Strategies: Core Fixed Income; Limited Duration; Unconstrained Credit; Intermediate Duration

BBH Taxable Fixed Income Quarterly Strategy Update – 1Q 2021

Co-Portfolio Managers, Andrew Hofer, Neil Hohmann and Paul Kunz provide an analysis of the investment environment and most recent quarter-end results of the Taxable Fixed Income Strategy.

Don’t Take the Bait

Credit and equity markets bottomed out in March of 2020, so the last 12 months have been all recovery, making for very pleasant reading in annual performance comparisons. The Bloomberg Barclays US Credit Index, for instance, is up 7.9% over the past 12 months. But it may be better to consider the last 13 months as a whole to judge by how much the recovery over the last year outweighs the drawdown in March of 2020. For that period, the same index is only up about 0.7% annualized. We are very pleased with the results of our process and our active management over this last credit cycle, and we think our clients have been as well. In addition, credit impairments among our positions have been negligible over the course of the last 15 months. Given all the fear and disruption in the pandemic, and our investments in several cyclical sectors before and after March 2020, we are gratified – if cautiously so – with our credit selection process.

The big story in fixed income in the first quarter of 2021 was a major move up in rates, bringing total returns on intermediate and longer duration notes and bonds into negative territory. The price performance of credit indexes, which was very powerful in the second half of last year, weakened over the last two quarters with the rise in rates. Index credit spreads1 (extra yield for credit risk) were rangebound for much of the first quarter. Meanwhile, economic trends from earnings to payrolls came in very strong, the Federal Reserve (Fed) has been steadfast that stimulus will remain in place, the government is considering a third huge stimulus spending bill, and investors are struggling with very low risk premia in fixed income.

This is a market heavily distorted by government action and, very likely, prone to significant bouts of volatility. Yet the economic context will likely include above-trend growth and some signs of inflation. It all adds up to an unprecedented combination. Accurate predictions are difficult even with solid historical parallels, let alone at a time like this.

Strong consumer trends, better-than-expected recovery in pandemic-affected sectors, massive fiscal and monetary stimulus, and continued trade frictions and interruptions in global trade have created inflation worries and driven investors from longer maturities.

The 10-year Treasury Note yield increased from 0.91% to 1.74% (see Exhibit I), with a negative return of about -7% for the quarter. While such a rise in rates certainly felt unfamiliar, we saw similar increases in 2008-2009, in the “taper tantrum” of 2013, and even in the second half of 2016. With short rates anchored around zero, the 2-10 year Treasury curve steepened to 1.57%, well above its average since 1977 of 0.91%, but certainly short of levels typically seen entering an expansion as well as its post crisis highs of 2.64%. These rate rises reversed some of the strong total returns in credit since April of 2020 (see Exhibit II). In summary, there has been a dramatic move in rates, but we are not in unprecedented territory, and there is risk of further moves if inflation rises above expectations. At the moment, the Treasury Inflation-Protected Securities (“TIPS”) market suggests a short run of inflation around 3%, moderating to 2.6% through 2025, then 2.2% thereafter. This market-implied forecast is quite similar to the forecasts of the Fed Governors, as well as those of many economists, but falls short of consumer surveys.


Exhibit I - “US Treasury Curve” line chart comparing the 12/31/2020 US Treasury yield curve to the 03/31/2021 US Treasury yield curve.


Exhibit II – “1Q 2021 Credit Market Returns” vertical bar chart with the total and excess returns of various fixed income asset classes and credit ratings.

We do not seek to quarrel with these forecasts, but rather to place large uncertainty ranges around them. First of all, surveys and market implied forecasts tend to miss the mark. As our colleague Jorge Aseff points out in this quarter’s BBH Inflation-Indexed Fixed Income quarterly strategy update, market-implied inflation forecasts have missed by 0.6% on average, and surveys by 0.7%. Also, there is simply too much unprecedented government stimulus and global change to feel certain about any one path for rates. Thanks to the pandemic, developed countries are re-thinking their supply chains. Fiscal discipline is not a constraint in policymakers’ priorities – except when it occasionally aligns with the partisan advantage. Many younger investors have no memory of the wreckage in the bond markets when inflation took hold in the 1970-1980s. We agree that there is a significant risk of elevated inflation, and certainly believe there is a likelihood of higher volatility in rates given the massive government interventions at play.

