: One day at a time, one bond at a time. The furious pace of new opportunities from last fall has now transitioned to a more normal cadence. The municipal market is by far the most diverse sector in fixed income. This diversity and the outsized influence of household investors, creates reliable opportunities. These opportunities are more abundant during volatile periods, pessimistic sentiment, and industry fund outflows. We faced these conditions last year, prior to the onset of the “everything rally”. Since then, generic high-grade municipal valuations have become frothy as ratios relative to Treasuries fell below 60%. We know from experience this likely will not last. This is one of those times we are grateful that we focus on market niches and assemble portfolios that do not resemble the general market.
Last November, multi-decade high yields, in conjunction with a cooling labor market and inflation statistics, ignited a historic municipal rally at the end of 2023. Unfortunately for the Federal Reserve (Fed), progress on inflation has stalled. Over the last three reporting periods, core Consumer Price Index (CPI) has increased at over a 4% annual equivalent rate and super-core CPI, which excludes goods and housing services, is up over 6%. Consequently, investor expectations for easier monetary policy have now cooled to three expected rate cuts this year, down from six. We understood the Fed’s desire to fine-tune policy because of the progress it had made on inflation, but pricing in an easing cycle felt premature. Although today’s investor expectations better align with those of the Fed, significant uncertainties remain. Anticipating monetary policy helps make for exciting financial news, but we would rather spend our energy evaluating new opportunities.
As Fed easing expectations declined, intermediate and long maturity yields increased 25 to 30 basis points1 during the first quarter. Shorter maturity yields fared worse, rising 40 basis points. A combination of low issuance volume and steady industry inflows led municipals to outperform Treasuries and kept valuations for generic high-grade municipal bonds expensive. Credit-sensitive bonds benefited from strong demand and limited supply with Triple-B and high-yield municipals outperforming by 100 basis points and 200 basis points, respectively, echoing the taxable credit market.
There are three classic methods of enhancing yield in bond portfolios: 1) extending duration, 2) adding credit risk, and 3) selling volatility via callable (or pre-payable) bonds. Although we do not view volatility as equivalent to risk, we recognize the importance of our clients’ ownership experiences, especially during turbulent markets. In normal market conditions, extending duration adds significant volatility relative to the incremental income it produces. That strategy is even more challenged given today’s unusual yield curve. We view adding credit risk as a tried-and-true measure of enhancing yield so long as the fundamentals are durable, and the incremental yield compensates for its risk plus a margin of safety.2 Lastly, although callable bonds provide extra yield, they tend to underperform during periods of high volatility. This is why when we evaluate callable bonds, we make conservative assumptions to value the embedded option to properly compare them with their non-callable counterparts.
In Municipals, we are fortunate to have a fourth option, owning off-the-run3 bond structures (Exhibit I). Among the aforementioned options, we view this option as the most stable. Zero-coupon bonds, floating-rate notes, and bonds subject to the Alternative Minimum Tax (AMT) all serve as good examples of how to enhance a portfolio’s risk-adjusted yield. Some structures such as delayed-delivery bonds help augment portfolio returns without increasing yield, which makes them important to our strategy as well. Many of these opportunities exist because of a pronounced investor preference for cash-flow, a reluctance to own securities that might generate some taxable income, and sometimes an aversion to bond math.
Despite higher Triple-A rates during the quarter, we are happy to report that our intermediate composite not only beat its benchmark by approximately 40 basis points, but also generated a modestly positive return. Despite minimal holdings of Triple-Bs and nothing below investment-grade, our portfolios still carry meaningful yield advantages versus their benchmarks of around 75 basis points. This, in addition to the outperformance of our Single-A rated holdings, bolstered our results.
It is easy to paint the municipal market with a broad brush. Yes, triple-A rated bonds with generic structures are expensive, but the market is vast, and we continue to find a steady stream of opportunities in niche corners of the market. In addition, we have established portfolio structures to take advantage of the peculiar shape of the yield curve. We never expected its bowl-shape to persist this long, but our Variable Rate Demand Notes (VRDNs), floaters, and longer zero-coupon bonds help provide a running yield advantage as we wait for the curve to normalize (Exhibit II).
Exhibit II: A line graph depicting the municipal yield curve as of 3/31/2024, where there has been little change over the past 15 months.
After a lengthy absence, delayed-delivery bonds sprung back to life during the first quarter. Municipal debt cannot be refunded with a new tax-exempt issuance more than 90 days ahead of a call or maturity date. Delayed-delivery bonds exploit a loophole that enables issuers to take advantage of current tax-exempt rates without running afoul of tax laws. During the quarter, we picked up three delayed-delivery bonds, matching our total from 2023. Perhaps most notable was Mississippi Institute of Higher Learning which had a four-month delay period. By our estimates, the bonds offered 15 to 30 basis points more yield than its fair value, depending on maturity. As the bonds approach settlement, we expect the yields on this new issue to converge with those of generic double-A securities. When we invest in this type of structure, we usually keep our committed, but unspent capital in cash reserves. We have a fondness for delayed delivery securities and the good values they have offered. Today’s elevated cash rates help magnify their benefits. For more on today’s high cash rates, please read our commentary titled “Mo[re] Money, No Problems”.
