BBH Municipal Fixed Income Quarterly Strategy Update – 2Q 2021

June 30, 2021
Portfolio Manager, Gregory Steier, provides an analysis of the investment environment and most recent quarter-end results of the Municipal Fixed Income strategy.

Retail Therapy

The U.S. economy surged during the second quarter, driven by strong capital spending and personal consumption. As our country continues to recover from the pandemic, municipal investors have also opted for a full regimen of retail therapy. The first six months of 2021 have continued where the second half of last year left off – amidst an epic municipal credit rally. Valuations of lower-rated debt now exceed their pre-pandemic levels and investor sentiment remains enthusiastic. Reluctant to sit on cash, investors keep piling into new issues even as the excess yield from credit-sensitive bonds declines further and further. In their fervor to keep up with the Joneses, investors appear to have lost track of the prices they are paying. While chasing trends and following the crowd into low-rated debt might be popular strategies, we pride ourselves on being bargain hunters, and believe conspicuous consumption is at odds with finding good value.

There are many reasons supporting the strong demand for credit-sensitive municipal bonds:

  • The most generous fiscal stimulus in the Post-War era
  • Hyper-accommodative monetary policy
  • Dramatically improved economic backdrop
  • Strong consumer balance sheets, flush with savings and gains from stocks and residential real estate
  • Growing likelihood for tax increases
  • Extra yield, albeit much less
With economic growth estimates of above 6%, the fundamental environment for credit remains very supportive. To put some context around the speed of this economic recovery, the labor market needed 10 years to recover following the Global Financial Crisis (GFC). This cycle, the unemployment rate has retraced 80% of its increase in only 16 months. Real economic output needed 3.5 years to exceed its pre-GFC peak. This time, the U.S. is on target to do so in 1.5 years, a textbook V-shaped recovery. Trillions of dollars of accumulated savings and wealth created over the last eighteen months should help fuel growth for the foreseeable future (See Exhibit I).

Exhibit 1: The first exhibit shows the unemployment rate over two recessionary time periods: the Global Financial Crisis and Covid-19. Though Covid-19 led to a higher unemployment at first, after sixteen months the unemployment rate is already lower than it was during the same time period for the GFC.

The majority of states have now completely erased their pandemic-related losses and are sitting atop a mound of federal aid, courtesy of the American Rescue Plan Act (ARPA) and last year’s CARES Act. Similar to the national economy, the speed of the bounce-back at the state level represents a drastic shift from that following the GFC, in which most states took several years to fully recover. Personal income taxes, the largest source of state revenues, have served as the backbone of state recoveries, increasing by 3% in calendar year 2020. These funds have helped to offset losses in sales taxes, the next largest revenue source. Sales tax collections declined by 2% in 2020, but have since rebounded, growing for three consecutive quarters. In addition, a large federal infrastructure plan is nearing fruition which would help build revenue-generating projects across the country, as well as subsidize borrowing costs for states.

New Jersey and Illinois have been the largest beneficiaries in the market. We have long held positions in New Jersey and are pleased the state has accelerated its plan to make full pension contributions. Illinois, on the other hand, is still running a structural deficit, excluding Federal stimulus payments. Despite receiving $8 billion in aid from ARPA, or about 20% of Illinois’ pre-pandemic budget, the State still has its hand out, asking for more money. Spreads on both credits compressed significantly as market participants treated them similarly. We must confess to sticker shock when seeing intermediate-maturity Illinois spreads in the 50-60 basis point range, a far cry from their pandemic peak of 450 basis points.

Local government performance has also been strong. Property tax receipts, which comprise about 80% of local government revenues, excluding Federal and State transfers, were up 4% in 2020. The stability provided by property taxes has allowed most local governments to maintain or even increase spending levels in their current budgets. The residential real-estate market has also been red hot, with median home prices appreciating by double digits in many areas, further supporting future revenue growth. Investors have viewed the strong backdrop here as a veritable green light for risk-taking and their resulting shopping spree has pushed spreads to record low levels. For example, 5- to 10-year maturity debt of the Chicago Board of Education, a junk-rated Ba3 / BB credit, ended the quarter with spreads in the 50-basis point range, much tighter than the 160-basis point spread that prevailed before COVID.

