BBH Municipal Fixed Income Quarterly Strategy Update – 1Q 2021

March 31, 2021
Portfolio Manager, Gregory Steier, provides an analysis of the investment environment and most recent quarter-end results of the Municipal Fixed Income strategy.

The Heat Is On

With each passing day and every vaccination, we take a step closer to our new normal. There are many reasons for optimism as we emerge from the pandemic and slowly regain our safety and freedom. Despite good reasons for optimism, much uncertainty remains. It is not unusual for economists and investors to extrapolate recent news into the future. A year ago, we found ourselves engulfed in an investor panic unlike any in the modern era as forecasts of a second Great Depression surrounded us. We leaned-in and took advantage of a plethora of investment opportunities. Today, growth forecasts are the strongest in the post-War era and the demand for credit-sensitive municipal securities has reached a fevered pitch. We find ourselves resisting the investor fervor for low-quality securities as their yields often provide inadequate compensation for risk. We must remember that even as the vaccine rollout accelerates and stimulus measures provide further fuel to our economic recovery, risks remain, and valuations still matter.

With the recent signing of the $1.9 trillion American Rescue Plan Act (ARPA), the Federal Government has now provided over $5 trillion of stimulus in the last 12 months. In the context of our $21 trillion economy, this amounts to a boost in excess of 20%. Never before in a peacetime environment has our economy received fiscal stimulus of this magnitude. Unlike the $2.2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act and the other 2020 relief packages, ARPA provides much more direct and less restrictive support to the municipal sector which should have a substantial impact.

ARPA is especially beneficial for state and local governments, which will receive $195 billion and $130 billion in funding for lost revenues, respectively. In contrast, the CARES Act and other subsequent relief acts offered support for virus-related expenditures, such as for testing, protective equipment, and cleaning. The ARPA funding formula is based largely on regional unemployment rates, and some of the hardest hit states such as New York, Hawaii, and Nevada can expect funding upwards to one- fifth of their fiscal 2020 revenues. Funding to local governments was also generous, with some large cities like Houston and Philadelphia receiving funding equal to a quarter of their fiscal 2020 revenues. This relief will reduce the need for further deficit borrowing and drawdowns of rainy-day funds as well as to help preserve funding for important social services.

Sector Aid Received ($ Billion) Description
States $195 Provides funding for lost revenues.
Local Governments $130 Provides funding for lost revenues.
Healthcare $63 Lowers cost of care through tax credits which will likely reduce bad debt for hospital systems.
Higher Education $40 Provides funding for lost revenues. A portion must be used for emergency student financial aid.
Mass Transit $31 Provides funding for both operating and capital support.
Housing $27 Financial assistance to households for rent, rental arrears, and utility costs.
Airports $8 Provides operating support and rent relief for airport concessionaires.
States $16 Healthcare aid for the 12 non-Medicaid expansion states.
Sources: Moody's and BBH Analysis

Enterprise sectors such as higher education, healthcare, mass transit, and airports will also benefit from ARPA. These sectors had already received generous support from the CARES Act, and the addition of ARPA relief will help solidify their financial positions. Most muni sectors will also indirectly benefit from ARPA provisions such as expanded unemployment benefits, direct transfer payments, and rental assistance.

After the Global Financial Crisis (GFC), it took states and other municipal sectors several years to recover, which led to a wave of austerity measures among state and local governments. Back then, the Federal Government’s response to the GFC neglected to provide direct aid to state and local governments. Post-COVID, we expect that the unprecedented fiscal and monetary policy stimulus measures will shorten recovery times. Cumulatively, the municipal sector has been the beneficiary of over $1.1 trillion in aid. ARPA provides a margin of safety for credit, but by itself is not sufficient to purchase a credit that does not satisfy our criteria. In other words, credit fundamentals still matter. For state and local governments with structural imbalances entering the pandemic, ARPA support will buy them time, but not cure problems that require reform.