Another important source of value has been bonds subject to the AMT. Municipal bonds which directly benefit private enterprises or individuals can be subject to the AMT. As we discussed last quarter, spreads for AMT bonds remain elevated despite the small number of households subject to the tax. Municipal airport debt represents most of our AMT exposure. During the first quarter, we also purchased Nevada Power Company, which is a subsidiary of Berkshire Hathaway and features a first mortgage pledge. In general, Investor-Owned Utilities are strong credits that benefit from their positions as regulated monopolies of an essential service. We are grateful to have the ability to invest side-by-side with our corporate team when investing in tax-free debt with a corporate risk component. In addition, we bought Texas student loan bonds, backed by the state, which are subject to the AMT. At purchase, the bonds offered a very attractive risk-adjusted yield of 70 basis points over generic Texas general obligation (GO) debt.
The municipal bond market settled into a more normal rhythm to start the new year. Strong reinvestment demand amid constrained supply pushed investors to find yield in familiar places. We do our best to avoid being influenced by swings in investor sentiment, as it is all too easy to lose one’s balance these days! We stay grounded by our focus on high-quality credits that provide more yield or return potential than is justified by their underlying risks. Often, we find these opportunities in areas where traditional household investors are least comfortable. It is in these “unfamiliar” places that we form the foundation to our strategy one bond at a time.
Thank you for your ongoing trust and confidence.
| Performance As of March 31, 2024 |
|||||||||
|---|---|---|---|---|---|---|---|---|---|
| Total Returns | Average Annual Total Returns | ||||||||
Composite/Benchmark |
3 Mo. |
YTD |
1 Yr. |
3 Yr. |
5 Yr. |
10 Yr. |
Since Inception |
||
BBH Municipal Fixed Income Composite (Gross of Fees) |
0.33% |
0.33% |
3.93% |
0.66% |
2.17% |
2.73% |
3.65% |
||
BBH Municipal Fixed Income Composite (Net of Fees) |
0.26% |
0.26% |
3.67% |
0.41% |
1.91% |
2.48% |
3.39% |
||
Bloomberg 1-10 Yr. Municipal Bond Index |
-0.37% |
-0.37% |
2.18% |
-0.01% |
1.44% |
1.99% |
3.18% |
||
Sources: BBH & Co. and Bloomberg |
|||||||||
Past performance does not guarantee future results. |
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| Representative Account Top 10 Obligors As of March 31, 2024 |
|
|---|---|
Texas School Bond Guarantee Program |
3.0% |
Port Authority of New York & New Jersey |
2.6% |
Illinois Housing Development Authority |
2.6% |
Texas Municipal Gas Corporation II |
2.6% |
Texas Department of Housing and community Affairs Single Family Mortgage Revenue Bonds |
2.5% |
Salem-Keizer School District #24J, OR |
2.4% |
New Mexico Mortgage Finance Authority |
2.3% |
Houston Airport Enterprise, TX |
2.2% |
Central Plains Energy Project Gas Project Revenue Bonds Project No. 5 Series 2022 |
2.2% |
Grossmont Healthcare District |
2.0% |
Total |
24.5% |
| Sources: Bloomberg and BBH Analysis | |
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 With respect to fixed income investments, a margin of safety exists when the additional yield offers, in BBH's view, compensation for the potential credit, liquidity and inherent price volatility of that type of security and it is therefore more likely to outperform an equivalent maturity credit risk-free instrument over a 3-5 year horizon.
3 Off-the-run refers to securities that have been issued before the most recent issue and are still outstanding.
Risks
There is no assurance that a portfolio will achieve its investment objective or that the strategy will work under all market conditions. The value of the portfolio can be affected by changes in interest rates, general market conditions and other political, social and economic developments. Each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.
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.
Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax.
The Strategy also 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 stock or bond investments.
As the Strategy’s exposure in any one municipal revenue sector backed by revenues from similar types of projects increases, the Strategy will become more sensitive to adverse economic, business or political developments relevant to these projects.
The Representative Account is managed with the same investment objectives and employs substantially the same investment philosophy and processes as the strategy.
The objective of our Municipal Fixed Income Strategy is to deliver excellent after-tax returns in excess of industry benchmarks through market cycles. The Composite includes all fully discretionary fee-paying municipal fixed income accounts with an initial investment equal to or greater than $5 million that are managed to an average duration of approximately 4.5 years. Portfolios that subsequently fall below $4.5 million are excluded from the Composite.
Bloomberg 1-10 Year Municipal Bond Index is a component of the Bloomberg Municipal Bond index, including bonds with maturity dates between one and 17 years. The Bloomberg Municipal Bond Index is considered representative of the broad market for investment grade, tax-exempt bonds with a maturity of at least one year. One cannot invest directly in an index.
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 par amount outstanding and with at least one year to final maturity.
Bloomberg US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility and financial issuers. The Index is a component of the US Credit and US Aggregate Indices. “Bloomberg®” and the Bloomberg 1-10 Year Municipal Bond Index are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the index (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 BBH Strategy. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to the fund.
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 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.
Holdings are subject to change.
Credits: 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.
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.
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. References to specific securities, are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.
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.
NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE MONEY
IM-14431-2024-04-09 Exp. Date 07/31/2024
