BBH Structured Fixed Income Quarterly Strategy Update – 2Q 2022

Portfolio Managers, Neil Hohmann, Andrew Hofer, and Chris Ling provide an analysis of the investment environment and most recent quarter-end results of the Structured Fixed Income strategy.


Structured Credit: Still Afloat Amidst the Maelstrom

The major concern of fixed income markets in the second quarter was inflation and the Federal Reserve’s (Fed) response. In June, the Con­sumer Price Index (CPI) came in at an alarming 9.1% year-over-year. The Fed hiked 0.5% in May and 0.75% in June (see Exhibit I). Two- and 10-year yields both rose about 60-65 basis points1 in the quarter (see Exhibit II). Short-end yields rose on expectations of Fed rate hikes, while intermediate and long yields rose on expectations around the Fed’s plan to shrink its balance sheet (quantitative tightening).


Exhibit I: Line graph with the yield to maturity of U.S. Treasury securities along the vertical axis and the tenor, or the time to maturity in years, along the horizontal axis. The exhibit shows the yield curves on December 31, 2021, March 31, 2022 and June 30, 2022.


Exhibit II: Changes in U.S. Treasury Yields by Tenor  - Stacked bar chart showing U.S. Treasury yields by tenor. Stacked bars are segmented into Q1 2022 yields and Q2 2022, with each stacked bar representing a tenor. Tenor buckets on the horizontal axis are 1 month to 30 years. Data reported as of March 31, 2022 and June 30, 2022.

The quarter’s rise in Treasury yields compounded what was already the worst fixed income performance in modern history, as U.S. bond yields surged upward from a low starting point. Bond indices for Trea­suries, Corporates, High Yield, Agency MBS, and the Aggregate have all dropped 9% or more on the year – all unprecedented bond market losses (see Exhibit III). The notable exception to the 2022 rout is short duration, higher carry credit sectors - structured credit such as asset-backed securities (ABS) and collateralized loan obligations (CLOs).


Exhibit III:  Table with Q1, Q2 and first half 2022 total returns for various fixed income indices and the BBH Structured Fixed Income Composite. Data reported as of March 31, 2022, and June 30, 2022

For several quarters, we have noted that these securitized sectors offered ideal positioning against a likely normalization of U.S. rates. Amidst all the tumult in markets today, we feel it’s important to underscore the value of owning shorter duration structured credit in fixed income portfolios, namely:

  • Exceptional capital preservation and low return volatility, as amply demonstrated over the last six months. The short rate and spread dura­tions of ABS, CLOs, and single-asset single-borrower commercial mortgage-backed securities (SASB CMBS) limit price downside. High-quality investment grade bond structures and collateral pools minimize downgrade risk.
  • Compelling income and return. Yields of 5%-8% are commonly available today on 2- to 4-year tenor investment grade ABS, CLO, and CMBS opportunities. The hefty compensation, in many cases significantly greater than equivalently-rated Corporates, derives from favorable techni­cals: heavy new issuance supply coupled to constrained demand given the limited set of investors familiar with these deals.
  • Unparalleled entry point. This is arguably the most attractive sustained entry point for performing structured credit in 10 years. The notably flat U.S. yield curve (near 3% from 2-year to 10-year) favors their short tenors, credit spreads hover at the upper quartile of a historical range, issuance is at record levels, and bonds today boast solid credit metrics and are stress-tested against direst economic stress.

As an example of the opportunity today, BBH’s Structured Fixed Income Composite, with two years rate duration, has declined just -4.25% (gross) through June. Despite its first half outperformance, a representative account in the BBH Structured Fixed Income strategy now offers a remarkable 7.2% yield on a high-quality short duration investment-grade portfolio that is diversified evenly across more than 20 asset types.2

Yes, There’s Still a Bond Sector Poised to be Positive in 2022

With higher rates resulting in a stunning loss of value for bond investors this year, just breaking even on nominal returns may seem like a distant pros­pect. For the short Treasury index (down 3% year-to-date with a current yield to maturity of 3%), with rates unchanged it will take until the middle of 2023 to recuperate the declines from the first six months of this year. Outside of money markets, even at today’s higher yields, it could in fact take years before the values of investors’ portfolios return to where they were at year-end, particularly given the lack of roll-down return along a flat yield curve.

There’s an important exception. Certain short duration, higher carry bond sectors such as structured credit can still near or exceed a positive return this year, underlining the importance of these in a robust fixed income portfolio (see Exhibit IV).


Exhibit IVProjected Calendar Quarters to Recuperate 1H 2022 Declines – Bar chart illustrating  projected number of quarters it would take various fixed income indices to recoup their respective year-to-date total return losses. Chart also includes a hypothetical BBH Structured Portfolio. Data reported as of June 30, 2022

Now is a Perfect Time to Hop into Structured Credit

Structured credit valuations have become increasingly attractive. Credit spreads have widened and, combined with higher Treasury yields, offer a yield to worst of 7.2% in BBH’s Structured Fixed Income strategy with a defensive 2.4-year duration (see Exhibit V).