Another source of volatility, familiar to our readers, may be the changing patterns of foreign institutional Treasury purchases (see Exhibit III). Foreign investors have been buying a shrinking share of Treasury instruments, leaving domestic sectors to pick up the slack. Within those purchases, they are also shifting purchases to bills from bonds. Declining foreign demand for Treasuries, offsetting Fed purchases, seems to be contributing to Treasury pricing on the margin. Fears of inflation may cause even larger changes in purchase patterns.


Exhibit III – “Foreign Ownership of Treasuries” combination chart of outstanding US Treasury bonds and bills (area chart) and foreign holders of bonds and bills (stacked bar chart), in trillions of US dollars.

Index average corporate spreads look like terrible value. History suggests they may move wider from these levels at some point, perhaps rapidly. We believe massive government stimulus, monetary and fiscal, may lead to more volatility.

In our last Quarterly Update, we described how our process  was leading us to buy more credit in pandemic-affected sectors, as the durability of many credits within those sectors was becoming clearer and value remained. While the recovery in those pandemic-affected sectors boosted our performance last quarter, value in those sectors is now becoming increasingly difficult to find (see Exhibit IV on the following page).

Nowhere is this more striking than the investment grade (IG) corporate bond market, where a miserable 3% of IG corporates now meet our valuation thresholds as a potential buy (see Exhibit V).

Recently, a prospect asked us if our valuation framework had been “invalidated” given the Fed’s decision to buy in the credit markets during the pandemic. We think not – in fact, it reinforces the need to assure sufficient value in each credit we purchase. The question reminded us of the “great moderation” that many pundits thought had been achieved in 2004-2006. A look at credit volatility in the eras before and after Quantitative Easing (QE) certainly doesn’t show that longer-term volatility in spreads subsequently disappeared (see Exhibit VI at the bottom of the next page), only that increasing government involvement can cause spreads to decrease rapidly in the short-term.

As always, we recommend investors eschew poor valuations. Instruments trading well below long-term average spreads in longer-term maturities bear greater risk from spread-widening. Don’t take the bait. But when you find a good value, lock it in. Like 2004-2006, and the 1960s, these periods of low spreads can last a while. Given the clear strength of the economy right now and the Fed pumping in massive excess liquidity, this value drought may go on for a while.


Exhibit IV – “Spread Widening and Recovery in Pandemic-Affected Sectors” a table showing the past six quarters of average option-adjusted spreads, categorized into the industry subsectors most affected by the pandemic. An additional column compares spreads on 12/31/2020 and 3/31/2021. There are two tables, one each for subsectors in Bank of America Merrill Lynch US Corporate Index and Bank of America Merrill Lynch US Cash Pay High Yield Index.

There are still some decent values to be had, mostly in less widely-followed sectors and industries with smaller issues and/or special circumstances.

The asset-backed securities (ABS) market continues to provide higher yields and little of the exposure to spread-widening risk currently embedded in the corporate market. The high yield (HY) market also has much better value than IG (see Exhibit IV), although closer inspection reveals that it is in “yield-to-call” investments – bonds that are likely to be called, but offer a relatively high yield for a short period of time (see Exhibit VII on the following page). Finally, investors still systematically shun bonds that appear to be less liquid. At the right valuation, we recommend investors take the illiquidity risk. Otherwise, short, higher-yielding credit is where our valuation framework takes us.


Exhibit V – “Investment Grade and High Yield Buy Zones” a 2-line chart of the percentage of bonds in the BBH Buy zone from 2009 to present. The two lines represent the percentage of “BBH BUY Zone” bonds in the Bank of America Merrill Lynch US Corporate Index and the percentage of “BBH BUY Zone” bonds in the Bank of America Merrill Lynch US Cash Pay High Yield Index, respectively.