There has also been a dramatic recovery in the most heavily impacted revenue bond sectors, airports and mass transit. Last year, air travel virtually stopped during the spring and early summer, but as shown in the exhibit below, the vaccine roll-out has brought travelers back in droves. Although air travel volumes have not yet fully recovered, the trend is clear. Despite improvements to the sector’s outlook, we remain cautious given current spread levels. Ten-year maturity high-quality airport spreads have declined to roughly 40 basis points, well below their pre-pandemic average. And remember, most of these bonds are subject to the alternative minimum tax, which typically accounts for about half of that spread (See Exhibit II).


 

Exhibit 2: The second exhibit shows airline travel over three time series: 2019, 2020, 2021. At the beginning of the pandemic, airline travel grounded to a halt and was sluggish to recover. In 2021, airline travel is quickly returning and measured in at 75% of 2019’s level as of June.

 

While the data clearly supports investor optimism, we caution that underlying credit fundamentals have become disconnected from market prices, particularly for lower-rated credits. Strong economic growth and accommodative fiscal policy will help alleviate short-term credit concerns for many weaker credits. However, we remain mindful that once the flood of federal money stops, meaningful reforms will be needed.

Despite the ongoing economic recovery and pick-up in inflation, long-maturity municipal yields declined 20 basis points in the second quarter from 1.8% to 1.6%. In contrast, short-to-intermediates remained fairly stable with the 5-year remaining at 0.5% and the 10-year down 5 basis points to 1.0%. Low-rated debt led the way again with Triple-B rated bonds outperforming Single- and Double-A rated municipals by 80 basis points and 150 basis points, respectively.

The challenge this year has been how to keep up with a rapidly rallying credit market while remaining faithful to our approach. Notwithstanding this backdrop, and despite our portfolios’ high-quality orientation, we are happy to report that our relative performance rebounded during the second quarter, driven predominantly by security selection. Well-performing highlights included New Jersey appropriation, Oregon, California and Philadelphia school districts, Connecticut Special Tax, and Northshore University Health. Our intermediate composite generated a return of 0.9% versus its benchmark of 0.6%. This brings our year-to-date results into positive territory at 0.4%, which is modestly ahead of our benchmark.

With regard to account activity, we spent most of the quarter window shopping, turning down far more potential opportunities than we accepted. As market valuations have become more expensive, we found value in a range of familiar issuers, but in less-traditional bond structures. Our purchases included low-coupon put bonds for McLaren Health Care in Michigan and Medina Valley Independent School District in Texas, delayed-delivery bonds issued by the State of California that are scheduled to settle in September, and short-maturity floaters from the E-470 Highway in Colorado and the MTA in New York. We also added low-coupon debt of the Port Authority of New York and New Jersey and zero-coupon bonds guaranteed by the city of Memphis. These opportunities were all “on sale,” relative to comparable, more traditional, 5% fixed-rate debt by the same issuers.

We recognize the abundance of support for muni credit, but we are also sensitive that broad market valuations already reflect the good news and it gives us little comfort to participate in new issues that wind up being 10-to-15 times oversubscribed. The muni market remains gripped by a dearth of tax-exempt supply. Although total supply is running at an annual pace of just over $400 billion, taxable bonds have comprised roughly one-third of this. Muni supply is likely to remain bottlenecked until tax-exempt advanced refundings are restored. At $300 billion, today’s pace of tax-exempt municipal issuance can barely satisfy reinvestment demand. With close to $100 billion of new capital flowing into municipal funds over the last twelve months, investors have been challenged to stay fully invested and market liquidity has suffered as a result. Thus far in 2021, average daily trading volumes are the lowest in over 15 years.

The Biden Administration has made tax reform a key policy initiative. The American Families Plan along with the American Jobs Plan call for restoring the top individual tax rate to 39.6%, raising the capital gain tax rate for those with incomes over $1 million, increasing the corporate tax, and potentially eliminating the State and Local Tax (SALT) Deduction cap. These policies, if implemented, should continue to support municipal bond demand. Unfortunately, bringing back tax-exempt advanced refundings does not appear to be a current priority. We continue to assess the numerous tax plans working their way through Congress, especially those which will impact the municipal bond market.

