Exhibit I: Fixed income index returns for various indexes as of March 31, 2024, displaying duration, total return, and excess return.
1Q Highlights
|
| Performance As of March 31, 2024 |
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|---|---|---|---|---|---|---|
|
Total Return |
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) |
2.42% |
2.42% |
10.18% |
3.34% |
3.86% |
4.34% |
BBH Structured Fixed Income Composite (Net of Fees) |
2.33% |
2.33% |
9.80% |
2.98% |
3.50% |
3.98% |
BBH Structured Fixed Income Benchmark |
0.79% |
0.79% |
4.53% |
0.37% |
1.68% |
1.85% |
| Past performance does not guarantee future results Returns of less than one year are not annualized BBH Structured Fixed Income Composite inception date is 01/01/2016 BBH Structured Fixed Income Benchmark is a combination of two indices. The Bloomberg US ABS Index was used prior to 11/1/2023; the Bloomberg U.S. ABS ex. Stranded Cost Utility Index is used subsequently. Due to recent changes in the composition of the Bloomberg US ABS Index, the new Bloomberg U.S. ABS ex. Stranded Cost Utility Index more closely reflects the effective duration of the strategy. One cannot invest directly in an index. Sources: Bloomberg and BBH & Co. |
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Market Environment
Treasury rates continued to be volatile as strong economic data and stubbornly high inflation data drove market sentiment back towards a “higher for longer in 2024” disposition, although the yield curve still had three 25 basis point1 Federal Reserve (Fed) interest rate cuts priced in by the end of this year. Shorter-duration fixed income indexes generated positive returns during the first quarter while longer-duration indexes experienced negative total returns. Excess returns to credit were positive across sectors, with agency mortgage-backed securities (MBS) being the notable exception that underperformed comparable duration Treasuries as the Fed continued shrinking its balance sheet.
Economic data has remained strong as inflationary pressures persist and there are few signs of recession on the horizon. Headline consumer inflation prints have been stronger than anticipated, and wage growth remains higher than historic averages. The Chicago Fed National Activity Index remains above its recession indicator threshold. Default rates of below investment-grade companies also remain subdued despite higher interest rates. The U.S. consumer appears to be on solid footing, with loan delinquency rates generally rising off very low bases and not indicating widespread issues. Although auto loan delinquency rates have risen to their highest levels since 2009, and defaults for subprime auto loans have increased above their pre-COVID-19 levels, these data points are within expected ranges for losses in asset-backed securities (ABS) and do not currently pose risk of impairment to bondholders. Delinquency rates on business loans held at U.S. commercial banks remain near cyclical lows. Commercial real estate loan delinquency rates at U.S. banks continue to creep higher, which parallels the rising delinquency rates being experienced in commercial mortgage-backed securities (CMBS) related to office properties.
Valuations
Credit spreads narrowed across sectors and qualities despite the deluge of issuance during the quarter. This highlights both the intense demand for credit and the increasing complacency of investors evaluating new issues. As a result of the tighter credit spread environment, we are finding fewer opportunities in traditional segments of the credit markets. No cohort of 30-year or 15-year agency MBS met our Valuation Framework,2 criteria for new purchases at quarter-end, and traditional segments of the ABS market, such as prime auto and bank credit card securitizations, continue to offer limited appeal to us.
Several segments of the ABS market continue to screen attractively despite the recent narrowing of credit spreads, with spreads in some select sectors remaining disconnected from their underlying credit risk. Opportunities are also arising in the CMBS market as investors differentiate between office properties and other property types with solid credit dynamics. We continue to find collateralized loan obligation (CLO) issuances with attractive valuations and strong structural protections. Debt issued by business development companies (BDCs) continues to offer attractive prospects. We continue to avoid non-agency residential mortgage-backed securities (RMBS) due to poor technical factors, and weak fundamentals, underpinned by poor housing affordability, low inventory of homes for sale, and stable-to-declining home prices.
Exhibit II: Market outlook by sector as of March 31, 2024, broken-down by reserves, structured credit, corporate credit, and other credit categories.
Performance
Sector allocation drove results during the quarter, as structured credit sectors performed strongly. CMBS contributed strongly and overwhelmed selection effects. Positioning in ABS, corporate credit, and CLOs impacted results favorably as well.
Selection detracted from relative results, although results were mixed among individual sectors. Holdings of agency CMBS and Single-Asset Single-Borrower (SASB) CMBS hindered results despite the portfolio’s lack of exposure to office properties. On a positive note, positions in bonds of aircraft equipment ABS, BDCs, CLOs, data center ABS, and recurring revenue ABS contributed to results.
The portfolio’s duration profile had a small but positive impact on relative returns during the quarter.
Exhibit III: Attribution as of March 31, 2024, showing average portfolio weight and gross contribution displayed in basis points.
Transaction Summary
We continued to find durable credits3 offering attractive value despite dwindling attractiveness of valuations of credits in Indexes. The purchases were made across a variety of sectors and industries. Descriptions of a few notable portfolio additions are included below.
FREMF 2024-K516 is a 2024 new-issue five-year fixed rate Freddie Mac agency CMBS transaction, secured by a pool of 24 first mortgage loans. The properties represented are 97% multifamily and 3% manufactured housing community assets, and the occupancy rate was 94.0%. BBH was active in credit due diligence of the deal, including reviews of third-party appraisal, environmental, and engineering reports, Freddie Mac underwriting loan tapes, rating agency presale reports, on-site visits to all collateral properties, and underwriting the individual loans in the pool. We purchased a position in the junior, non-guaranteed class C notes at a forecasted spread of 475 basis points over Treasuries for an estimated yield of 9.3%.
