Exhibit I: Fixed income index returns for various indexes as of December 31, 2023, displaying duration, total return, and excess return.
4Q Highlights
|
| Performance As of December 31, 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) |
3.60% |
9.99% |
9.99% |
3.12% |
3.73% |
4.17% |
BBH Structured Fixed Income Composite (Net of Fees) |
3.51% |
9.61% |
9.61% |
2.76% |
3.37% |
3.81% |
BBH Structured Fixed Income Benchmark |
2.89% |
5.31% |
5.31% |
0.05% |
1.82% |
1.81% |
| 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
Interest rates fell and credit spreads narrowed across the fixed income markets during the fourth quarter. Just three months ago, the Bloomberg Aggregate Index (the “Index”) had a negative year-to-date total return after interest rates rose and market conditions suggested a “higher-for-longer” interest rate environment. Those conditions changed rapidly, as investor expectations now reveal quicker and larger Federal Reserve (Fed) rate cuts in 2024. The prospect of near-term Fed easing may also alleviate investor concerns about near-term economic risks.
On a duration-adjusted basis, structured credit indexes outperformed Treasury alternatives during the quarter, but the outperformance was not accompanied by a corresponding decrease in valuation conditions in several sectors (see Exhibit I). Indexes of collateralized loan obligation (CLO) debt and commercial mortgage-backed securities (CMBS) experienced strong results, and the Agency MBS Index also posted notably strong performance after exhibiting volatility throughout the year as the Fed executes its quantitative tightening campaign. Nontraditional asset-backed securities (ABS) outperformed similar duration Treasuries by a small margin, particularly when compared to the performance of other credit indexes during the quarter.
Year-to-date, all credit indexes had positive excess returns. Non-agency CMBS outperformed comparable duration Treasuries slightly despite negative headlines regarding commercial real estate. 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. 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 (see Exhibit II). 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 demonstrating strong and durable credit1 performance.
Exhibit II: Market outlook by sector as of December 31, 2023, broken-down by reserves, structured credit, corporate credit, and other credit categories.
There are several sectors where valuation and durability concerns lead us to avoid positions in client portfolios. Valuations of agency MBS weakened amid strong spread compression during the fourth quarter, and only small segments of the market screen as a “buy” candidate to us. We continue to avoid non-agency residential mortgage-backed securities (RMBS) due to poor technical factors and weak fundamentals underpinned by weak housing affordability, low inventory of homes for sale, and stable-to-declining home prices.
Performance
Favorable selection results drove performance during the quarter (see Exhibit III). Contributions were diversified among the sectors emphasized in the portfolio. Holdings of bonds from CLOs, SASB CMBS, senior loans secured by electric utility revenues, recurring revenue ABS, BDC debt, and cell tower ABS all had meaningful contributions to selection results. Positions in aircraft equipment ABS and insurance-linked ABS detracted modestly.
Exhibit III: Attribution as of December 31, 2023, showing average portfolio weight and gross contribution displayed in basis points.
Sector allocation contributed modestly to results, as the positive impact from holding positions in secured corporate debt and BDC debt more than offset negative sector effects in ABS. The duration profile had a small but positive impact on relative returns.
Transaction Summary
We continued to find durable credits 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 2023-K753 is a 2023 new-issue seven-year fixed rate $964.3 million Freddie Mac agency CMBS transaction, secured by a pool of 32 first mortgage loans across 37 properties. The properties represented are 95% multifamily and 5% senior housing facilities and manufactured housing community assets, and the occupancy rate was 95.1%. 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 positions from the deal in interest-only bonds at a spread of 447 basis points2 over Treasuries and in junior non-guaranteed notes.
WESTF 2023-A is an aircraft equipment ABS deal brought by Willis Engine. Willis Lease provides long and short-term operating leases for commercial jet engines for passenger airlines. The company is a repeat ABS issuer with strong past performance, and the bonds possess strong structural protections and credit enhancement. We purchased the 5-year weighted average life (WAL), single-A rated bonds at a spread of 350 basis points over Treasuries for a yield of 8.5%.
MFIT 2023-AA is a personal consumer loan ABS deal brought by Mariner Finance. Mariner is a community-focused financial services business that offers auto-secured, soft-secured, and unsecured personal consumer loans in 22 states to below prime credit borrowers. The collateral pledged to the securitization is subprime and near-prime, fixed rate, fully amortizing, personal consumer loans and indirect sales finance contracts originated by Mariner Finance’s branch network. The bonds feature sizable credit enhancement levels and strong structural protections. We purchased the 2-year WAL, triple-A rated bonds at a spread of 190 basis points over Treasuries for a yield of 6.9%.
TYSN 2023-CRNR is an SASB CMBS deal secured by a first mortgage loan for The Tysons Corner Center, a super regional mall located in McLean, Virginia. The property benefits from its proximity to a dense, affluent population, access to major transportation links, and surrounding commercial activity, and the company has healthy operating performance with over 95.4% leased, strong inline sales, and healthy occupancy costs. We purchased the 5-year WAL, triple-A rated bonds at a spread of 230 basis points over Treasuries for a yield of 6.5%.
ANTR 2019-1A is a new issue middle market CLO managed by Antares Capital Advisers LLC. Antares is a large and experienced CLO manager with a top tier management team. The bonds feature strong structural protections and very high levels of credit enhancement. We purchased the 7-year WAL, double-A rated bonds at a spread of 335 basis points over Treasuries for a yield of 8.7%.
FS Investment Corp is a NYSE-listed BDC that is subadvised by KKR. The company is a leading BDC with strong long-term credit performance, a well-diversified portfolio of primarily secured loans, and a strong management team. The portfolio is well diversified and consists primarily of secured loans. We purchased the new issue 5-year, BBB- rated bonds at a spread of 335 basis points over Treasuries for a yield of 8.0%.
Characteristics
At the end of the quarter, the Strategy’s duration was 1.8 years and continued to approximate that of its benchmark (see Exhibit IV). The Strategy had 87.7% of its investments in IG credits, while HY and unrated investments represented 12.3%. Yield to maturity was 8.6% and remained elevated versus bond market alternatives. The option-adjusted spread (OAS) was 391 basis points over Treasuries; for reference, the Bloomberg U.S. Corporate Index’s OAS was 99 basis points over Treasuries at quarter-end and the OAS of the Bloomberg ABS Index, a proxy for traditional ABS, was 68 basis points over Treasuries.
Exhibit IV: Characteristics as of December 31, 2023, including credit rating and sector allocation for both the portfolio and benchmark.
Conclusion
Several forces are being exerted on credit markets in 2024, and the effect on credit spreads and transaction volumes is uncertain. Valuations, potential defaults and recession, the prospect of Fed easing, heightened refinancing needs, and fund flows in a higher Treasury rate environment can cause the market to behave erratically in any given year, and this year promises to be no different. That is why strong valuation and credit disciplines are imperative to performing in the market.
1 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.
2 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.
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.
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IM-14151-2024-02-02 Exp. Date 04/30/2024
