BBH Structured Fixed Income Quarterly Update Q1 2021

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

Q1 2021 – Farewell to the Great U.S. Bond Rally?

For 40 years, gradually declining rates have provided bond investors a helpful tailwind of price return above their purchase yield. From a 1981 peak of 16% during the Volcker era, the 10-year yield has meandered downward to a low of 0.5% in August of last year. As a result of this mega-rally, an investor in the Bloomberg Barclays U.S. Treasury Index over that period earned a tremendous 51% price return in excess of their coupon – working out to about 1% annually. This has benefited holders of longer duration notes in particular, softening the impact of short-term rate swings.

The first quarter’s sharp rate rise may, however, constitute a definitive end to that long, benign run and usher in an unpalatable turn – sustained periods of negative price returns as yields rise from their low levels. Holders of long-duration portfolios may now turn in to and contend with persistent headwinds muting returns. The rise in intermediate and long rates through March, which steepened the yield curve, is driven by several factors – a lift in anticipated economic growth, the passage of massive fiscal stimulus, continued expansive monetary policy, and rising inflation concerns – all of which we will discuss below. The consequent capital loss for bond investors with meaningful rate exposure has been severe. The Bloomberg Barclays Aggregate bond index, with 6.4 years’ rate duration, lost more than 3% of its value through the end of March.

Low yield levels across the curve, alongside purchase competition from the Federal Reserve (Fed) for Treasuries and agency mortgage-backed securities (MBS), have driven investors to the credit markets for greater yield. Investment grade (IG) bond funds have accordingly seen strong flows. But incremental compensation on offer in corporate credit is mostly tapped out. Both IG and high-yield (HY) corporate spreads over Treasuries stand at their tightest levels since 2006. Credit fundamentals are improving, but are far from pristine, and maturities are long – averaging nine years duration in the Corporate index.

Unsurprisingly, it’s the overlooked and less familiar segments of the credit market that offer both attractive value and lower rate exposure today. For example, in contrast to the large price declines suffered this year across fixed income, BBH’s Structured Strategy (the “Strategy”) – focused primarily on short tenor non-traditional1 asset-backed securities – returned 1.8%2 last quarter. One-year composite returns are 11.9%, and annual returns from inception in early 2016 are 4.9%, with solid positive returns in each succeeding year. A representative account in the Strategy today offers a 4.3% yield on a high-quality, two-year duration, IG portfolio that is well diversified across more than 20 subsectors. That’s a compelling option in the current yield-challenged environment.

In this Quarterly Update, we delve further into the source of the sharp rate sell-off and curve steepening in the first quarter. We note the potential for further rate increases and offer our guidance to investors to favor higher carry, shorter duration positions. Following this, we lay out a brief summary of the technicals, compensation, and credit outlook across the major fixed income sectors. We acknowledge the paltry spread compensation investors face today across most sectors, while parts of the structured credit market still screen favorably. Next, with the benefit now of a full year’s perspective, we review the durability of the asset-backed securities (ABS) sector through the pandemic – its low return volatility versus other credit sectors at the height of last March’s dislocation and its spotless credit performance across 30-plus subsectors (excepting aviation). As independent support for ABS’ credit stability, we undertake a thorough analysis of every ABS downgrade by the agencies over the last 15 months. Finally, we discuss last quarter’s issuance and spread activity across structured credit markets and provide a description of the many opportunities in which BBH participated – purchasing $900 million in structured credit across our mandates in the first quarter.

No taper, just tantrum

We noted in our January Quarterly Update that with fixed income market yields at all-time lows, bond investors this year would suffer negative returns with even a tiny sell-off in rates or spreads. Well, the rate move came fast and large in the first quarter. U.S. intermediate and long rates shot up at their fastest pace since the Taper Tantrum of 2013, with U.S. 5-year and 10-year Treasury yields rising 58 basis points3 (bps) and 85 bps, respectively. If you include the gradual pickup in rates since August 2020, U.S. Treasury yields have spiked more than through all of 2013 – and without the Fed even signaling a tapering of its Quantitative Easing (QE) program. Short U.S. rates, up to two years, continue to be anchored near zero by the Fed’s determination to keep the Fed Funds rate at zero. The upshot has been a sharp yield curve steepening (as shown in the green line in Exhibit I) that has spared shorter bonds from poor returns, but savaged longer-duration positions.