Exhibit V: Fixed Income Sectors: Current Attributes and Return Impact of Normalization of Rates and Spreads – Table of various fixed income indices and a hypothetical BBH Structured Portfolio showing the characteristics, year-to-date 2022 returns and projected returns for full year 2022. Characteristics include duration, spread duration, option adjusted spread and yield to worst. Data reported as of June 30, 2022.

This is arguably the best non-distressed entry point for fixed-rate structured credit in 15 years, given the inversion of the yield curve and credit spreads toward the top of their historical range. While the yield is attractive on its own merits, we believe investors also realize further benefit from favor­able roll-down benefits than that offered from longer maturities. The yields of structured credit indexes – including CLOs, non-traditional ABS,3 and non-agency CMBS – are also distinctly attractive versus the traditional set of investment-grade sector indexes (see Exhibit VI), yet an active approach is required to extract the full benefits and yield opportunities from within those sectors.


Exhibit VI: Yield to Worst and Duration by Sector – Scatterplot showing the yields to worst of fixed income various indexes and the BBH Structured Fixed Income strategy versus their respective rate durations. The individual points are color-coded to differentiate traditional indexes, non-traditional structured credit indexes, and the BBH Structured Fixed Income strategy. Data reported as of June 30, 2022; data presented is that of a single Representative Account

In addition to compelling valuations, structured credit fundamentals are strong and should offer exceptional durability against an uncertain environment. Credit enhancements remain robust and exceed even the most draconian loss experiences (see Exhibit VII). These enhancements provide investors cushions that remain intact, and the risk that credits may breach these cushions remains remote.

If we look at where the first signs of potential stress might emerge, we see underlying strength today. Loan delinquency rates for consumer, auto, busi­ness, and commercial real estate loans remain subdued. We believe this supports the notion that structured credit fundamentals are sturdy.


Exhibit VII: Total Credit Enhancement of ABS by Subsector – Bar chart of various structured subsectors and their respective total credit enhancement levels. Data reported as of June 30, 2022.

Structured Credit Issuance Provides an Abundance of Opportunities

ABS issuance during the quarter topped $73 billion and was record-setting. Despite the challenging market environment and persistent out­flows from fixed income that have characterized 2022 thus far, attrac­tive structured credit opportunities are amply available. Heavy issuance has been dominated by the higher-yielding non-traditional deals, where we observe spreads on A/BBB rated securities anywhere from 200-500 basis points over Treasuries. There was over $30 billion of CMBS issu­ance during the quarter, of which $23 billion were SASB securitizations or commercial real estate (CRE) CLOs. Spreads on high-quality securities were 200-400 basis points over SOFR.4 CLO new issuance topped $40 billion with attractive opportunities across the capital stack.

Our Activity

As valuations improved with spreads and issuance remained accommo­dative, we initiated positions in numerous durable credits5 for clients in our structured fixed income strategies.

We purchased a variety of ABS across 10 different asset types during the quarter. Westlake is a leading subprime auto loan lender with a network of 14,000+ car dealerships across all 50 U.S. states. Westlake’s ABS collateral is distinguished by lower loan-to-value (LTV) ratios and a consistent mix among origination channels. We participated in A-rated notes with strong structural protections at a spread of 210 basis points to Treasuries.

Global Jet Capital brought an aircraft equipment securitization to market. The company is led by seasoned veterans that keeps skin in the game by retaining all equity of their securitizations, and touts securitizations with strong structural protections, operating performance, and low annual net losses. We participated in A-rated notes at a spread of 235 basis points to Treasuries and BBB-rated notes at a spread of 325 basis points to Treasuries.

We participated in an ABS deal sponsored by Freedom Financial, a leading personal consumer loan company with a 20-year operating history. Free­dom Financial’s ABS deals have demonstrated strong credit performance with ample credit enhancements and structural protections. We participated in AA-rated notes at a spread of 285 basis points to Treasuries and A-rated notes at a spread of 400 basis points to Treasuries. We also purchased securities of a personal consumer loan ABS brought by Lendmark, an established lender offering a variety of loans to non-prime credit borrowers. Lendmark’s historical net portfolio losses have been well managed due to the company’s sound underwriting standards, collections, and servicing plat­forms. The deal has strong structural protections to augment its solid credit performance history, and we participated in notes rated AA+ at a spread of 250 basis points to Treasuries and A-rated notes at a spread of 350 basis points to Treasuries.

