BBH Municipal Fixed Income Quarterly Strategy Update – 3Q 2023

September 30, 2023
Portfolio Manager, Gregory Steier, provides an analysis of the investment environment and most recent quarter-end results of the Municipal Fixed Income strategy.

3Q Highlights

  • High-quality intermediate duration municipal portfolios now generate over 4% yields, tax exempt. That is nearly 7% pre-tax for an investor in the top federal income tax bracket.
  • We took advantage of a wide range of opportunities during the quarter as spreads for housing, prepaid gas, zero-coupon bonds, and longer-maturity callable bonds remained at attractive levels.
  • Municipal opportunities have rarely been more attractive. We believe the confluence of high base rates, healthy credit spreads, and substantial compensation for non-standard structures offer the potential for robust total returns.

A Sorta Fairytale

Once upon a time, politicians could work across the aisle, municipal advance refundings could be tax-exempt, and working five days a week in the office was normal. A few years ago, we also would have dreamed about 4% tax-exempt yields. Well, dreams sometimes do come true. 18 months into the Federal Reserve’s (Fed) hiking cycle, we remain excited about the investment opportunities on offer. Nominal and Real1 yields are now at their highest levels in decades and the prospect of “higher Fed policy rates for longer” has gained traction.

A steeply inverted yield curve was not sustainable unless the Fed was poised to pivot to an easier posture sometime soon. As this has become less likely, Treasury and municipal yield curves began to dis-invert, with longer-maturity rates rising more than those with short maturities. During the third quarter, intermediate and long-maturity municipal yields rose 90 basis points2, while short-maturity yields were up 70 basis points. We have enjoyed locking in these higher rates for our clients. Consistent with our experience, negative investment sentiment has again produced bountiful investment opportunities. After several years of cautious investing when rates were closer to 0%, we have become much more active.

For the quarter, intermediate benchmark returns fell 3%, the third worst quarter in the last 25-years. This brought year-to-date results to moderately negative. Fortunately, our client portfolios declined less and outperformed on a relative basis. Once again, the yield advantage of our client portfolios played a key role. Our exposures in State Housing Finance Authority agencies (HFAs), airports, school district zero-coupon bonds, and prepaid natural gas bonds served as the primary drivers of that yield advantage.

Historically, periods of poor bond market performance are often followed by strong rebounds, but not so in 2023. Elevated money market yields now provide households with their most substantial returns on their savings in decades. After the bear market of 2022 and a persistent inversion of the yield curve, it is no wonder why there is reluctance to buy longer maturity bonds in favor of greater than 5% yields on cash.

We are nearing the end of the active phase of this tightening cycle. Even if the Fed nudges rates up further, it is difficult to fathom they would push their policy rate aggressively higher from here. Inflation is slowly receding and introducing more hard-landing risk or further turmoil in the banking system to get faster results would seem to be imprudent. In that context, “higher-for-longer” appears reasonable and investors have taken notice.

Since the tightening cycle began, many investors have sought to reduce risk by shortening their portfolio’s duration, and in some cases, moving to cash. For a long-term investor who desires income stability, holding cash for an extended period might not be the best solution. When judging longer bonds, the relevant investment horizon, inflation rate, and prevailing yields are all important factors.

There are many attractive uses of cash today. High-quality intermediate duration municipal portfolios now generate over 4% yields, tax exempt. That is nearly 7% pre-tax for an investor in the top federal income tax bracket. Let us also not forget that the Tax Cuts and Jobs Act (“TCJA”), which brought the top bracket down from 39.6% to 37%, is poised to expire at the end of 2025.

While generic AAA municipal yields have hit a new high, client portfolio yields are even better and provide a substantial advantage relative to benchmarks (see Exhibit I). Not only do these yields provide near equity pre-tax return potential, but they also provide significant protection should interest rates increase. By virtue of their quality and contractual maturities, investment-grade bonds offer a much narrower range of return outcomes. We have not had valuations this attractive in many years.


Exhibit I: A line graph displaying 10-year municipal bond yields from September 2009 through September 2023.

