BBH Municipal Fixed Income Quarterly Strategy Update – 2Q 2024

June 30, 2024
Portfolio Manager, Gregory Steier, provides an analysis of the investment environment and most recent quarter-end results of the Municipal Fixed Income strategy.

2Q Highlights

  • The first half of 2024 provided plenty of investment opportunities. Strong issuance was driven by several factors including tighter credit spreads, the increased cost of construction after multiple years of high inflation, and a desire to tap markets before the election.
  • We expect market volatility to remain elevated as we progress on an uncertain path to an eventual easing of monetary policy.
  • We are proud of our first half performance, generating a return of 0.72%, outperforming the index by 135 bps. Generating a positive return in the face of an interest rate sell-off is a testament to the strong portfolio income and security selection results.

Abracadabra

Inflation dominated the landscape again in Q2 2024 as investors fixated on every macroeconomic indicator and every word from the Federal Reserve (Fed). Once again, interest rates bounced around with the ebbs and flows of the data and rhetoric. Breaking the spell of inflation has remained much more difficult than the Fed initially hoped. We expect market volatility to remain elevated as we progress on an uncertain path to an eventual easing of monetary policy. Investor sentiment reflected this uncertainty as early-quarter pessimism abruptly swung to optimism by quarter-end. We stayed focused and took advantage of market volatility by steadily adding new opportunities, many of which featured non-standard bond structures.

Market volatility was again driven by changing Fed policy expectations. After looking for six to seven rate cuts at the beginning of the year, investors now only see two cuts, one before the presidential election and one after. Strong labor and housing markets, accommodative financial conditions, and large federal fiscal deficits have benefited the economy, but present strong resistance to the Fed’s inflation fight. Core inflation has risen an annualized 3% to 4% for the last six months. Super-core inflation, which measures price changes in core services excluding housing, was up more than 5% over the same period. These are not the typical preconditions for a pivot to easier monetary policy, but the Fed can always pull a rabbit out of its hat. Tighter monetary policy has not had the bite that policy makers expected, and many are now questioning the restrictiveness of the Fed’s stance.

Although elevated, municipal yield volatility declined to well-below 2022 and 2023 levels, which were the most volatile back-to-back years in decades. Just like the dynamic in taxable corporate bonds, credit-sensitive municipals strongly outperformed. Whereas Aaa-rated General Obligation (GO) bond yields fluctuated widely, premiums for lower-rated paper consistently narrowed. Simply put, the weaker the credit, the better the performance. We have experienced market conditions like this before and they are typically challenging for us. Indiscriminate buying tends to reward the less deserving and drives strong competition for new issues. Broad credit fundamentals remain healthy, with most states and local governments still sitting atop large, post-pandemic reserves. Revenue bonds have also performed well, buoyed by the strong economic growth. This sound foundation has helped low-rated credit spreads to approach their record tight levels. We will never buy a bond without a sufficient margin of safety,1 and today’s credit spreads provide slimmer margins than they had for the past couple of years.

We are proud of our first half performance, generating a return of 0.72%, outperforming the index by 135 bps.2 Generating a positive return in the face of an interest rate sell-off is a testament to the strong portfolio income and security selection results. We are also proud we beat the index despite such a small exposure to BBB credit, which tightened by roughly 45 bps since the start of the year. We continue to scratch our heads as other investors continue to pile into risky credits. We prefer alternatives to traditional credit to achieve similar yields with less risk.

The first half of 2024 provided plenty of investment opportunities, assisted by record supply. Strong issuance was driven by several factors including tighter credit spreads, the increased cost of construction after multiple years of high inflation, and a desire to tap markets before the election. Lastly, several large issuers invoked “extraordinary redemption provisions” (ERP) on their outstanding taxable Build America Bonds (BABs). ERPs give the bond issuer the right to call back the bonds at par if certain “extraordinary” conditions are met. Keep in mind, the word “extraordinary” is open to interpretation, making them difficult to analyze. Upon calling their BABs, these municipalities issued new tax-exempt bonds. Los Angeles Unified School District was the largest deal at $2.6 billion. From an investment perspective, we try to avoid premium bonds with par-priced ERPs. While we are grateful for the rebound in supply, we note that issuance was very concentrated, with a record number of billion-dollar new deals. We frequently source opportunities from the niche corners of the municipal market, rather than from larger, more generic GO bonds.