 

Exhibit I: U.S. Yield Curve is Remarkably Low and Flat by Historical Standards - Entering an Economic Expansion -A line graph of the 10-year US Treasury rate, the 2-year US Treasury rate and the spread between the two since March of 1977. Recessions are also show by shaded bars.

 

The ensuing carnage is widely evident across the bond markets this year (see Exhibit II). The Bloomberg Barclays U.S. Aggregate, Treasury, and Corporate Indices have declined 3.4%, 4.3%, and 4.7%, respectively, in value so far in 2021. Shorter duration sectors, such as commercial mortgage-backed securities (CMBS), ABS, and agency MBS have held in much better. Floating rate loans and non-traditional ABS did quite well on the quarter with their modest rate exposure and higher carry.

Important developments underlie the rise in intermediate and longer rates. First, the Democrats’ control of the Senate opened the door to further massive fiscal stimulus – multi-trillion-dollar COVID relief and potentially new infrastructure spending. Support on this scale is unprecedented, and along with a reopening of the economy and the potential for consumers to spend some of the >$2 trillion of accumulated savings over the past year, an economic boom is now likely to pressure inflation expectations and rates higher. Economists in the Bloomberg survey raised their estimates for U.S. gross domestic product (GDP) growth this year to 5.7% and next year to 4.0%, and their forecast for U.S. government debt to a remarkable 107% of GDP.


Exhibit II: First Quarter Devastates Fixed Income Markets, But Sparing Shorter Duration Higher Carry Sectors - Bar chart of the total return and excess return of various fixed income asset classes.

 

Second, monetary policy remains highly expansive. The Fed this quarter reiterated its “soft” position on inflation – a commitment to allow inflation to rise well above 2% before tightening action. Meanwhile, stimulus checks and QE have jump-started M24, the broadest measure of U.S. money supply, by 25% over the last year. That’s multiples of a typical year’s growth. Ten-year breakeven inflation rates, a measure of long-term inflation expectations, shot up 40 bps this year to 2.4%. Nominal rates have also responded.

Third, U.S. rates are rebounding from an exceptional pandemic nadir of essentially zero. Even with this year’s sell-off, rate levels are at record lows versus their entire pre-COVID history – and we’re entering a roaring expansion. The prior figure shows that the 2s-10s steepness of the rate curve remains a full point below where it ultimately peaked coming out of each of the past three recessions – yet its base, the two-year yield, is still essentially zero. From another vantage point, U.S. real yields are surprisingly depressed given an economy in rebound – 5-year real yields at -1.7% are at their lowest recorded level. Risks lean toward the curve’s further steepening, and we maintain our prescient guidance of last quarter: There is little reward and substantial risk to investors for holding any meaningful rate duration. Short, higher-carry holdings are much preferred in this environment.

Structured credit continues to offer appealing opportunity amid rising rates and meager spreads

Fed Chairman Jerome Powell recently noted that Fed Treasury and MBS purchases will not taper until suitable progress toward labor market and inflation targets are truly observed. So massive Fed buying continues here, forcing private U.S. and foreign investors into the very crowded credit market. Fixed income investors continue to face a tough challenge in most bond sectors. For illumination, we updated our schematic of investment conditions across fixed income sectors. The table below outlines the current demand technical; available compensation; interest rate and spread risk; credit conditions; and ratings trajectories for each major sector of the fixed income market. Red shading conveys poorer conditions than historical norms, green suggests better than normal conditions, and yellow more normal conditions.


Exhibit III: Structured Credit Sectors Offer Balance of Favorable Technicals, Compensation, and Credit Performance – Table comparing the attractiveness of various fixed income asset classes on the basis of technical and fundamental factors.

