Exhibit I: Fixed income index returns for various indexes as of September 30, 2023, displaying duration, total return, and excess return.
3Q Highlights
|
| Performance As of September 30, 2023 |
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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) |
2.02% |
6.17% |
6.32% |
2.71% |
3.25% |
3.83% |
BBH Structured Fixed Income Composite (Net of Fees) |
1.93% |
5.89% |
5.95% |
2.35% |
2.89% |
3.47% |
BBH Structured Fixed Income Benchmark |
0.84% |
2.35% |
2.89% |
-0.77% |
1.49% |
1.49% |
| 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
U.S. Treasury rates rose during the third quarter. The U.S. economy appears to be on strong footing, and investors are capitulating to the view that the Federal Reserve (Fed) will need rates to be “higher for longer.” The Fed hiked the target range of the federal funds rate by 0.25% to 5.25%-5.50% at its July meeting. The Fed’s next announcement is scheduled for November 1st. In addition, the Fed continued its campaign of shrinking its portfolio of assets acquired through open market operations by a maximum of $95 billion per month.
On a duration-adjusted basis, nearly every credit index earned positive excess returns during the quarter, though agency mortgage-backed securities (MBS) were a noteworthy underperformer (see Exhibit I). Indexes tied to floating rate investments and with shorter durations experienced positive total returns despite the rise in rates, including benchmarks of collateralized loan obligation (CLO) debt, nontraditional asset-backed securities (ABS), non-agency commercial mortgage-backed securities (CMBS), and traditional ABS.
Year-to-date, all credit indexes had positive excess returns except for agency MBS. Non-agency CMBS slightly outperformed comparable duration Treasuries despite negative headlines regarding commercial real estate (CRE). Indexes of CLO debt and nontraditional ABS posted strong excess returns.
Valuations
We are finding an abundance of attractively valued opportunities as we observe a continuing disconnect between wider credit spread levels and solid credit performance (see Exhibit II). These opportunities are primarily non-traditional ABS issuances, Single Asset, Single Borrower (SASB) CMBS, and CLO debt that come with attractive compensation and have strong durability and structural protections. In the CMBS market, we are seeing attractive deals secured by non-office properties coming with attractive compensation potential. We continue to find value in corporate bonds issued by business development companies (BDCs), as BDC bonds offer healthy spreads over index bonds with similar tenors and credit quality while also having a conservative leverage profile that is constrained by law to no more than a 2:1 debt/equity ratio.
Exhibit II: Market outlook by sector as of September 30, 2023, broken-down by reserves, structured credit, corporate credit, and other credit categories.
Opportunities are emerging in parts of the agency MBS market as valuations improve, and we are prepared to add positions.
We continue to avoid non-agency residential mortgage-backed securities (RMBS) due to ongoing concerns about lower durability, thin credit enhancement, and prepayment risk.
Performance
Favorable selection results impacted the portfolio’s performance. Contributions were diversified among the sectors emphasized in the portfolio (see Exhibit III). Holdings of aircraft equipment ABS, collateralized fund obligations, recurring revenue ABS, and small business loan ABS were among the ABS subsectors that impacted selection results positively during the quarter. In the CMBS sector, the portfolio’s positions in SASB experienced demonstrable outperformance, offset general CMBS sector weakness, and was additive to results. The portfolio’s holdings of corporate bonds issued by business development companies (BDCs) and senior bank loans secured by electric utility assets contributed further to results. Positioning in CLO debt further enhanced relative returns.
Exhibit III: Attribution as of September 30, 2023, showing average portfolio weight and gross contribution displayed in basis points.
Sector allocation hindered results modestly, as CMBS sector exposure more than offset contributions from the portfolio’s investments in corporate credit, ABS, and CLOs. The portfolio’s duration profile detracted from total returns as interest rates rose.
Transaction Summary
We purchased bonds from a variety of issuances during the quarter. Purchases included, but were not limited to, bonds from securitizations of rental fleet loans, auto floorplan loans, triple net lease mortgages, insurance-linked loans, subprime auto loans, small ticket equipment loans, data center leases and revenue, and personal consumer loans. We also purchased bonds from SASB CMBS securitizations. Descriptions of a few notable portfolio additions are included below.