Exhibit I: A graph showing the record first half tax-exempt issuance.

Over the past years, strong technical factors, underpinned by low supply, have helped support valuations in the municipal market. During May, outsized issuance volume in the second quarter helped to drive the municipal market’s worst two-week period of performance since the onset of COVID-19. The change was most notable in the intermediate portion of the curve, which has been inverted for 18 months due to heavy retail demand. By quarter end, intermediate maturity yields increased by 20 bps to 45 bps, while the rest of the curve experienced more muted increases. We have consciously de-emphasized the area of the deepest inversion and expect to maintain this positioning. The sell-off quickly reversed as the continued pace of strong fund flows helped to absorb much of the new issuance, driving a rally in June. We strive to avoid being influenced by the Presto Chango of investor sentiment. This year, like in the past, periods of volatility are often accompanied by attractive opportunities.

During the quarter we purchased a wide array of opportunities across a range of sectors and structures, most of which fall out of the scope of retail investor preferences. We added two prepaid gas transactions, a floater backed by J.P. Morgan and a put bond backed by RBC with yield spreads of about 100 bps. Prepaid gas deals typically contain two elements retail investors seek to avoid: non-standard coupon structures, and corporate credit risk. Prepaid deals also contain several ERPs which must be thoroughly assessed. Other corporate-backed bond purchases for the quarter include puts from Intel and Duke Energy. We are grateful for the assistance we receive from our corporate analysts. This is a nice benefit of us all sitting together.

We also added bonds from two toll systems, a floater from E-470 in Colorado, and a zero-coupon bond from the Pennsylvania Turnpike Commission (PTC). The pandemic reinforced our assessment of toll road bond durability. That period presented a stress test that none of us fathomed before 2020. Both toll systems were able to offset lower traffic volume by reducing expenditures, delaying capital spending, or raising toll rates. Finally, housing planned amortization class (PACs) bonds continue to offer the best risk-adjusted value in the municipal market and played a large role in our activity. We purchased housing PACs across several states at spreads around 140 bps.


Exhibit II: A line graph depicting the municipal yield curve as of 6/30/2024.

In good times and bad, we try to stay steady. We do not bet on what we do not know. We have a lot of tools and analytics at our disposal, but not a crystal ball to see the future movements of interest rates, economic releases, election outcomes, or Fed utterances. We stick with what we can analyze – credit, valuation, and portfolio construction. In other words, we spend our time evaluating rather than predicting. This approach helps us stay focused in the face of the noise and distractions of swings in investor sentiment. It is anyone’s guess what the future holds, but we will be prepared. Not magic, but good old-fashioned analysis.

Author

Performance
As of June 30, 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)

0.45%

0.78%

4.64%

0.48%

1.87%

2.60%

3.62%

BBH Municipal Fixed Income Composite (Net of Fees)

0.39%

0.66%

4.38%

0.23%

1.62%

2.35%

3.37%

Bloomberg 1-10 Yr. Municipal Bond Index

-0.40%

-0.77%

2.31%

-0.35%

1.03%

1.79%

3.14%

Sources: BBH & Co. and Bloomberg
Returns of less than one year are not annualized.
BBH Municipal Fixed Income inception date is 05/01/2002.

Past performance does not guarantee future results.

Representative Account
Top 10 Obligors
As of June 30, 2024

Texas School Bond Guarantee Program

3.0%

Texas Municipal Gas Corporation II

2.6%

Port Authority of New York & New Jersey

2.6%

Illinois Housing Development Authority

2.5%

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%

Dominion Resources Inc

2.1%

Total

24.5%

Sources: Bloomberg and BBH Analysis

1 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.
2 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.

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.

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IM-14886-2024-07-05         Exp. Date 10/31/2024

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