 

 

The Fed continues to buy Treasury and MBS irrespective of their compensation. Its outsized presence serves to dampen volatility in these markets, encouraging investors to hold positions they would normally reduce at these yields. The demand technical for U.S. government and agency bonds is unprecedented. It helps suppress medium- and longer-maturity yields below a normal level for this point in the cycle and with a pending hike in U.S. debt load. The U.S. sovereign rating is on a downslope. Fundamentals in the agency MBS market have improved temporarily as higher rates have halted the refinancing boom but set up mortgages for the prospect of meaningful duration extension should rates rise further. Treasury and agency MBS sectors are unsurprisingly painted with a lot of red in the table.

In 2013 and 2018, sell-offs in interest rates catalyzed major widening of corporate spreads. The rate shock in 2021, however, hasn’t yet dissuaded investors from chasing U.S. credit for the last drip of extra income. Both IG and HY corporates, still backstopped by Fed purchase programs, are at their record tights since 2007 – spreads over Treasuries of 0.9% and 3.1%, respectively, in the Bloomberg Barclays Indices. Their yields are also near the bottom. Further, corporate issuance is poised to drop, pushing technicals toward even tighter levels. The duration of the IG Index is almost nine years – interest rate and spread vulnerability is very high. Though credit fundamentals continue to improve given the economic recovery, segments of the IG and HY market remain poised for downgrades. BBH continues to find attractive pockets of value in the Corporate market, but we rate just a miserable 3% of the IG corporate index as a buy according to our valuation framework.4  In the corporate market broadly, depressed compensation doesn’t cover the risk of spread-widening from these low levels.

Move outside the umbrella of fixed income with current or potential Fed purchase support (i.e. Treasuries, corporates, municipals, and agency MBS) and what’s left is the $2 trillion Structured Credit market. Here, durations are shorter and yield levels vastly more appealing – as they must be to continue to attract private investment away from the Fed-sheltered sectors.

The traditional ABS sectors – auto makers and bank credit card issuers – are an exception. As for corporates, strong demand for this mostly AAA staple of the ABS market has driven yields below a half percent. But within the much larger, lesser known non-traditional side of the ABS market, bond tenors are a short two to three years and the compensation remains highly attractive. For example, the JPM Other ABS index is yielding 3.6%. Technicals here still favor the investor. The fundamental credit outlook is strong and, as we see below, any ratings watches have resolved positively. Non-traditional ABS is the only fixed income sector that screens green across the board for 2021. Here, BBH continues to find the most value within structured credit.

CMBS and collateralized loan obligations (CLOs) benefit from the similarly-limited investor set, keeping compensation in these sectors compelling. Some of the most appealing secondary opportunities in fixed income today can in fact be found in CMBS. But investors must sift carefully through credit fundamentals in parts of these markets.

Structured credit has historically been distinguished by the absence of Fed, foreign, and large U.S. buyers and, particularly in this frenzied environment, continues to offer a sizable compensation boost of 50 to 400 bps over similarly-rated, more on-the-run credit options credit options (see Exhibit IV).


Exhibit IV: Non-Traditional ABS and CMBS Spreads Remain Compellin as Corporates and Traditional ABS Tighten – Bar chart comparing the spreads of corporate bonds to the spreads of Traditional and Non traditional structured bonds. Comparisons are grouped by credit rating and ordered by tenor.

 

Taking stock of 2020: ABS exhibit price stability and credit strength through extreme turbulence

The turbulent onset of the pandemic in the U.S. is well in the rearview mirror. With a full year’s perspective, we can begin to draw conclusions about return stability and credit performance across different sectors following the unparalleled dislocation in March 2020. Painful as it may be to revisit, Exhibit V traces excess returns over Treasuries during the market dive in the first quarter of 2020. We measure returns over Treasuries in order to focus just on the credit component of performance; i.e., what credit discount did investors apply to different market segments, putting aside the effect of interest rate changes?

Relative to other credit sectors, ABS showed the most stability through the first quarter of 2020. ABS market segments, represented in green by sub-indices of the JPM ABS Index, generally showed the least credit return dislocations, although Student Loan ABS do show greater declines that are similar to CMBS and CLOs. (Student loan ABS have longer average lives that extended out due to COVID-related loan deferrals.) The relative robustness in ABS returns is attributable to high credit quality, short tenor, and reasonable liquidity.



