BBH Municipal Fixed Income Quarterly Update Q4 2020

December 31, 2020
Portfolio Manager, Gregory Steier, provides an analysis of the investment environment and most recent quarter-end results of the Municipal Fixed Income strategy.

2020: It Was the End of the World As We Knew It (But Munis Did Fine)

I think we are in good company wishing 2020 good riddance. The “fear-of-not-knowing” has dominated life and financial markets for most of the past year. From the health and economic impact of the novel Coronavirus, to unprecedented market volatility, to months of doubt about a second stimulus package, we have found ourselves looking for answers during much of 2020. A global pandemic that none of us saw coming turned our personal and professional lives upside-down. As most of the country hunkered down for safety and basic necessities were in short supply, it initially felt like the end of the world. Even R.E.M.’s 1987 hit resurfaced toward the top of the music charts.

While the spring’s COVID-19 case counts seem like a mere foothill compared to today’s mountain, many of the uncertainties we faced in March and April have dissipated. Back then, there were many significant unknowns. How contagious was the virus; how did it spread; how deadly was it; what could we do to protect ourselves; were there effective treatments? The unknowns were so significant that we voluntarily shut down wide swaths of our economy out of desperation to contain the virus. Our economy plunged, with gross domestic product (GDP) down over 30% during the second quarter – a magnitude comparable to the Great Depression.

In response, financial markets writhed in volatility even greater than that which we endured during the Global Financial Crisis (GFC). Other than in cash and Treasuries, there was no place to hide since most credit sectors experienced their sharpest downturn on record as investors fled for safety. In the process, Municipal mutual funds suffered record redemptions of over $40 billion during the second half of March. The 10-year municipal-to-Treasury yield ratio spiked at 300%, more than twice its GFC high. Even generic triple-A rated five-year municipal bonds plunged almost 10% in price from March 9th to March 23rd.

The investor fear that overwhelmed markets spurred the Federal Government to enact a record-sized relief package, the $2.2 trillion Coronavirus Aid Relief and Economic Security Act (CARES Act). The Federal Reserve (Fed) also joined the relief efforts by cutting short-term rates to zero, initiating over $3 trillion of asset purchases, and activating a wide range of credit-support programs. These efforts helped quell liquidity fears and, as the U.S. flattened the curve after the first wave of infections, investors became more comfortable. Valuations continued to improve over the summer when positive developments emerged on potential vaccines.

Rising infections and hospitalizations, social unrest, a tumultuous presidential election, and months of uncertainty about a second aid package did not disrupt investor optimism. Neither did the termination of the Fed’s Municipal Liquidity Facility (MLF). After all, only the State of Illinois and New York’s Metropolitan Transportation Authority (MTA) borrowed from it. Investors remain focused on the end of the crisis as multiple vaccines have now successfully crossed the finish line and are in the early stages of distribution.

Consequently, yields and credit spreads have fallen dramatically from the spring. Municipal fund inflows have remained consistently positive over the past few quarters, reversing the weakness earlier in the year. This has left many fund managers scrambling to invest. A relative dearth of tax-exempt new issuance has served to heighten the competition for new supply, acting as a catalyst for the ongoing market rally. Despite broadly expensive valuations, we still added several attractive opportunities during the quarter including Salem Keizer School District zero-coupon bonds, New Jersey American Water bonds, New Jersey General Obligation bonds, a prepaid natural gas floater backed by Bank of America, and a range of state housing finance authority securities.

Now is not the time for complacency, neither about the coronavirus nor the municipal market. We do not find solace in low market volatility and tight credit spreads. In fact, they make us more cautious as valuations provide a slimmer safety margin. Yes, 2020 was full of loss and hardship, but among the pandemic, widespread social unrest, and the contested Presidential election, the year could have easily gone worse. We are cautiously optimistic that the worst is behind us, but we are cognizant that we will face many lasting credit impacts from the crisis. Some of these challenges can be more readily quantified, while others may take years to fully grasp.

The pandemic has left a deep financial scar across the muni sector that will be felt for years to come. Some sectors like transportation will continue to face significant challenges even as the economy improves. Others may recover more quickly, but we should remember that it took roughly five years for most states to recover from the GFC. The revenue shortfalls have also led to a rapid depletion of reserves, erasing a decade of savings in a flash. For those without strong safety cushions, deficit borrowing has provided short-term relief at the cost of long-term leverage. Where borrowing and spending reserves were not enough, many credits were forced to make tough budget cuts, which in many cases will amplify social risk through a reduction in services. Finally, December’s stimulus package failed to provide direct aid to states and cities. With a Democrat-controlled Congress, we expect state and local government assistance is much more likely, but not guaranteed. Combined, these factors leave the muni sector financially vulnerable to further economic headwinds and with fewer tools the address the next downturn.