As the incremental benefits of accommodative monetary policy on real growth have declined, the Federal Reserve (Fed) has sought the assistance of fiscal policy, and now they have it. Last summer, the Fed pivoted toward an average inflation target of 2% when assessing whether it is achieving its price stability goal. Because of subdued inflation in the past, the implication here is that the Fed will not proactively tighten to prevent higher inflation. The days of taking away the proverbial punchbowl are over, with the Fed now preferring higher inflation, rather than facing the opposite risk. Near-zero policy rates and continued asset purchases will likely remain in place as we emerge from the pandemic. We expect the Fed’s self-professed tolerance for letting the economy run hot will be tested and bond investors have already taken notice.

Despite steady short-term rates, long-term Treasury yields climbed 80 basis points1 during the quarter, completely reversing their pandemic-led rally. With a return of -13%, long Treasuries singed more than a few portfolios. This led the Treasury yield curve to steepen to its highest level in over five years. Inflation expectations rose over 35 basis points, ending the quarter at an eight-year high. With investors becoming more concerned about the prospects of an extended period of higher inflation, investors turned to inflation-protected assets such as equities and TIPS (Treasury Inflation-Protected Securities).

The municipal market often takes its cue from the Treasury market. Despite high correlations between the two markets, big divergences can occur. Thus far in 2021, the municipal bond market has proven resilient to much of the weakness experienced by Treasuries. As opposed to the double-digit negative returns in long Treasuries, long-maturity Municipals declined less than -0.50% during the quarter. Reflective of this relative outperformance, Municipal-to-Treasury yield ratios decreased 10-to 15-percentage points in intermediate and long maturities. After peaking at over 300% last spring, the 5-year and 10-year ratios ended the quarter at 54% and 65%, respectively. In certain respects, municipal valuations more than reflect prospective tax increases.

Although less dramatic than the move in Treasuries, the 2-to 10-year municipal yield curve did steepen during the quarter. For the quarter, 1- to-5-year muni rates increased an average of 12 basis points, while those in 7-to-10-year maturities climbed 40 basis points. For an extended time, we have positioned our intermediate portfolios with an emphasis on floating-rate securities and intermediate maturity zero-coupon bonds. To fund this position, we continue to deemphasize traditional 1-to-5-year maturity debt. Relative to our benchmarks, we own about 15% less exposure in these short maturities, which detracted about 10 basis points of relative return.

The overall muni market has benefited from strong technical support. Through February (year-over-year comparisons through March are highly distorted), new municipal issuance was constrained, down more than 15% compared to last year. Taxable muni issuance to refund older, more expensive debt continues to be popular, leaving tax-exempt issuance down more than 20% over the same period. This, combined with record-paced fund inflows of over $25 billion, has created an imbalance and helped to drive credit to increasingly expensive valuations. As you can see in the accompanying table on the next page, thus far in 2021, BBB-rated issues have generated over 200 basis points of excess return relative to generic AAA-rated securities.


 “1Q 2021 Municipal Fund Flows” displays the first quarter municipal fund flows for each of the last 13 years. While the first quarter of 2020 received an outflow of over $18 billion, 2021 received an inflow over $26 billion.

Our portfolios’ credit posture has been little-changed and we continue to focus on issuers that we perceive as durable and resilient to unexpected economic events, which typically results in us owning highly rated bonds. In terms of lower-rated bonds, we only own two major BBB-rated positions, State of New Jersey essential-purpose appropriation debt and Oglethorpe Power revenue bonds. Together, these names represent roughly 3%-4% of portfolios. Index holdings of BBB-rated debt is twice that. This relative exposure also cost portfolios approximately 10 basis points of return during the quarter.

Despite the strong performance of low-quality issuers, we kept to our strategy. We had numerous positions perform notably well throughout the quarter, such as Connecticut Special Tax, Houston Airport, Northshore Memorial Hospital bonds, and several holdings in the Prepaid Natural Gas sector. However, we did not own enough credit-sensitive holdings in aggregate to keep up with the broad-based credit rally in our benchmarks. Ten-year maturity airport spreads in the 40-basis point range, after adjusting for the Alternative Minimum Tax (AMT) and high-quality hospitals and healthcare systems with sub-30 basis point spreads, do not provide sufficient yield for us to consider adding positions in these areas. We have owned much larger exposures to these sectors in the past and are prepared to again – subject to our assessment of the individual credits and their valuations.