Exhibit V: Excess Return Over Treasuries, 1Q 2020 Declines – Bar chart of the Q1
2020 excess returns of various index subsectors of ABS, CMBS, CLO’s and investment grade and high yield corporates.


 

 

The impact of COVID on hospitality, retail, and office usage disproportionately pressured CMBS last March. But interestingly, it’s the IG and HY corporate indices that experienced the greatest credit-related underperformance, -13.5% and -17.0%, respectively. The credit underperformance in these sectors was partly masked by the rally in rates and began to retrace with the announcement of direct Fed purchases through the Corporate Credit Facilities. But it remains the case that tremendous selling pressure in March 2020 plunged longer corporate bonds to sizable discounts. CLOs, another segment of structured credit secured by corporate loans, suffered too with the repricing of corporate credit as well as for their longer tenors.

Remarkably, returns for all these sectors (except student loan ABS) recovered for the full year 2020 and ultimately exceeded Treasury returns. Most parts of the credit market made a performance roundtrip in 2020 and started 2021 right back at the bottom of their normal compensation range. Still, the comparative price stability of ABS versus other credit is a notable takeaway from 2020. This doubtless owes a great deal to ABS’ credit resilience, which we examine next.

ABS credit performance is visible earlier and more frequently than, for example, corporate reporting with its quarterly cycle. Likewise, our team prides itself on immediate and transparent access to the senior management teams of issuers. We also have good reason to expect our ABS holdings to perform through a harsh recession. Issuer equity cushions beneath ABS debt are, by design, conservatively sized to withstand a Depression-level downturn.

Even in the Spring of 2020, ABS monthly reporting and issuer conversations were sketching a picture of persistent credit strength everywhere – except aviation. Our experience since then confirms this (see Exhibit VI on the following page). The monthly non-payment rate is a useful performance metric for comparing ABS subsectors. The green bar represents a typical level of credit enhancement (or cushion) as percent of total loans, for ABS notes by subsector. The red bar represents the range across issuers of their peak monthly non-payment rates in March and April. With the benefit now of a full year of observations, we add the blue bar, which represents more recent months’ non-payment rates.

The patterns of non-payment rates across subsectors are revealing. Importantly, for all but student loans and aircraft ABS, hefty credit enhancement levels comfortably cover non-payment rates. Consumer subsectors like auto and personal consumer loans maintained surprisingly stable non-payment rates, when compared to the Global Financial Crisis (GFC) and issuers’ own stress cases. Even at their April peak, non-payment rates remained well-covered by the available credit enhancement on these notes (as shown in green). Commercial ABS subsectors also performed well through the depth of the economic downturn. Asset types with large corporate lessees – heavy equipment, railcars, containers, fleet lease, cell tower, and venture debt – continue to experience low, stable lease non-payment rates that are below 3%.


 

Exhibit VI: Peak Non-Payment Rates Across ABS Assets Remained Low Relative to Ample Credit Enhancement – Bar chart of the non-payment rates for various ABS subsectors in March/April of 2020 and in March of 2021. The chart also presents the typical credit enhancement levels for each subsector.

 

Aircraft ABS remain the only credit outlier, unsurprising given that air travel essentially ceased for several months in 2020. However, thick credit enhancement cushions have protected investors against a truly calamitous stress event. With air traffic rebounding now, cash flows across aircraft trusts will slowly build back towards pre-COVID expectations over several years. We expect both the senior and next priority B tranches across aircraft trusts to perform, albeit the latter with extended repayments. BBH has, in any case, avoided purchasing commercial aircraft ABS for several years on value and credit grounds, instead making limited investments in corporate jet and aircraft engine ABS that have been strong performers through COVID.