We bought bonds from several ABS issuances amid heavy volume. VDCR 2023-1A A2A is a data center ABS brought by Vantage Data Centers, a leading owner, developer, and operator of large hyperscale data centers in North America. The collateral consists of eight data centers in Northern Virginia, Montreal, and Quebec City. We purchased the A- rated bonds at a spread of 285 basis points1 over Treasuries. ONDK 2023-1A A is a small business loan ABS deal brought by OnDeck. The company has a 15+ year history of underwriting small business loans, and the deal is backed by a highly diversified portfolio of loans and lines of credit (LOCs) made to small businesses. We bought the triple-A rated notes at a spread of 265 basis points over Treasuries. Aligned Data Centers issued its third deal secured by data center revenues, ADC 2023-1A. The securitization portfolio consists of six wholesale data centers and the associated leases, with contractual cashflows generated from leases to 32 hyperscale, large, enterprise, carrier companies. We bought the A- rated notes at a spread of 250 basis points over Treasuries.
Adams Outdoor Advertising issued its fifth securitization secured by a portfolio of billboard assets and the revenue generated from leasing its space, ADMSO 2023-1. The collateral includes 9,983 billboards with no client or industry accounting for more than 3% and 12% of the pool, respectively. We bought the 4.1 year duration, A- rated notes at a yield of 7.1% and a spread of 310 basis points over Treasuries.
CFG 2023-1 was the fourth ABS issuance brought by CFG Holdings, Ltd., a consumer finance company that offers unsecured personal consumer loans in seven markets, including Panama, Puerto Rico, and the Dutch Caribbean islands. CFG operates in markets with stable macroeconomic performance, the deal features robust excess spread and sizable credit enhancement levels, and the loan portfolio exhibited reasonable historical loss rates. The triple-B rated notes have a 2.4 year duration and were purchased at a yield of 8.7% and a spread of 425 basis points over Treasuries.
CRSO 2023-BRND B is an SASB CMBS deal secured by The Americana at Brand, a lifestyle luxury retail center located in Glendale, California that is 99.4% leased by 75 tenants. The property demonstrates low loan-to-value (LTV) ratios and strong operating performance. The AA- rated notes have a 5 year weighted average life, and we purchased the bonds at a yield of 7.8% and a spread of 350 basis points over Treasuries. DC 2023-DC is an SASB CMBS deal secured by three Tier 3 data centers located in the “data center alley” of Northern Virginia. The centers are 97.2% leased to 19 tenants, featuring a roster of blue-chip tech companies and large hyperscale users. The properties have low LTV ratios and demonstrated strong performance throughout the COVID-19 pandemic. The A- rated notes have a weighted average life of 5 years, and we purchased the bonds at a yield of 7.4% and a spread of 290 basis points over Treasuries.
Characteristics
At the end of the month, the portfolio’s duration was 2.1 years and continued to approximate that of its benchmark (see Exhibit IV). High yield and unrated investments represented 14.2% of the portfolio. Yield to maturity was 10.6% and remained elevated versus bond market alternatives. The portfolio’s option-adjusted spread (OAS) was 533 basis points over Treasuries; for reference, the Bloomberg U.S. Corporate Index’s OAS was 121 basis points over Treasuries at month-end.
Exhibit IV: Characteristics as of September 30, 2023, including credit rating and sector allocation for both the portfolio and benchmark.
Conclusion
Higher interest rates will ultimately bring higher returns for credit investors. We caution that a strong economy should not be the basis for investor credit decisions. Higher-for-longer interest rates will eventually weigh on many borrowers. Instead, we focus on durable credits2 which is a hallmark of our process. Thank you for your continued trust, and we look forward to our conversations over the coming weeks.
1 Basis point (bps) is a unit that is equal to 1/100th of 1% and is used to denote the change in 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. Durable means the ability to withstand a wide variety of economic conditions.
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.
Duration is a measure of the portfolio’s return sensitivity to changes in interest rates.
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. 2023. All rights reserved.
Not FDIC Insured No Bank Guarantee May Lose Money
IM-13627-2023-10-24 Exp. Date 01/31/2024