GCBSL 2024-72A is a CLO brought by Golub Capital Partners, one of the leading private credit and direct lending asset managers. The bonds have low leverage and very high levels of credit enhancement, and we purchased the AA rated bonds at a spread of 210 basis points over Secured Overnight Financing Rate (SOFR)4 for a spread of 7.4%.
OXFINF 2024-A is a venture debt securitization brought by Oxford Venture Finance, a specialty finance company focusing on lending to early and middle stage life sciences companies. The company has had less than 1% of cumulative net charge-offs since 2002. The bonds boast considerable credit support rising from overcollateralization. We purchased the BBB rated bonds at a spread of 355 basis points over Treasuries for a yield of 7.7%.
LFT 2024-1A is a personal consumer loan ABS deal brought by Lendmark, a community-focused financial services business that offers hard-secured, soft-secured and unsecured personal consumer loans to below prime credit borrowers. The company has built sound underwriting standards, collections and servicing platforms to originate and service personal consumer loans, and historical net portfolio losses have been well managed. We purchased the 3-year weighted average life AAA rated bonds at a spread of 145 basis points over Treasuries for a yield of 5.6%.
We purchased bonds of a SASB CMBS issuance, DK 2024-SPBX. The loan is secured by a diversified portfolio of 108 self-storage facilities spread across nine states, and the deal had strong structural protections and robust debt service coverage ratios under a variety of scenarios. We purchased the 2-year weighted average life, floating-rate, AAA rated bonds at a spread of 150 basis points over SOFR for a yield of 6.8%.
We also participated in a personal consumer loan securitization, PPWR 2024-A, brought by Purchasing Power, a specialty online retailer that sells products and services directly to employees of its clients through an employee benefit model which are paid via automatic payroll deductions or allocations. Past ABS issuances brought by Purchasing Power had low and predictable loss levels, the deal had strong structural protections to protect bondholders, and we purchased the AAA rated bonds at a spread of 140 basis points over Treasuries for a yield of 6.0%.
BHG 2024-1CON is a small business loan ABS deal brought by Bankers Healthcare Group, a specialty finance company providing commercial and consumer financing to high income, skilled professionals in proven healthcare practices. The deal features robust credit enhancements through overcollateralization and excess spread, and we purchased the AAA rated bonds at a spread of 130 basis points over Treasuries for a yield of 5.9%.
We found appeal in several issuances from BDCs that possessed strong management, exceptional credit performance history, and the conservative leverage profile common among BDCs, including Owl Rock’s Blue Rock Technology Finance Corp II (5-year, BBB rated bonds at a spread of 283 basis points over Treasuries for a yield of 7.0%), venture debt lender Trinity Capital (5-year, BBB- rated preferreds at a spread of 365 basis points over Treasuries for a yield of 7.9%), and Main Street Capital (5-year, BBB- rated bonds at a spread of 300 basis points over Treasuries for a yield of 7.0%).
Exhibit IV: Characteristics as of March 31, 2024, including credit rating and sector allocation for both the portfolio and benchmark.
Characteristics
At the end of the quarter, the portfolio’s duration was 1.9 years and continued to approximate that of its benchmark. The portfolio had 87.8% of its investments in investment-grade credits, while high yield and unrated investments represented 12.2%. The portfolio’s yield to maturity was 8.2% and remained elevated versus bond market alternatives. The portfolio’s option-adjusted spread was 334 basis points over Treasuries; for reference, the Bloomberg U.S. Corporate Index’s option-adjusted spread was 90 basis points over Treasuries at quarter-end and the option-adjusted spread of the Bloomberg ABS Index, a proxy for traditional ABS, was 55 basis points over Treasuries.
1Basis points (bps) is a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.
2Our valuation framework is a purely quantitative screen for bonds that may offer excess return potential, primarily from mean reversion in spreads. When the potential excess return is above a specific hurdle rate, we label them “Buys” (others are “Holds” or “Sells”). These ratings are category names, not recommendations, as the valuation framework includes no credit research, a vital second step.
3Obligations 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.
4SOFR = Secured Overnight Financing Rate, which is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.
Definitions
Bloomberg US ABS Index is the asset backed securities component of the Bloomberg US Aggregate Bond Index. 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. The Bloomberg U.S. ABS ex. Stranded Cost Utility Index excludes certain stranded cost utility bonds included in the Bloomberg US ABS Index.
An index is not available for direct investment.
“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 indexes (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 Strategy. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to the Strategy.
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.
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 failureor 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 ratingsfrom 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 deductionof 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 is comprised of all fully discretionary, fee-paying structured fixed income accounts over $10 million. Investments are focused on asset-backed securities, commercial mortgage-backed securities, collateralized loan obligations, and corporate debt securities that are primarily investment grade. Non-investment grade securities may be held. Investments are focused on U.S. dollar denominated securities, but non-U.S. dollar securities may be held. The accounts are managed to a duration +/- 2 years of the Bloomberg ABS ex-Stranded Cost Utility Index. Effective December 1, 2022, the composite definition was slightly altered to establish a band around the duration of the Bloomberg ABS ex-Stranded Cost Utility Index.
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).
Brown Brothers Harriman & Co. (“BBH”) may be used 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. 2024. All rights reserved.
Not FDIC Insured No Bank Guarantee May Lose Money
IM-14634-2024-05-03 Exp. Date 07/31/2024