The rating agencies confirm: ABS credit emerges basically unscathed from the pandemic

Our surveillance clearly indicated to us the strength of credit last year across the 30+ ABS subsectors. Now, with a year of perspective, investors can see this independently as well in the actions of ratings agencies. We analyzed all ABS downgrades from all nationally recognized statistical ratings organizations (NRSROs) made from December of 2019 to March of this year. You can see the results in Exhibit VII. We focus on the downgrades that took bonds below IG (“fallen angels”). Starting with the number of issuers, there are roughly 450 different issuers of ABS with bonds outstanding today – about 30 issuers of aircraft ABS and 427 issuers of all other outstanding ABS. Of the former, 21 issuers experienced a downgrade of at least one bond to below IG, demonstrating the extremity in the aviation industry. Of the remaining 420 other issuers across the other 30 ABS subsectors, however, only eight issuers representing four subsectors experienced a downgrade below IG anywhere amid their numerous trusts. Or put another way, 26 of the 30+ ABS subsectors witnessed no meaningful downgrade activity whatsoever through the pandemic.


 

Exhibit VII Of 32 ABS Subsectors, Only 5 Experienced Downgrades to Below Investment Grade on Any Tranche from Any Agency – Bar chart of the number of downgrades in various ABS subsectors.

 

The proportion of all ABS outstanding issuance trusts (about 1,720) that contained any bond downgraded below IG was just 2.3% (see Exhibit VIII). Out of all ABS tranches (about 4300), the proportion is 1.5%. Finally, fallen angel bonds as a proportion of all outstanding ABS balances are only 1%. (The vast majority of these are aircraft ABS notes.). To put this ABS credit performance into context, Moody’s forecasts that 5% of its IG ratings on corporate bonds will have transitioned from IG to HY over the last 15 months – and this is just one rating agency.


 

Exhibit VIII: Only 1% of Outstanding ABS Notes Downgraded Below Investment Grade Over Last 15 Months, Preponderance in Aviation – Table presenting downgrade data for Aircraft, Auto Fleet, Student Loan (FFELP), Student Loan (Private) and Whole business ABS subsectors..

 

With respect to the eight fallen angel issuers outside of aviation, none of them upon examination reflect any real cracks in ABS credit. The two Federal Family Education Loan Program (FFELP) student loan ABS issuers, for instance, are secured by federal government-guaranteed loans. They were downgraded only out of risk of a purely technical maturity default that would never manifest in actual investor losses. The two private student loan ABS issuers with fallen angels, on the other hand, stem from poorly underwritten pre-2008 deals that were progressively downgraded years before COVID. They have little bearing on contemporary ABS. The two downgraded whole business ABS issuers are the restaurant chains TGI Fridays and Hooters. These are essentially corporate exposures in a securitized wrapping. We don’t regard them as ABS nor do we buy them. Finally, the two fleet ABS issuers that experienced a fallen angel are the rental companies Hertz and Avis. For Avis, two of three rating agencies maintained their IG ratings and the notes trade near par. For its part, the Hertz corporation went into bankruptcy. Yet by virtue of the ample credit enhancement implicit in the security of Hertz’ fleet of a half million vehicles, their ABS notes have stayed near par and are on notice for upgrade.

All in all, the three dozen or so ABS sectors have a remarkably clean credit slate through the worst economic downturn in modern times – and one that’s resolved for investors more quickly than for other credit sectors. This was also the case for ABS through the GFC – only one ABS trust suffered any loss (this was just 0.03% of outstandings). This was not for lack of exposure to COVID-impacted industries. Half of U.S. small businesses closed, U.S. auto sales plummeted 40%, and more than 25 million American consumers lost their jobs. Yet the long experience and strong underwriting of ABS issuers, together with ample structural protections, assured minimal credit impact to investors. The worst impacted U.S. industry was aviation – airline revenue declined essentially to zero with passenger travel down in April to 4% of prior levels. Yet even in aircraft ABS, the deftness of experienced lessors and sizable credit enhancement cushions have resulted in practically every senior note retaining a stable IG rating and the junior B tranches down only a notch or two from their original BBB rating.

The Strategy has benefited from the inherent safety of ABS, further reinforced by our own rigorous credit overlay. BBH’s credit performance has been notably clean. Of the hundreds of ABS notes owned across our dedicated structured strategy, we have witnessed over the last year only two downgrades below IG – Hertz and one older, amortized aircraft deal. Both have recovered in price and we expect to pay in full. It’s a great story about ABS and our credit work that we don’t mind telling.