Performance by Credit Grade
  1Q 2021
AAA -0.82%
AA -0.58%
A 0.09%
BBB 1.26%
Non-Investment Grade 2.13%
Past performance is no guarantee of future results
Sources: Bloomberg Barclays Municipal Bond Index and BBH Analysis

As credit spreads narrowed, we have focused on enhancing our portfolios’ yields through off-the-run bond structures, such as zero-coupon bonds, and within sectors such as State Housing Finance Authorities (HFAs). We added several attractive positions during the quarter including a Texas HFA bond, backed by mortgages that have seasoned over 10 years, with an effective spread of close to 100 basis points; and a Chaffey, California school district zero-coupon bond at a similar spread. Perhaps the most interesting addition to our intermediate and longer portfolios was an obligation of Allan Hancock Joint Community College District, also in California. This bond is a zero-coupon until 2030, at which time it begins paying a 5.4% coupon. It is callable five years later. The effective spread on this bond was 105 basis points, with meaningful upside potential as the coupon conversion date approaches. With this security, we view the coupon income as well worth the wait.

We remain selective and deliberate as we assess potential opportunities. Currently, our portfolios’ cash and longer-term reserve holdings amount to 15%-20% of their market values, giving us ample flexibility to take advantage of future opportunities. It is hard to believe that only one year ago markets were in freefall, with panicked investors sending in record-sized redemption requests. Today, sentiment is unabashedly positive, with red-hot demand for credit. Rather than joining the crowd and chasing the momentum of strong credit returns, we prefer to wait patiently. One of the most important aspects of our long-term success is not getting burned along the way. We have always preferred the slow and steady approach to the alternative.

Thank you and stay well.

Sincerely,

Gregory S. Steier
Portfolio Manager

Performance As of March 31, 2021
  Total Returns Average Annual Total Returns
(a/o 03/31/2021) 3 Mo.* YTD* 1 Yr. 3 Yr. 5 Yr. 10 Yr. Since
Inception
BBH Municipal Fixed Income Composite (Gross of Fees) -0.51% -0.51% 4.91% 4.71% 3.55% 3.88% 4.12%
BBH Municipal Fixed Income Composite (Net of Fees) -0.60% -0.60% 4.65% 4.45% 3.29% 3.62% 3.87%
Bloomberg Barclays 1-10 Yr. Municipal Bond Index -0.26% -0.26% 4.54% 3.97% 2.65% 3.16% 3.72%
Top 10 Obligors by Market Value
California School District General Obligations 8.5%
Philadelphia School District, PA 3.4%
Texas Department of Housing and Community Affairs Single Family Mortgage Revenue Bonds 3.3%
New Jersey, NJ 3.24%
Minnesota Housing Finance Agency, MN 2.5%
New Mexico Mortgage Finance Authority, NM 2.4%
Texas Municipal Gas Acquisition and Supply Corp II 2.3%
State of Ohio 2.3%
Michigan Qualified School Bond Loan Fund 2.3%
Connecticut Special Tax Transportation 2.3%
Total 32.6%


1 Basis point 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 the account whose investment guidelines allow the greatest flexibility to express active management positions. It is managed with the same investment objectives and employs substantially the same investment philosophy and processes as the proposed investment strategy.

The BBH Intermediate Municipal Strategy is comprised of fully discretionary, fee-paying municipal fixed income accounts over $5 million that are managed to an average duration of approximately 4.5 years. Accounts are benchmarked to the Bloomberg Barclays 1-10 Year Municipal Blend Index. On 10/1/2020 the BBH Intermediate Municipal Strategy was renamed the BBH Municipal Fixed Income Strategy.

Bloomberg Barclays 1-10 Year Municipal Bond Index is a component of the Barclays Municipal Bond index, including bonds with maturity dates between one and 17 years. The Bloomberg Barclays 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.

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. 2021. All rights reserved

NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE MONEY

IM 09422-2021-04-23     Exp. Date 07/31/2021

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