BBH Municipal Fixed Income Quarterly Strategy Update – 3Q 2022

September 30, 2022
Portfolio Manager, Gregory Steier, provides an analysis of the investment environment and most recent quarter-end results of the Municipal Fixed Income strategy.

All Shook Up

3Q Highlights

  • The Federal Reserve has tightened policy at the quickest pace in decades in an urgent effort to quell inflation.
  • Market sentiment remains pessimistic, in contrast to last year’s enthusiasm. Recessionary fears have helped normalize credit spreads and
    municipal yields are their highest since the Global Financial Crisis.
  • We view our credits as well-positioned to withstand a potential recession.
  • Higher yields, wider credit spreads and rampant forced selling have created our broadest opportunity set in over a decade.

By the end of the third quarter, investors had endured nine-months of turbulence. Not since the Global Financial Crisis (GFC) have we experienced such an extended period of elevated volatility. In late 2007, without knowing what was to come, then-Citigroup CEO Chuck Prince uttered the following:

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”1

Dancing at proverbial parties has never been for us, even with the Federal Reserve (Fed) as a host. When investing, we like to avoid crowds both in the securities we choose and from sentiment-driven fund flows. We never understood the excitement that drove record fund inflows last year when valuations were unattractive. Purchasing bonds with poor valuations often leads to poor returns. The party is now over, the punchbowl is gone, and investors have been duly shaken. Aggressive Fed tightening and rising expectations for additional rate hikes have erased the inflated valuations from last year. Anxious investors have sought the comfort of cash all year long, redeeming from funds in droves. After another weak quarter, returns across the major fixed income sectors are now down double-digits (see Exhibit I).

Exhibit 1:  Fixed Income Sector Returns

  3Q 2022
YTD 2022
U.S. Treasuries
-4.40% -13.10%
Agency  Mortgage-Backed
Securities
-5.40% -13.70%
Investment Grade
Corporates
-5.10% -18.70%
Municipals -3.50% -12.10%
Sources: Bloomberg and BBH Analysis

Last year, easy monetary policy, accommodative fiscal policy, and record inflows into municipal funds bolstered investor confidence and risk appetites. This year, those supports have been broken. Unlike when the Fed seeks to cushion the impact of an economic slowdown, today they are driving us toward recession. In contrast to last summer, when the Fed forecast no change in policy for 2022, rate hikes are now occurring at their quickest pace in 40 years; such is their urgency to quell inflation.

Owning resilient credits remains a cornerstone of our municipal fixed income strategy. Strong economic growth, unprecedented stimulus measures, and yield-chasing investors have driven the marginal demand for credit-sensitive bonds for the last couple of years. Consequently, low-rated issuers enjoyed relatively unhindered and inexpensive market access. Today’s environment is different, and we expect an ongoing normalization of credit spreads from rising fundamental risks and stronger competition from the much-improved yields on high-quality securities.

Swings in investor sentiment and the short-term volatility it generates are a feature of financial markets and often provide attractive long-term opportunities. In the municipal market, these swings occur regularly. With a growing percentage of investments held in mutual funds and Exchange-Traded Funds (ETFs), municipal investors now have much more liquid means of transacting than in the past. It is far less costly for a household investor to subscribe to or redeem from a fund than to buy and sell individual securities. As a result, inflow and outflow cycles have become larger, with a more pronounced impact on valuations. Year-to-date fund redemptions have already wiped out 2021’s inflows, resulting in record-breaking forced-selling by fund managers (see Exhibit II). In nearly 70% of trading days this year, municipal investors, in aggregate, have tried to sell over $1 billion worth of bonds (see Exhibit III). The previous record was in 2018 at 30%.


Exhibit II: Cumulative Municipal Bond Fund Flows is a line graph showing fund flows from 2018 through September 30, 2022. Year to date fund outflows have wiped out the inflows of 2021.


Exhibit III: Record Forced Selling is a graph depicting the percentage of trading days with greater than $1 billion in Bid Wanteds by year.  The graphic shows the unprecedented number of trading days with Bid Wanted in excess of $1B in 2022, which totaled 70% of trading days as of September 30.  For comparison, other years associated with high volatility, such as 2018 (the last Fed tightening cycle), 2020 (the onset of the Covid-19 pandemic), or 2008 (the Global Financial Crisis) were much lower at 30.5%, 16.6%, and 11.6% of trading days, respectively.

Thin market liquidity has generated disconnected trading conditions. For instance, the yield of a generic 10-year AAA-rated municipal bond at the beginning of the quarter was 2.7%, rallied to 2.2% by July 31st, and finished the quarter at 3.3%. This represented a swing of more than 100 basis points2 in three months for a security that normally fluctuates 50 to 60 basis points in an entire year. Rather than the usual doldrums, this summer was more of a roller coaster. Municipal yields overall jumped 50 to 100 basis points during the quarter, bringing the year-to-date rate increases to 225 to 275 basis points. Fed tightening affected short maturity bonds the most. By the end of September, the municipal yield curve had significantly flattened with 2-year, 10-year, and 30-year yields at 3.1%, 3.3%, and 3.9%, respectively. There has been no place to hide.

Our portfolios generally trailed their benchmarks by 10 to 20 basis points for the quarter, leaving us behind 20 to 30 basis points year-to-date. Our floating rate securities accounted for most of our underperformance. Municipal floaters tend to be niche investments with below-average liquidity. Many of our floaters also have a bank element to their credit and widened in sympathy with corporate financial spreads. We have no credit concerns on any of these holdings. As the tightening cycle progresses, we expect the performance of our floating rate holdings to improve. We were pleased that our housing sector holdings stabilized during the quarter after struggling earlier in the year.