In the CMBS sector, we participated in two deals with strong credit protection and durable collateral. We invested in the floating-rate, A-rated notes at a spread of 275 basis points to SOFR secured by a 2.7 million square foot super regional mall and two adjacent office buildings in Honolulu, HI that was 91% occupied by over 350 tenants. We also initiated a position in a floating-rate note rated A- at a spread of 400 basis points to SOFR secured by a 1.4 million square foot super regional mall in Sweetwater, FL that was 98% occupied with resilient sales performance through the COVID-19 pandemic.

We also initiated positions in several CLOs at attractive valuations. Bain Capital Credit brought a CLO refinancing that is collateralized by a portfolio of senior secured term loans, managed by a high-quality management team, highly diversified across industries, with a protective CLO structure. We participated in the floating-rate, A-rated notes at a spread of 350 basis points to SOFR. We also purchased a middle market CLO managed by Midcap Financial Services Capital Management. The notes feature very high level of credit enhancements that allow the notes to withstand multiples of our base case cumulative default rate curve without impairment of principal or interest. We participated in the single-A rated floating-rate notes at a spread of 340 basis points to SOFR.

Conclusion

Higher interest rate levels, higher spreads, and short duration profiles all combine to offer attractive return prospects for structured credit fixed income. It is a fertile opportunity set, but we caution that an active approach is needed to extract the full benefits and yield opportunities. We believe our investment approach, combined with our established presence and issuer relationships, allow us to optimize client portfolios and navigate through any periods of uncertainty. We look forward to uncovering future opportunities for your portfolio and discussing the continuing evolution of the economic environment.

 
Performance
As of June 30, 2022
  Total Returns Average Annual Total Returns
Composite/Benchmark 3 Mo.*
YTD* 1 Yr. 3 Yr. 5 Yr.
Since Inception
BBH Structured Fixed Income Composite (Gross of Fees) -2.61% -4.25% -2.97% 1.87%
3.28%
3.73%
BBH Structured Fixed Income Composite (Net of Fees)
-2.70% -4.42% -3.31 1.52% 2.92% 3.37%
Bloomberg US ABS Index -0.91% -3.77% -4.27% 0.51% 1.38% 1.55%
*Returns are not annualized. BBH Structured Fixed Income Composite inception date is 01/01/2016.
Sources: BBH & Co. and Bloomberg
Past performance does not guarantee future results.
Bloomberg ABS Index is the ABS component of the Bloomberg US Aggregate index and is comprised of credit and charge card receivables, autos loan receivables, and utility receivables with at least an average life of one year, $500 million deal size and $25 million tranche size and an investment grade rating (Baa3/BBB- or higher) by at least two NRSROs. The index is not available for direct investment.

1 A unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.
2 The Representative Account is managed with the same investment objectives and employs substantially the same investment philosophy and processes as the Structured Fixed Income Strategy
3 Traditional ABS include prime auto backed loans, credit cards and student loans (FFELP). Non-traditional ABS include ABS backed by other collateral types.
4 SOFR = Secured Overnight Financing Rate, which is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.
5 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. Durable means the ability to withstand a wide variety of economic conditions.

Risks

Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Mortgage-backed and asset-backed securities have prepayment and extension risks.

Single-Asset, Single-Borrower (SASB) lacks the diversification of a transaction backed by multiple loans since performance is concentrated in one commercial property. SASBs may be less liquid in the secondary market than loans backed by multiple commercial properties.

Asset-Backed Securities (“ABS”) are subject to risks due to defaults by the borrowers; failure of the issuer or servicer to perform; the variability in cash flows due to amortization or acceleration features; changes in interest rates which may influence the prepayments of the underlying securities; misrepresentation of asset quality, value or inadequate controls over disbursements and receipts; and the ABS being structured in ways that give certain investors less credit risk protection than others.

Below investment grade bonds, commonly known as junk bonds, are subject to a high level of credit and market risks.

Foreign investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards.

The Structured Fixed Income Strategy Representative Account is managed with the same investment objectives and employs substantially the same investment philosophy and processes as the strategy.

The securities discussed do not represent all of the securities purchased, sold or recommended for advisory clients and you should not assume that investments in the securities were or will be profitable.

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.

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 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. The Not Rated category applies to Non-Government related securities that could be rated but have no rating from Standard and Poor’s or Moody’s. Not Rated securities may have ratings from other nationally recognized statistical recognized statistical rating organizations.

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.

The objective of our Structured Fixed Income Strategy is to deliver excellent returns in excess of industry benchmarks through market cycles. The Composite includes all fully discretionary fee-paying accounts with an initial investment equal to or greater than $10 million that are managed to the Structured Fixed Income strategy. The target duration may range from 2 to 6 years. Investments are focused on asset-backed and related structured fixed income securities. Holdings are primarily investment grade but non-investment grade securities may be held. Investments may include non-dollar fixed income.