The best place to find one-off, or idiosyncratic, value opportunities in otherwise complacent markets is in the BBB to BB range. Our research shows that credit spreads in general are both wider and more volatile here than underlying fundamentals require or suggest. This is particularly true in this “crossover range” of credit ratings, where long-term defaults are very low, but compensation tends to be high and variable. In fact, if you were to invest passively in one grade of credit, BB-rated obligations have generally provided the best risk-adjusted long-term returns. In Exhibit VIII, we show the long-term range of spreads for each rating, as well as the long-term default cost of investing in each rating category. BBB and BB stick out as offering higher and wider-ranging compensation with low default costs. Compared to IG credit, there are more small issues and pure-play companies in the BBB and BBB- rating categories. Rating agencies tend to lower ratings for those reasons, a method with which we do not agree. Compared to B and CCC rated credit, default rates are significantly lower for BB-rated credits. As in other periods of generally slim opportunities, some of our best individual credit picks are in the BBB to BB ratings categories.


Exhibit VI – “Credit Volatility Before and After QE” a combination chart showing the Bloomberg Barclays IG Corporate Index 90-day Volatility as a line versus a stacked area showing Fed balance sheet as a percentage of GDP and Fed Budget Deficit and a percentage of GDP.


Exhibit VII – “Buy Zone Bonds vs. Holds/Sells in HY” bar chart comparing 2 sets of bonds: the “BBH Buy zone” bonds and the “BBH Hold/Sell zone” bonds in Bank of America Merrill Lynch US Cash Pay High Yield Index. The y-axis is the number of bonds in each category and the x-axis separates each set into effective duration buckets.

Zero risk-free yields are making investors a little crazy, but it is always a good time to take a valuation-based approach.

There is no mystery why it is very difficult to find yield with a stable price in today’s environment. This is simply because the Fed is buying up Treasuries and keeping rates low to incentivize investors to put their money at risk. As a result, valuations are at extremely rich levels in the markets adjacent to Treasuries (IG corporates, mortgage-backed securities or “MBS”, and other agency credit).
We won’t take the bait – we don’t want to lock in bad valuations for the long run. We continue to pick-off good values in less-traveled parts of the market like structured credit, certain niche corporate sectors, the ‘crossover’ ratings categories, and loans and short, callable high yield. Fundamental credit trends are improving, making it even easier to avoid stretching credit standards to get invested. Market volatility will eventually do the work for us, as it did in 2020.


Exhibit VIII – “Historical Loss Cost in Spread vs. Option-Adjusted Spread Range by Rating in Basis Points” this chart compares the Average OAS, the OAS range (from 10th to 90th percentile) and the loss costs of defaults in terms of spread. Bonds are separated into ratings categories, from AAA to CCC. There is also a category of All investment grade and all high yield.

Andrew P. Hofer
Portfolio Co-Manager
Neil Hohmann,PhD 
Portfolio Co-Manager
Paul Kunz
Portfolio Co-Manager

Past performance is no guarantee of future results.

Gross of fee performance results for the composites do not reflect the deduction of investment advisory fees. Actual returns will be reduced by such fees. Net of fees performance reflects the deduction of the maximum investment advisory fees. Performance is calculated in U.S. dollars.

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.

The Core Fixed Income Representative Account is managed with the same investment objectives, employs substantially the same investment philosophy as the strategy and is the account whose investment guidelines allow the greatest flexibility to express active management positions.

* Returns are not annualized

On 10/1/2020, the BBH Credit Value Composite was renamed the BBH Unconstrained Credit - Fixed Income Composite, the BBH U.S. TIPS Composite was renamed the BBH Inflation-Indexed Fixed Income Composite, and the BBH Intermediate Municipal Composite was renamed the BBH Municipal Fixed Income Composite.

BBH Limited Duration Fixed Income Composite inception date is 1/1/1990, BBH Unconstrained Credit – Fixed Income composite inception date is 5/15/2014, BBH Structured Fixed Income Composite inception date is 1/1/2016, BBH Intermediate Duration Fixed Income Composite inception date is 7/1/1985, BBH Municipal Fixed Income Composite inception date is 5/1/2002, BBH Core Fixed Income Composite inception date is 1/1/1986, BBH Inflation-Indexed Securities Composite inception date is 4/1/1997.

Index Definitions

The BofA Merrill Lynch U.S. Corporate Index tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market.