We took advantage of a wide range of opportunities during the quarter as spreads for housing, prepaid gas, zero-coupon bonds, and longer-maturity callable bonds remained at attractive levels. Spreads for State HFA bonds remained near 150 basis points for three-to five-year average lives. HFAs continue to represent our largest revenue bond sector exposure. Regarding prepaid gas bonds, we added an eight-year put bond backed by Royal Bank of Canada (RBC) with a spread of 170 basis points. Within the industrial development revenue bond sector, we added a bond backed by Intel which helped to fund a clean water project at their Chandler, Arizona production facility. This bond paid +130 basis points for a five-year effective maturity, a wider spread than Intel’s taxable corporate notes. Credits like this highlight the collaboration between our taxable and tax-exempt analyst teams. Finally, we added a range of zero-coupon Oregon school bonds, at 100-150 basis points above generic triple-A bonds.

School districts represent the vast majority of our general obligation (GO) bond exposure. We have long believed school district bonds are superior to most other types of local government securities. In addition to providing an essential service, school bonds often carry a “double-barreled pledge.” The first pledge is a GO of the school district, which is the most common security pledge for local governments. Through a GO security, the district pledges its “full faith and credit” to bondholders. The second pledge is provided by the district’s state government. There are several types of enhancement mechanisms. For example, in Texas, the second barrel is backed by an asset pool, while in Michigan, the second barrel is backed by the state’s GO pledge. The added protection of the secondary pledge on top of an already-robust first pledge provides significant credit strength. More importantly, it also allows us to participate in less-liquid structures in exchange for extra yield. We are active buyers of zero-coupon, low-coupon, and puttable school district bonds. We never want to be forced sellers of securities with weaker liquidity because of a credit issue. Owning school bonds backed by enhancements effectively mitigates this risk.

Like last year, tax-exempt new issuance has been modest. We estimate 2023 supply will fall short of last year’s by 15% and let us not forget that 2022 issuance was down 20% versus 2021. There are a few important implications. First, retail municipal Separately Managed Account (SMA) programs, which often focus on top-rated securities, have kept downward pressure on yield ratios relative to Treasuries. By inflating triple-A bond valuations, retail SMAs have also helped widen spreads on single-A and double-A rated securities, particularly in intermediate maturities. Second, the dearth of new issuance and strong demand from municipal high yield funds has driven a credit rally in triple-B and non-investment grade bonds this year. We operate between these two influential investor groups taking significant exposures to high-quality off-the-run bond structures. Since the 2017 TCJA, municipal supply has struggled, but we remain hopeful it will one day become robust again.

Municipal opportunities have rarely been more attractive. We believe the confluence of high base rates, healthy credit spreads, and substantial compensation for non-standard structures offer the potential for robust total returns. The Fed has abruptly ended the decade-long fairy tale of free money, restoring bonds to their proper role as both an income generator and ballast to the inherent volatility of equity returns. This is the happily-ever-after for which we have long waited!

Authors

Performance
As of September 30, 2023
  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)

-2.35%

-0.15%

3.82%

-1.29%

1.67%

2.31%

3.42%

BBH Municipal Fixed Income Composite (Net of Fees)

-2.41%

-0.34%

3.57%

-1.53%

1.42%

2.06%

3.16%

Bloomberg 1-10 Yr. Municipal Bond Index

-2.23%

-0.81%

2.29%

-1.41%

1.20%

1.68%

3.04%

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 September 30, 2023

Texas School Bond Guarantee Program

3.0%

Iowa Housing Finance Authority

2.8%

Public Energy Authority of Kentucky Gas Supply Revenue

2.7%

Texas Municipal Gas Corporation II

2.7%

Texas Municipal Gas Acquisition and Supply Corporation I Series 2008D

2.6%

California School District General Obligations

2.5%

New Mexico Mortgage Finance Authority

2.5%

Port Authority of New York & New Jersey

2.4%

Salem-Keizer School District #24J, OR

2.4%

Houston Airport Enterprise, TX

2.2%

Total

25.8%

Sources: Bloomberg and BBH Analysis

1 Real yields is a measure of the stated return on bonds, minus inflation.
2 A unit that is equal to 1/100th of 1% and is used to denote the change in 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. 2023. All rights reserved.

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IM-13490-2023-10-05         Exp. Date 01/31/2024

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