ABS issuance pace accelerates in the first quarter, providing a multitude of attractive opportunities for investors

The spread tightening trend of late last year picked up again at the beginning of the first quarter, largely in sectors most directly impacted by the pandemic – such as aircraft, rental and retail CMBS. While traditional ABS spreads tightened in January, these prime auto and credit card ABS spreads ended up marginally wider on the quarter as they approached historical tights. Many sectors6 within non-traditional ABS, though, continued to trade wide relative to pre-pandemic spread levels and led the quarter’s spread tightening, on average by approximately 50 bps.

Issuance volume for the first quarter of 2021 was strong, easily surpassing first quarter volume from last year by almost 30% (see Exhibit IX). Demand for new issuance was high throughout the quarter – rates volatility did not have a material impact on demand. The short duration of ABS deals helped insulate it from the recent rate movements prevalent in the longer end of the curve.


 

Exhibit IX: ABS Issuance Ramped Up Again in First Quarter to Near Record Levels - Bar chart of quarterly ABS issuance from Q1 2015 to Q1 2021. Bar are segmented by ABS subsector.

 

Given the combination of heavy issuance and attractive spreads, BBH was highly active in structured markets this quarter, purchasing just under $1 billion of non-traditional ABS and other structured credit across accounts and funds. Below are more notable additions.

In CMBS, we invested in two static commercial real estate (CRE) CLOs, ACR 2021-FL4 and PFP 2021-7, issued by specialty finance firms Ares Commercial Real Estate Corporation and Prime Finance, respectively. Both are a $1 billion issues collateralized by 34 and 43 properties. We participated in the AAA-rated Class A notes, supported by 45% and 43% of credit enhancement at 1-month London Interbank Offering Rate (LIBOR) plus 83 and 85 bps, respectively. In addition, we participated in the AAA-rated senior notes of the WFCM 2021-SAVE deal, a single-asset, single-borrower (SASB) floating rate financing, collateralized by a portfolio of 45 properties, consisting mainly of grocery stores, two office, and two industrial buildings across California and Nevada. The AAA-rated Class A notes were offered at 115 bps over a 1-month LIBOR at an extremely low loan-to-value (LTV) of 28%.

It was another busy quarter for recurring revenue ABS, a newer ABS product secured by historically zero-loss loans to U.S. software companies. Monroe Capital issued its first recurring revenue ABS, MCAF 2021-1, with a two-year reinvestment period. Monroe Capital is a lower middle market lender that was founded in 2004. Similar to other recurring revenue ABS issuers, Monroe has a spotless technology and software lending record since 2009. We participated in the single-A rated senior notes and BBB-rated junior notes at spreads to Treasuries of 240 and 350 bps, respectively. Golub issued its third recurring revenue ABS, GCPAF 2021-1. We participated in the single-A rated senior tranche and the BBB-rated junior tranche at spreads to Treasuries of 214 and 319 bps, respectively.

CUNA Mutual issued its third collateralized fund obligation (CFO) ABS transaction in the fourth quarter of last year. The notes are backed by the cash flows from a seasoned portfolio of private equity and credit fund investments. In the secondary market we purchased the A-rated senior tranche of MCA 2020-1 A, an infrequently issued asset type, at an attractive spread of 207 bps to Treasuries.

It was also an active quarter for personal consumer loan ABS issuance. Oportun Inc. is lender certified by the U.S. Department of Treasury as a Community Development Financial Institution that provides loans to borrowers who are traditionally underserved by mainstream financial institutions. We participated in the A-rated and BBB-rated tranches at spreads of 110 and 335 bps to Treasuries, respectively. These are attractive compensation for notes we regard as environmental, social, and governance (ESG) impact bonds given their facilitation of lending to disadvantaged borrowers. Similarly, Regional Management issued its fifth securitization. We purchased the senior A-rated RMIT 2021-1 A notes at a spread of 140 bps to Treasuries. Finally, we purchased the A-rated and BBB-rated tranches of ABS from Mariner Finance at attractive spreads of 194 and 279 bps to Treasuries, respectively.