Fortunately, weak markets provided attractive opportunities during the third quarter. Spreads of over 100 basis points for BBH-acceptable credits had been rare for the last two years, but now they have become more prevalent. We added two prepaid gas issues: a 2.5-year average life floating-rate bond supported by Bank of America at a spread of 110 basis points, and a 7-year note supported by Goldman Sachs at a spread of 175 basis points. We purchased several airport credits including Houston, Honolulu, Orlando, and Port Authority of New York and New Jersey that offered spreads between 100 and 110 basis points. We also invested in several state housing finance authorities with 2- to 5-year average lives offering spreads between 125 and 150 basis points. For a final highlight, we purchased a note backed by Duke Energy, with the security of a first mortgage pledge at a spread of 110 basis points. Consistent with our strategy, we like to actively engage when market conditions are choppy, because of the attractive values often available.

We view our credits as well-positioned to withstand a potential recession. Considering uncertainties arising from the pandemic, the economy, and Federal aid, many municipal issuers have been hesitant to spend and have built impressive war chests. Currently, state rainy-day fund balances are higher than in any other pre-recession period since the turn of the century. Many revenue-bond issuers have benefitted from strong stock market returns in 2021 to drive outsized reserve growth. Lastly, liquid reserves relative to spending were at decade highs at the end of fiscal 2021 for both the higher education and healthcare sectors.

We are mindful of headwinds ahead as recession threats grow. After historic gains last fiscal year, the median U.S. pension return declined -7.9% for the year ending June 30, the worst return since 2009. In addition to poor returns, wage inflation is also placing pressure on pension costs as actuarially-required contributions adjust to the inflationary environment. Wage inflation has been particularly acute in sectors such as Healthcare, which is suffering from a nationwide nursing shortage. State and local governments have thus far avoided large pay increases, but collective bargaining agreements usually take time to complete. We expect that public wages will eventually need to catch up and will pressure budgets.

With these challenges in mind, governments and enterprises cannot rely solely on high reserve levels to maintain their financial positions. During previous economic downturns, we witnessed management teams reduce budgets by making cuts to personnel and delaying capital projects. This year, we have witnessed the opposite. Several states have cut taxes and several more have issued cash rebates to taxpayers. While many states can comfortably relinquish small portions of their revenues, some states are more generous than common sense would dictate. When the pandemic aid runs out, we expect well-run governments to once again make tough decisions to control costs. We consider the analysis of management to be a crucial element of our investment process. Even the most durable credits will eventually face tough times, and it is the strength of managements that will ultimately have lasting impacts for bondholders.

The Inflation Reduction Act (IRA) was yet another reminder that the wishes of municipal investors are not always a priority in Washington. The IRA failed to address state and local tax deductions (SALT) and it did not provide a meaningful borrowing program for municipals. The IRA will, however, have some implications for the municipal market. Most notably, it introduced a 15% corporate minimum tax to businesses with over $1 billion in profits. For corporations subject to this tax, all bond income will be taxed regardless of a bond’s original tax status. While corporations comprise roughly 25% of municipal demand, most of the major corporations that own municipals will not be subject to this tax. Therefore, we do not expect a material decline in municipal demand. In addition to this tax reform, the IRA makes several investments to tackle climate change, which will likely benefit public power credits by helping to offset the cost of building clean-energy infrastructure. Finally, the IRA provides a three-year expansion of premium assistance for the Affordable Care Act, which will benefit the healthcare sector as wider access to care should increase demand for services.

The shake-up of 2022 has been among the most severe in decades. We understand the reasons for fear. This has been a ferocious bear market in bonds and fundamental risks are rising. We find that our own sentiment is more linked to the prevalence of actionable opportunities: durable credits that provide attractive yields. When viewed through this lens, we remain optimistic despite pervasive pessimism. Higher yields, wider credit spreads, and rampant forced selling have created our broadest opportunity set in over a decade. We remain focused on steadily adding positions in resilient credits and allowing their yields to benefit our clients over time.

Sincerely,

Gregory S. Steier
Porftfolio Manager

Performance As of September 30, 2022

 

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)

-2.66%

-9.03%

-8.65%

-0.89%

1.05%

1.91%

3.40%

BBH Municipal Fixed Income Composite
(Net of Fees)

-2.72%

-9.20%

-8.88%

-1.14%

0.80%

1.65%

3.14%

Bloomberg 1-10 Yr. Municipal Bond Index

-2.30%

-7.72%

-7.55%

-0.83%

0.71%

1.41%

3.07%

* Returns are not annualized.

BBH Municipal Fixed Income inception date is 05/01/2002.

Sources: BBH & Co. and Bloomberg

Past performance does not guarantee future results.

Representative Account
Top 10 Obligors
As of September 30, 2022

California School District General Obligations

9.5%

State of New Jersey

3.8%

State of Maryland

3.3%

Texas Municipal Gas Acquisition and Supply Corporation I Series 2008D

3.1%

Texas Municipal Gas Corporation II

3.0%

Texas School Bond Guarantee Program

2.8%

Texas Department of Housing and Community Affairs

2.7%

Salem-Keizer School District #24J, OR

2.3%

State of Ohio

2.3%

Public Energy Authority of Kentucky Gas Supply Revenue

2.3%

Total

34.9%

Sources: Bloomberg and BBH Analysis

1 Financial Times, July 2007: Citigroup chief stays bullish on buy-outs.
2
One “basis point” or “bp” is 1/100th of a percent (0.01% or 0.0001).

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®” 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 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. 2022. All rights reserved.

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IM-11781-2022-10-13    Exp. Date 1/31/2023

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