Standard deviation measures the historical volatility of a returns. The higher the standard deviation, the greater the volatility. The Sharpe ratio is the average return earned in excess of the risk-free rate (the Fed Funds rate).

Definitions

Bloomberg US Investment Grade Corporate Bond Index (BBG IG Corp) represents the corporate bonds in the Bloomberg US Aggregate Bond Index, and are USD denomi­nated, investment-grade (rated Baa3 or above by Moody’s), fixed-rate, corporate bonds with maturities of 1 year or more.

Bloomberg US Corporate High Yield Index (BBG HY Corp) is an unmanaged index that is comprised of issues that meet the following criteria: at least $150 million par value outstanding, maximum credit rating of Ba1 (including defaulted issues) and at least one year to maturity.

The Bloomberg US Aggregate Bond Index represents USD-denominated, investment-grade (rated Baa3 or above by Moody’s), fixed-rate, and taxable areas of the bond market. This is the broadest measure of the taxable U.S. bond market, including most Treasury, agency, corporate, mortgage-backed, asset-backed, and international dollar-denominated issues, all with maturities of 1 year or more.

Bloomberg ABS Index (BBG ABS) is the ABS component of the Bloomberg US Aggregate Index. The ABS Index has three subsectors: credit and charge cards, autos and utility. The index includes pass-through, bullet, and controlled amortization structures. The ABS Index includes only the senior class of each ABS issue and the ERISA-eligible B and C tranche.

Bloomberg Non-AAA ABS Index (BBG Non-AAA ABS) is the non-AAA ABS component of the Bloomberg U.S. Aggregate Bond Index, a market value-weighted index that tracks the daily price, coupon, pay-downs, and total return performance of fixed-rate, publicly placed, dollar-denominated, and non-convertible investment grade debt issues with at least $300 million par amount outstanding and with at least one year to final maturity.

Bloomberg Agency Mortgage-Backed Securities (BBG MBS) Index is the Agency Mortgage-Backed Securities component of the Bloomberg US Aggregate Bond Index, a market value-weighted index that tracks the daily price, coupon, pay-downs, and total return performance of fixed-rate, publicly placed, dollar-denominated, and nonconvertible investment grade debt issues with at least $300 million par amount outstanding and with at least one year to final maturity.

Bloomberg CMBS Index (BBG CMBS) is the CMBS component of the Bloomberg US Aggregate Bond Index, a market value-weighted index that tracks the daily price, coupon, pay-downs, and total return performance of fixed-rate, publicly placed, dollar-denominated, and non-convertible investment grade debt issues with at least $300 million par amount outstanding and with at least one year to final maturity.

Bloomberg Non-Agency CMBS Index is the Non-Agency CMBS components of the Bloomberg Barclays US Aggregate Bond Index, a market value-weighted index that tracks the daily price, coupon, pay-downs, and total return performance of fixed-rate, publicly placed, dollar-denominated, and non-convertible investment grade debt issues with at least $300 million par amount outstanding and with at least one year to final maturity.

JP Morgan Other ABS Index (JPM Other ABS) represents ABS backed by consumer loans, timeshare, containers, franchise, settlement, stranded assets, tax liens, insurance premium, railcar leases, servicing advances and miscellaneous esoteric assets (that also meet all the Index eligibility criteria) of the The JP Morgan ABS Index. The JP Morgan ABS Index is a benchmark that represents the market of US dollar denominated, tradable ABS instruments. The ABS Index contains 20 different sub-indices separated by industry sector and fixed and floating bond type. The aggregate index represents over 2000 instruments at a total market value close to $500 trillion dollars; an estimated 70% of the entire $680 billion outstanding in the US ABS market.

JP Morgan CLO Index (JPM CLO) is a market value weighted benchmark tracking US dollar denominated broadly-syndicated, arbitrage CLOs. The index is comprised solely of cash, arbitrage CLOs backed by broadly syndicated leveraged loans. All CLOs included in the index must have a closing date that is on or after January 1, 2004. There are no weighted average life (WAL) limitations. There are no minimum tranche size restrictions and includes only tranches originally rated from AAA/Aaa through BB-/Ba3.

S&P/LSTA Leveraged Loan Index is a market value-weighted index designed to measure the performance of the U.S. leveraged loan market based upon market weight­ings, spreads and interest payments. Facilities are eligible for inclusion in the indexes if they are senior secured institutional term loans with a minimum initial spread of 125 and term of one year. They are retired from the indexes when there is no bid posted on the facility for at least 12 successive weeks or when the loan is repaid.

“Bloomberg®” and the Bloomberg indexes 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 Structured Fixed Income Strategy. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to the strategy.

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-11472-2022-08-03       Exp. Date 10/31/2022

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