Bloomberg Barclays US Aggregate Bond Index is 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 U.S. 1-3 Year Treasury Bond Index is an index of fixed rate obligations of the U.S. Treasury with maturities ranging from 1 to 3 years.

Bloomberg Barclays 1-10 Year Municipal Bond Index is a component of the Barclays Municipal Bond index, including bonds with maturity dates between one and 17 years. The Bloomberg Barclays Municipal Bond Index is considered representative of the broad market for investment grade, tax-exempt bonds with a maturity of at least one year.

Bloomberg Barclays Intermediate Gov/Credit Index is a broad-based flagship benchmark that measures the non-securitized component of the US Aggregate Index with less than 10 years to maturity. The index includes investment grade, US dollar-denominated, fixed-rate treasuries, government-related, and corporate securities.

Bloomberg Barclays U.S. TIPS Index includes all publicly issued, U.S. Treasury inflation-protected securities that have at least one year remaining to maturity, are rated investment grade, and have $250 million or more of outstanding face value.

Bloomberg Barclays US ABS Index is the asset backed securities component of the Bloomberg Barclays U.S. 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 Indexes are not available for direct investment.

Composites Description

The BBH Limited Duration Fixed Income Composite is composed of all fully discretionary, fee-paying accounts over $10 million that are managed in the Limited Duration strategy. Under normal market conditions, the target duration may range from approximately 1 to 3 years. May invest in a broad range of taxable fixed income securities, including futures.

The BBH Unconstrained Credit - Fixed Income Composite is composed of all fully discretionary, fee-paying accounts over $10 million that are managed using the Unconstrained Credit - Fixed Income strategy. Under normal market conditions, the target duration is approximately 2 to 6 years. Invests in a broad range of taxable fixed income sectors. Holdings may include investment grade and non-investment grade securities. Futures, options, derivatives, and non-dollar fixed income may be held. Futures, options, and derivatives may be used on a regular basis for risk management and portfolio adjustment. These instruments may be considered leveraged when exposure to the underlying asset is gained with little or no initial cash outlay.

The BBH Structure Fixed Income Composite is composed of all fully discretionary, fee-paying accounts over $10 million that are managed in the Structured Fixed Income strategy. The target duration may range from 2 to 6 years. Investments are focused on asset-backed and related structured fixed income securities. Holdings are primarily investment grade but non-investment grade securities may be held. Investments may include non-dollar fixed income.

The BBH Intermediate Duration Fixed Income Composite is composed of all fully discretionary, fee-paying fixed income accounts over $5 million that are invested in governments and corporates, with a duration of approximately 3 years.

The BBH Municipal Fixed Income Composite is composed of all fully discretionary fee paying municipal fixed income accounts over $5 million that are managed to an average duration of approximately 4.5 years.

The BBH Core Fixed Income Composite is comprised of fully discretionary, fee-paying core fixed income accounts over $10 million that are managed to a duration of approximately 4.5 years and are invested in a broad range of taxable bonds. Historically to December 31, 2000 the account minimum was $5 million.

The BBH Inflation-Indexed Fixed Income Composite is composed of all discretionary, fee-paying domestic accounts over $10 million with an emphasis on U.S. inflation indexed securities. May invest up to approximately 25% outside of U.S. inflation indexed securities, and a duration of approximately 7-9 years.

1 Spread is the difference in yield between a U.S. Treasury bond and another debt security of the same maturity but different credit quality.
2 Our 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.

Risks

Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, maturity, call and inflation risk; investments may be worth more or less than the original cost when redeemed.

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.

Investing in derivative instruments, investments whose values depend on the performance of the underlying security, assets, interest rate, index or currency and entail potentially higher volatility and risk of loss compared to traditional bond investments.

Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax.

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 W. Ackler at 212 493-8247 or via email at john.ackler@bbh.com.

Past performance does not guarantee future results
Portfolio holdings and characteristics are subject to change.
Basis point 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
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 speculative in nature and are vulnerable to the possibility of issuer failure or business interruption. High yield bonds, commonly known as junk bonds, are subject to a high level of credit and market risks.

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. 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.

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-09345-2021-04-16    Exp. Date  07/31/2021

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