BBH Municipal Fixed Income Quarterly Strategy Update – 3Q 2021

September 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.

A Bridge Over Troubled Waters

For decades, investors have flocked to the municipal bond market for a consistent source of tax-free income and portfolio stability. It has not always been smooth sailing, especially last year. Pandemic-related economic and market disruptions required a coordinated policy response that was both swift and of an unprecedented magnitude. Along with the record-fast development of effective COVID vaccines, these rescue measures established the foundation for a robust economic recovery and served as a bridge for countless creditors, preventing widespread defaults. Although the crisis period has passed, we are still living and investing with the policy consequences. The waves of stimulus money have compressed yields, alleviated short-term credit concerns, and driven strong demand for lower-quality bonds.

A year-and-a-half into the pandemic, municipal fundamentals remain on an uptrend. Both Moody’s and S&P report that upgrades have now outpaced downgrades through the first half of the year. State rainy day funds are rebounding, while demand-driven sectors such as toll roads and airports continue to see volume increases. The bull run in the equity market has bolstered not-for-profit endowments as well as reduced net pension liabilities for states. The vast majority of muni credits generate enough revenues to balance their budgets without extraordinary aid, but many lower-rated entities have become reliant on external financial support to maintain their basic operations. This is especially true for sectors that were the hardest hit by the pandemic, such as long-term care facilities and mass transit. Meanwhile Illinois, which despite receiving over $10B in direct aid, still has over $5B in unpaid bills in addition to its debt service requirements. Although the bonds of many of these credits are currently trading at historically narrow levels, they still require significant reform and are riskier than today’s market pricing indicates.

With tax-exempt yields moderately higher for the year, the returns of credit-sensitive bonds have kept broader municipal indices in positive territory. Year-to-date, intermediate-maturity municipal returns are up 0.4% to 0.5%, while the full-maturity index has generated 80 basis points of total return. Together, Double- and Triple-A bond returns have declined 10 basis points year-to-date, while Single-A-rated securities have risen 1.5% and Triple-B’s have climbed 4%. For the past twelve months, Triple-B rated municipals have now outperformed their Triple-A-rated counterparts by nearly 7%. This historic rally in low-quality credit has presented a performance headwind for us for much of the year. In the most recent quarter, our higher quality orientation subtracted roughly 5 basis points.

We have remained patient, as we expect the bond market to join with the economy on its return to normalcy. Thus far, we have been underwhelmed. At 1.1%, the 10-year ended the quarter up 10 basis points and it is now 45 basis points higher for the year, but it still remains 40 basis points below its pre-pandemic level. Shorter maturities performed better, increasing less than 5 basis points. Currently, short-maturity yields stand 60 to 90 basis points below their pre-COVID levels. Anchored by the Fed, short maturity bonds remain the most expensive along the yield curve and we continue to bridge over them with a combination of floating-rate notes and intermediate-maturity zero-coupon bonds. For the quarter, this position detracted about 5 basis points of performance, but we remain committed to it. Overall, our composite trailed its benchmark by approximately 10 basis points for the quarter, leaving year-to-date results slightly behind indices.

Bond markets remain flooded with liquidity as the Fed continues to grow its balance sheet at an annual rate of nearly $1.4 trillion. The Fed now owns an astonishing $8 trillion of assets, representing nearly 25% of all outstanding coupon-bearing Treasuries and U.S. Agency Mortgage-Backed securities (see Exhibit I). In addition, the Fed is now absorbing over $1 trillion per day with its overnight repo facility. Investors and banks are willingly accepting 5 bps from the Fed for the convenience of parking overnight funds. In other words, they do not see better alternatives, highlighting the current struggle to generate safe income.


Exhibit 1: The first exhibit shows the Federal Reserve’s asset purchases since 2000. The Fed’s assets spiked dramatically during the Global Financial Crisis and then again at the onset of the pandemic.

 

The magnitude of the Fed’s intervention has helped suppress U.S. government bond rates and markets linked to it, such as corporates and municipals. To earn a respectable return, many investors have reached for longer maturities and weaker credits. The resulting compression of credit spreads and their associated returns has soothed the pain of low interest rates for now. We expect the combination of low rates and narrow credit spreads to result in choppy waters ahead. The coordinated fiscal and monetary stimulus will eventually subside and end.

During periods of expensive valuations, it is risky to look like the generic market and dangerous to follow the proverbial herd. Here are a few simple rules we follow:

      #1        Maintain our credit standards – free money will not last forever

      #2        Maintain our valuation discipline – do not chase after expensive credit

      #3        Subject to 1, and 2, think creatively

Today’s market conditions remind us of the years following the Global Financial Crisis (GFC). Back then, valuations were also expensive, and the market was replete with credit concerns. At the time, we identified a wide range of opportunities in broken auction rate securities. We focused on high-quality credits, that paid interest at a multiple of a short-term index, and that were available at prices below par. At the time, none of us knew when the Fed would raise interest rates. We did know that once the tightening cycle commenced, the coupons on our bonds would rise faster than policy rates, that their cash flows would be more valuable (unlike traditional bonds), and that their prices should rise. In addition, the probability that issuers would redeem the securities at par increased. We could not predict the timing, but as the Fed raised rates, beginning in 2015, these securities behaved as we expected, and they served as an effective bridge to more normal interest rates.