Vitality Re XII 01/25 is an unusual IG note that provides Aetna Life with protection against extraordinarily high medical claims. Payments from Vitality Re would only be triggered to the extent the medical benefit ratio of the covered business exceeds an annually determined trigger level with a very remote probability of attachment. Ironically the pandemic actually reduced medical claims overall due to a marked decline in ordinary and elective medical care. Given heightened but misplaced concerns over any form of medical exposure, we were able to purchase the BBB-rated senior tranche at an attractive spread of 225 bps to 3-month Treasury Bill.

In the residential space, BBH continues to participate only in off-the-run opportunities outside of U.S. conventional mortgages. Resimac Group issued RESI 2021-1, an Australian residential mortgage-backed security (RMBS) collateralized by prime quality residential mortgage loans. The AAA-rated USD tranche was issued at a spread of 70 bps to 1-month LIBOR. Waterfall Asset Management issued Cascade Finance Mortgage Trust CFMT 2021-HB5 securitized by inactive reverse mortgages issued by Ginnie Mae and insured by the Federal Housing Administration (FHA) through the Department of Housing and Urban Development (HUD). We purchased the AAA-rated senior tranche at an attractive spread of 71 bps to Treasuries.

In CLOs, we continue to find very attractive AAA-rated opportunities selectively within broadly syndicated loan CLOs with relatively short duration profiles. We added a few short reinvestment period AAA CLO tranches via refinancing or secondary market purchases at spreads over 3-month LIBOR between 93 and 106 bps.

Further down the stack, Angelo Gordon refinanced a broadly syndicated loan CLO WOODS 2019-20 with 3 years of reinvestment period remaining. We participated in the BBB- tranche at a spread of 435 bps to 3-month LIBOR.

Bain Capital Credit refinanced broadly syndicated loan CLO BCC 2016-2, which has exited its reinvestment period and will be near-static. We rolled our existing single-A position into the new refinanced notes at a spread of 200 bps to 3-month LIBOR.

BLKMM 2021-6 is a new issue middle market CLO managed by BlackRock Capital Investment Advisors, BlackRock’s middle market lending team that was formerly known as Tenenbaum Capital Partners. This CLO will have a 4-year reinvestment period. The AAA rated tranche was issued at a spread of 170 bps to 3-month LIBOR.

DIMND 2019-1 is a refinancing of a post-reinvestment period middle market CLO managed by Blackstone Alternative Credit Advisors (formerly GSO). This CLO has passed the end of its reinvestment period and will be near-static. The single-A rated tranche and the BBB- rated tranche were issued at spreads of 240 and 340 bps to 3-month LIBOR, respectively.

DPATH 2021-1 is a new-issue middle market CLO managed by Deerpath Capital Management, a middle market lender that specializes in first lien underwriting. This CLO will have a 3-year reinvestment period. The BBB-rated tranche was issued at a spread of 435 bps to 3-month LIBOR.

Palmer Square issued its twentieth static pool CLO, PSTAT 2021-2. We made a minority investment in the equity tranche, where we expect an annualized return in excess of 12% over a range-bound tenor under 4 years to redemption, depending on market conditions.

BBH was also highly active this quarter in the corporate debt of business development corporations (BDCs), an attractive corner of the direct lending market. Although the notes hold a general rather than secured claim on a BDC’s direct loan assets, the high asset coverage of BDC notes is similar to ABS notes. Total debt to loan assets are low - ranging from only 35% to 55% - and are capped by law at 60%. BDC notes hold up to the same or tougher stress cases as our ABS and CLO holdings and are regarded by many market participants as comparable to AAA-rated CLOs or A-rated ABS. We purchased BBB-rated debt from larger BDCs – Business Development Corporation of America, Blackrock TCP, and Main Street – between 250 and 270 bps spreads to Treasuries. We participated in the A-rated and BBB-rated 5-year notes of medium-sized BDCs Pennant Park, Saratoga, CION, Stellus, and OFS at spreads over Treasuries between 325 and 450 bps. These BDCs all have long track records of low losses on their lower middle market lending. We also got involved in issuance for two BDCs that specialize in lending to venture stage firms, a form of finance with particularly low historical loss rates. We participated in Horizon and Trinity at 265 and 350 bps, respectively. Finally, we participated in an unusual BBB-rated joint venture financing within Franklin Square KKR’s large flagship BDC at an attractive 308 bps over Treasuries.