Looking ahead, the demographic challenges facing municipals are harder to measure. The expansion of remote work, education, and healthcare have caused major shifts in migration and spending patterns. It is unclear how much of this will be a short-term blip as opposed to a long-term change, but the impacts are already being felt. States with high costs of living like California and New York were experiencing outmigration patterns prior to COVID from both residents and corporations, alike. We anticipate this trend will accelerate. For decades, states competed with their neighbors on the basis of their relative costs of living. Should remote work trends continue, high-tax states may be forced to reconsider their tax policies to maintain their competitiveness. This outmigration trend will also likely prolong the economic recovery for many areas, while speeding up the recovery for beneficiaries.


The chart “Population Losers vs. Gainers” is a map of the country that shows each state’s net domestic migration rate for the year 2019. The following states had net domestic migration rates below -5 per 1000: AK, CA, CT, HI, IL, NJ, NY. The following states had a net domestic migration rate above 5 per 1000: AZ, CO, DE, FL, ID, MT, OR, NC, NV, SC, TN.

The pandemic will also lead state governments to reassess their spending priorities. For example, how necessary is additional transportation infrastructure if fewer and fewer people are commuting to work? Do public universities really need to charge a premium for country club-style amenities when most students can learn online? In some locations, taxes and other revenues will also need to be reassessed; how can a city with a tourism-driven economy maintain their social services with double digit declines in sales taxes? Perhaps the largest impact will be felt by a sector we will not own – Continuing Care and Retirement Communities (CCRCs). Ravaged by the virus, many CCRCs will likely struggle to remain solvent. In addition to potential litigation risk, CCRC’s face declining occupancy and weakened financials amid a growing consensus against crowded senior living facilities.

We are not in the business of forecasting these macroeconomic factors and we certainly do not pretend to have all the answers, but we will continue to monitor the long-term effects of the pandemic and assess what it means for our credits.

In a year like 2020, we are fortunate to have found reasons to be grateful. We are pleased at how effectively we transitioned into a remote and physically-distanced operating environment. Zoom meetings and conference calls replaced our usual desk huddles. We effectively shared our internet bandwith with our kids’ remote learning. We took care of our families, young and old… and two of our teammates welcomed new children. Talk about stress! Through it all we tirelessly re-underwrote our credits, looked for new virus-driven weaknesses and sought to identify new opportunities, which were more plentiful in the spring than in the fourth quarter. We find it ironic that we ended 2020 just as we started it – bemoaning expensive market valuations!

There are several other important highlights. First, all of our credits remain in good stead and the sales that we executed throughout the year were on our terms – not forced by broken credit theses caused by the virus. Second, although finding new opportunities has become more difficult lately, over the course of the year, we purchased over $1 billion of attractive municipal opportunities for our clients. These bonds represent a silver lining of the crisis. Third, our portfolio performance was strong. For the quarter, our intermediate composite return was modestly ahead of its benchmark with a return of 1%. This left our composite at just over 5% for the year, as a whole, and ahead of its benchmark by 100 basis points.1

Although none of us anticipated the trying times of 2020, we were still prepared. We prioritize capital preservation and owning durable credits2 for good reasons. It helps keep our portfolios safe and allows us to respond offensively to market volatility. We are all ready for the healing to begin with a successful vaccine rollout and hopefully a decline in hyper-partisan politics. We look forward to an end of social distancing and to safely seeing our families, friends, colleagues, and clients in-person, once again.

Thank you for your continued trust and confidence and we wish you a healthy, happy, and more normal 2021.

Sincerely,

Gregory S. Steier
Portfolio Manager

Gross and Net of fees performance for BBH Municipal Fixed Income Composite as of December 31, 2020.
Performance
As of December 31, 2020
  Total Returns Average Annual Total Returns
  3 Mo.* YTD 1 Yr. 3 Yr. 5 Yr. 10 Yr. Since Inception
BBH Municipal Fixed Income Composite  (Gross of Fees)
1.11% 5.30% 5.30% 4.68% 3.93% 3.99% 4.21%
BBH Municipal Fixed Income Composite (Net of Fees)
1.02% 5.04% 5.04% 4.42% 3.67% 3.73% 3.95%
Bloomberg Barclays 1-10 Yr. Municipal Bond Index
0.98% 4.23% 4.23% 3.82%
2.96% 3.26%
3.78%
* Returns are not annualized.
BBH Municipal Fixed Income inception date is 05/01/2002.
Past performance does not guarantee future results

Sources: BBH & Co. and Bloomberg
Representative Account Top 10 Obligors as of December 31, 2020.
Representative Account
Top 10 Obligors
As of December 31, 2020

California School District General Obligations
7.7%
Philadelphia School District, PA 3.4%
New Jersey, NJ 3.2%
Minnesota Housing Finance Agency, MN 2.8%
Texas Department of Housing and Community Affairs 2.6%
New Mexico Mortgage Finance Authority, NM 2.5%
State of Ohio 2.3%
Connecticut Special Tax Transportation 2.3%
Texas Municipal Gas Acquisition and Supply Corp II 2.3%
Michigan Qualified School Bond Loan Fund 2.2%
Total 31.2%

Sources: Bloomberg and BBH Analysis

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
2 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.

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-08975-2021-01-25   Exp. Date 04/30/2021

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