Against the backdrop of today’s strong economic performance, last year’s concern that states could see up to $400 billion in revenue losses feels like a distant memory. Our conservative underwriting standards neither relied on, nor anticipated, the $5 trillion in aggregate federal aid, a successful vaccine rollout in under a year, or the fastest economic growth in over thirty years. We consider our country to be fortunate as we have emerged from the pandemic so quickly. The range of potential outcomes last year was wide, with downside risks not seen in generations. Other nations are experiencing much more severe impacts. While others may speculate on positive outcomes, such as from economic rebounds or government bailouts, we focus on owning a portfolio of durable credits that possess resilience to unexpected challenges -- we never want to find ourselves experiencing buyer’s remorse. As many stores struggled to keep paper towels, wipes and hand sanitizer in stock last spring, high-quality municipal bond opportunities were widespread. Now, shoppers can have all the paper products they like, but finding attractive municipal bonds has become mighty tough. There are no free returns in the municipal market, so it is best to avoid impulse purchases and stay selective.

Sincerely,


Gregory S. Steier
Portfolio Manager

Performance As of June 30, 2021
  Total Returns Average Annual Total Returns
(a/o 06/30/2021) 3 Mo.* YTD* 1 Yr. 3 Yr. 5 Yr. 10 Yr. Since
Inception
BBH Municipal Fixed Income Composite (Gross of Fees) 0.99% 0.48% 3.15% 4.74% 3.39% 3.68% 4.12%
BBH Municipal Fixed Income Composite (Net of Fees) 0.93% 0.35% 2.89% 4.48% 3.13% 3.43% 3.87%
Bloomberg Barclays 1-10 Yr. Municipal Bond Index 0.62% 0.36% 2.43% 3.91% 2.48% 2.97% 3.70%

* Returns 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, 2021

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%

State of California

2.5%

New Mexico Mortgage Finance Authority

2.3%

Texas Municipal Gas Acquisition and Supply Corp II

2.3%

Minnesota Housing Finance Agency

2.3%

Connecticut Special Tax Transportation

2.3%

State of Ohio

2.2%

Michigan Qualified School Bond Loan Fund

2.2%

Total

31.4%

RISKS

Investors should be able to withstand short-term fluctuations in the fixed income markets in return for potentially higher returns over the long term. The value of portfolios changes every day and can be affected by changes in interest rates, general market conditions and other political, social and economic developments.

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, a portfolio will also become more sensitive to adverse economic, business or political developments relevant to these projects.

Holdings are subject to change. Totals may not sum due to rounding.

Effective duration is a measure of the portfolio’s return sensitivity to changes in interest rates.

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.

Data presented is that of a single representative account ("Representative Account") that invests in the strategy. It 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.

For purpose of complying with the GIPS® standards, the firm is defined as Brown Brothers Harriman Investment Management ("IM"). IM is a division of Brown Brothers Harriman & Co. ("BBH"). IM claims compliance with the Global Investment Performance Standards (GIPS®). To receive a list of composite descriptions of IM and/or a presentation that complies with the GIPS standards, contact John W. 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. Performance calculated in U.S. dollars.

The Composite 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 Barclays index or equivalent. The Bloomberg Barclays 1-10 Year Municipal Blend Index is a market value-weighted index which covers the short and intermediate components of the Barclays Municipal Bond Index --an unmanaged, market value-weighted index which covers the U.S. investment-grade tax-exempt bond market. The 1-10 Year Municipal Blend index tracks tax-exempt municipal General Obligation, Revenue, Insured, and Prerefunded bonds with a minimum $5 million par amount outstanding, issued as part of a transaction of at least $50 million, and with a remaining maturity from 1 up to (but not including) 12 years. The index includes reinvestment of income. The Bloomberg Barclays 1-10 Year Municipal Bond Index is a rules-based, market-value-weighted index for the long-term tax-exempt bond market.

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. IM-09680-2021-07-14

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