ABS combine short rate duration, credit stability, and high carry – a timely remedy for a steepening curve

Last March, we drew confidence in ABS credit performance from our direct conversations with the senior management teams of issuers. Similarly, we observed that excess returns versus Treasuries for ABS were muted versus other credit sectors. Over the last year, our positive expectations for credit performance have been supported by the monthly remittance data. Credit strength can now be independently confirmed by the ratings agencies – shown in our analysis above of the last 12 months’ ABS downgrades. With the exception of aircraft ABS, we see no scope for impairments or downgrades across the entire ABS market.

Similarly, we expect the IG tranches of CMBS and CLOs to perform, with the possible exception of a handful of BBB-rated tranches with outsized COVID concentrations.

Yet compensation available across structured credit remains compelling, both in absolute terms and against the norm of the last decade. As BBH’s Structured Strategy exemplifies, a 2-year duration portfolio of non-traditional ABS, diversified across more than 20 subsectors with an average A-rating, can still provide today’s investors a yield over 4%. That’s quite an attractive refuge within any fixed income investor’s portfolio against a steepening yield curve and the historically tight spread levels in the broader credit markets.

We look forward to sharing more of the attractive structured credit opportunities that we are finding for our investors in months ahead.

Sincerely,

Portfolio Management Team

Neil Hohmann, PhD
Head of Structured Products
    
Chris Ling
Structured Products Trading
    
Andrew P. Hofer
Head of Taxable Fixed Income

 
Performance
As of March 31, 2021
  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) 1.78% 1.78% 11.86% 4.88%
5.17%
4.92%
BBH Structured Fixed Income Composite (Net of Fees)
1.69% 1.69% 11.47% 4.51% 4.80% 4.56%
Bloomberg Barclays US ABS Index -0.16% -0.16% 4.57% 3.68% 2.56% 2.70%
*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 Barclays ABS Index is the ABS component of the Bloomberg Barclays 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 Traditional ABS includes prime auto backed loans, credit cards and student loans (FFELP). Non-traditional ABS includes ABS backed by other collateral types.
2 Strategy returns reported gross of fees.
3 Basis point (bps) 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.
4 M2 is a measure of the money supply that includes cash, checking deposits, and easily convertible near money.
5 Our valuation framework is a purely quantitative screen for bonds that may offer excess return potential, primarily from mean-reversion (a theory that suggests that asset price volatility and historical returns eventually will revert to the long run mean or average) 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.
6 Non-traditional ABS and CMBS market include more than 20 subsectors away from prime auto and card ABS and conduit CMBS, such as personal consumer loan ABS, equipment lease ABS, cell tower ABS, and single-asset, single-borrower (SASB) CMBS.

 

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.

The Structured Fixed Income Strategy Representative Account is a single representative account that invests in the Structured Fixed Income strategy. It 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 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.

Quality ratings reflect the credit quality of the underlying issues in the fund portfolio and not of the fund itself.  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 Composite is comprised of fully discretionary, fee-paying structured products accounts over $10 million that are managed in the Structured Fixed Income strategy. The target duration may range from1 to 4 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. Accounts are benchmarked to the Barclays Capital Asset-Backed Index or equivalent.

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.

Definitions

Bloomberg Barclays US Corporate Bond Index (BBG IG Corp) measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility and financial issuers

Bloomberg Barclays 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.

Bloomberg Barclays ABS Index (BBG ABS) is the ABS component of the Bloomberg Barclays 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 Barclays Non-AAA ABS Index (bbg Non-AAA ABS) is the non-AAA ABS component of the Bloomberg Barclays 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 Barclays CMBS Index (BBG CMBS) is the CMBS component of the Bloomberg Barclays 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

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.

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-09437-2021-04-27          Exp. Date 07/31/2021

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