Recently, we have identified opportunities in delayed-delivery bonds: please see our commentary, “Good Things Come to Those Who Wait”. Delayed-delivery bonds may not offer the exceptional opportunities that ARS once did, but they still offer compelling value. The opportunities that we have found most appealing are from Double-A and Triple-A rated issuers, with 1.5% to 2% price discounts relative to their fair values. The price discounts effectively represent an incentive from the issuer to compensate investors for bearing interest rate and credit risk until the settlement date without any income. As the settlement date approaches, the pricing discount disappears, accruing to the bonds returns. When they settle, we are left with liquid, high-grade credits that can be easily sold to fund more attractive long-term opportunities. Importantly, the position serves as a bridge to the future, and eventually better valuations. During the third quarter we added three delayed-delivery bonds to our portfolios, the City and County of Honolulu, The State of Maryland, and the Maryland Department of Transportation. We also found several other attractive opportunities during the quarter including zero-coupon bonds issued by Duluth school district, backed by the State of Minnesota, and floating rate notes issued by Texas Municipal Gas, supported by JP Morgan.

Congress is currently debating a multi-trillion-dollar infrastructure plan, known as the Build Back Better Act (BBB), which contains provisions that could profoundly impact the muni market. While there have been numerous ideas floated, there are three major tax proposals worth watching. The first is the increase in the top tax rate to 39.6% from the current 37%. Because almost half the municipal market is owned by households, a change in the top rate will undoubtedly increase demand from that cohort. Similarly, the proposed 3% surtax on high income individuals would have the same effect on demand. The third is an increase in the corporate tax rate to 26.5% from 21%. Banks and insurance companies hold about one quarter of municipal debt. After the Tax Cuts & Jobs Act of 2017 (TCJA), we witnessed banks shed municipal exposure at a rapid pace. That trend has reversed since the 2020 election. Banks have already increased their municipal holdings by 6% through the first half of the year, and we expect this trend to continue going forward (see Exhibit II).


Exhibit 2: The second exhibit shows bank purchases of municipal bonds from 2007 to 2021. Banks were consistently buyers on municipal bonds up until the Tax Cuts & Jobs Act. After the TCJA was passed, banks started to sell their municipal holdings. That trend has reversed as we edge closer to new tax legislation.


Exhibit 3: The third exhibit shows the muni centric BBB proposals by their effect on supply and demand. Tax increases are expected to spur tax-exempt municipal bond demand, while the supply picture is less clear.

 

On the supply side, the BBB legislation calls for trillions in infrastructure spending (see Exhibit III). While both the top-line and mechanics of this plan are still being debated, there have been several calls for the reinstatement of federally-subsidized municipal debt. The last major program of this kind was Build America Bonds (BABs), which were issued in 2009-2010 to jumpstart infrastructure investments following the GFC. BABs are taxable with federal interest subsidies that reduce the borrowing cost to the issuer. Should this type of bond return, the supply of traditional tax-exempt debt will likely remain under pressure. However, another proposal that will have more of a positive impact on supply would be the return of advanced refundings. The 2017 TCJA prohibited tax-exempt advanced refundings, which once represented 25% of the of tax-exempt supply. Finally, a third proposal calls for the expansion of private activity bonds (PABs) to cover more infrastructure, like broadband. Together, PABs and tax-exempt advanced refundings would provide much needed relief to an ever-hungrier market.

Performance As of September 30, 2021
  Total Returns Average Annual Total Returns
(a/o 09/30/2021) 3 Mo.* YTD* 1 Yr. 3 Yr. 5 Yr. 10 Yr. Since
Inception
BBH Municipal Fixed Income Composite (Gross of Fees) -0.17% 0.31% 1.42% 4.64% 3.29% 3.39% 4.06%
BBH Municipal Fixed Income Composite (Net of Fees) -0.23% 0.12% 1.17% 4.38% 3.03% 3.13% 3.80%
Bloomberg 1-10 Yr. Municipal Bond Index -0.01% 0.35% 1.33% 3.93% 2.50% 2.72% 3.65%

* 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 September 30, 2021

California School District General Obligations

8.6%

State of Maryland

3.7%

Texas Department of Housing and Community Affairs

3.1%

Philadelphia School District, PA

2.5%

State of Ohio

2.3%

Connecticut Special Tax Transportation

2.3%

Michigan Qualified School Bond Loan Fund

2.3%

New Mexico Mortgage Finance AuthorityState of Ohio

2.2%

Salem-Keizer School District #24J, OR

2.2%

Texas Municipal Gas Acquisition and Supply Corp II

2.1%

Total

31.2%

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 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. As of 10/1/2020, the Intermediate Municipal Composite was renamed BBH Municipal Fixed Income.

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 Intermediate Municipal Bond Fund. 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. 2021. All rights reserved.

                            NOT FDIC INSURED          NO BANK GUARANTEE         MAY LOSE MONEY


IM-10136-2021-10-10          Exp. Date 01/31/2022

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