Find Fixed Income Value Where the Federal Reserve is Not – In Structured Credit

The third quarter brought needed economic relief to the U.S. economy, but any timetable for full recovery is extended and uncertain. New COVID cases continue to rise, economic stimulus programs have halted, and the impact of new vaccines may not be felt until the middle of 2021 or beyond. The unemployment rate declined sharply from 14.7% in April to 7.9% through September, but 11 million fewer Americans are at work today than in February. In September, U.S. retail sales exceeded prior year by a robust 5.4% but are uneven – grocery sales are up 11%, while chain store sales are down 5%. Consumer sentiment is mired near its 2009 low, and U.S. output and corporate earnings aren’t expected to catch up to pre-COVID levels until the second half of 2021. The U.S. economy may have rebounded this summer from truly depressionary conditions, but now it faces a slow climb out of a downturn that is remarkable for its pronounced impact on particular sectors – travel, energy, retail, and entertainment.

A sluggish and patchy recovery leaves cracks within the U.S. credit market. U.S. companies did exceed earnings expectations for the second quarter. Most maintain solid liquidity cushions. Yet for many firms, a path back to stability remains challenging. Average debt leverage levels among U.S. companies have reached a new high, stemming from both depressed earnings before interest, taxes, depreciation, and amortization (EBITDA) and record bond issuance, placing many firms’ financials at higher risk (see figure below). JP Morgan, for instance, estimates that $300 billion of BBB- corporate bonds are on negative outlook and vulnerable to ratings downgrade to high yield status. Since March, $160 billion of corporate notes have already transitioned to “fallen angel” status. Another economic downturn could jeopardize still-delicate recoveries underway at many companies.

The fragility in parts of corporate credit has been masked though by prodigious demand from investors, hungry for return. With U.S. Treasury rates at historic lows, a frenzied search for yield has, for example, induced domestic funds and exchange traded funds (ETFs) to add from $50 to $100 billion in high grade corporate bonds in each of the last few months. The near-zero rate at the short end also has reduced hedging costs to European and Japanese investors, making U.S. corporate bond yields more attractive to foreign buyers than at any point since 2017. Finally, although their purchases have been sparing recently, the Federal Reserve’s (Fed) $750 billion Corporate Credit Facilities (CCF) remain an effective backstop, encouraging the plentiful demand from private sources and quashing price volatility. All told, index yields for investment-grade corporate bonds have fallen to an all-time low below 2% – and this against a backdrop of considerable credit uncertainty and lengthening bond tenors. (Credit index duration have recently extended almost one year.)

Beyond corporates, investors face a tough challenge across most categories of fixed income. The table on the next page tallies investment conditions across fixed income sectors: the current demand technical; the compensation available; interest rate and spread risk; credit conditions; and ratings trajectories. Red shading conveys poorer conditions than historical norms; green shading suggests better than normal conditions.

Unsurprisingly, the large fixed income sectors in which the Fed is directly involved in purchases are painted today with a lot of red. The Fed holds more than $4 trillion of U.S. Treasuries and $2 trillion of agency mortgage-backed securities (MBS) and is purchasing more than $180 billion each month. The Fed’s massive presence has dampened volatility in these markets, spurring heavy U.S. and foreign private investment (the exception being declining overseas interest in MBS). This demand technical for U.S. government and agency paper is unprecedented, even amidst booming Treasury supply, and has helped drive medium and longer maturity yields to unappealing levels well inside of 1%. The AAA credit profile is still an anchor of support, but ballooning debt has put the U.S. sovereign rating on a downtrend. Fundamentals in the agency MBS market are also quite challenging in the midst of a Fed-engineered refinancing boom – prepayment speeds in September were the fastest observed since 2004.

With little income available in government and agency bonds, we noted that private U.S. and foreign investors have piled into U.S. corporates, catalyzing a wave of almost $2 trillion of new issuance this year, at longer maturities than in the past. Corporate spreads have tightened at blistering pace, and the Index’s yield of 2% today is deep in the red zone, at the lowest recorded level in history. With duration in the investment-grade Index at almost nine years, interest rate and spread risk is also higher than ever. Credit fundamentals are generally fair given the macroeconomic backdrop, but patchy, and large segments of the investment-grade and high yield market remain poised for downgrade. While BBH has been able to find attractive pockets of value in the corporate market, it’s questionable whether, more broadly, depressed corporate compensation covers the elevated risk.

Once an investor moves outside the umbrella of fixed income with direct Fed purchase support (i.e. Treasuries, corporates, municipals, and agency MBS), what’s left is the $2 trillion Structured Credit market. Here, durations are shorter and yield levels are far more appealing – as they must be to continue to attract private investment. Traditional asset-backed securities (ABS) issuers – the auto companies and bank credit card issuers – have seen strong demand that has driven yields on this mostly AAA-rated part of the market to below half a percent (see chart on the following page). But on the much larger non-traditional¹ side of the ABS market, the bond tenors are short, from two to three years, and compensation remains near its most attractive level since the Global Financial Crisis (GFC) – 3.9% in the JP Morgan Other ABS index. With technicals that still favor the investor, a strong fundamental credit outlook and their ratings watches resolving positively this summer, non-traditional ABS is the only fixed income sector that screens green across the board from a value and credit perspective. This is where we continue to find the most opportunity within structured credit. Demand for commercial mortgage-backed securities (CMBS) and collateralized loan obligations (CLOs) is similarly limited, so compensation remains compelling. Some of the most appealing opportunities in fixed income today can be found, for example, in CMBS. But investors need to sift through credit fundamentals and navigate possible downgrades in parts of these markets.

The combination of rock-bottom yields and long durations is of particular peril to fixed income investors. The breakeven rate in the credit market – i.e. the rise in yield or spread that can wipe out a year of carry return – is much lower than it ever has been. The chart below shows the pattern of return breakevens in the Corporate Index for the last five years. At today’s depressed rate levels and with the Index at a record long duration, the current return breakeven is dangerously low – around 30 basis points² (bps). Even a modest sell-off in rates or spreads would clear this bar and cancel a year’s income to an investor. Particularly with interest rates at the trough of their historical range, the U.S. credit market has never been on such a razor’s edge. Shortening up on corporate bond durations is no solution. The yield, for example, of the Corporate Index at 1-3 year tenors is only 0.7%. At this meager yield, the breakeven on short corporates is almost as low.

Structured credit offers a strong contrast. Take for instance non-traditional ABS. Represented in the chart above by the JP Morgan Other ABS Index, the Index yield today is almost 4% and the return breakeven remains over 100 bps. Amidst the general paucity of yield in fixed income markets today, Structured Credit yields remain compelling and the prospect for return impairments is low.

While their yields appeal, ABS have also definitively passed the credit performance test of the last six months. BBH confirms this through monthly bond-level reporting and direct conversations with senior management of more than 100 issuers. In the 2Q Quarterly Strategy Update, we noted that lease and loan non-payment rates across ABS subsectors picked up in March and April and began recovering in May and June. Now, with the benefit of data through September, we find that non-payment rates have returned for the most part to low pre-COVID levels. And the large equity safety cushions beneath the notes provided investors ample protection against potentially much larger loss spikes along the way. (We expand on this later in the commentary.) Last quarter, we also pointed to another tell-tale – rating agencies had placed a handful of the more than 20 ABS subsectors on watch in March and April – auto loans, dealer floorplan, personal consumer loans, net lease, and aircraft. With the exception of aircraft ABS, all of these watches had resolved positively by September. It’s too early for a final determination, but we foresee no impairments across the entire ABS universe, with the exception of the junior-most tranches of certain aircraft ABS deals. This credit performance is impressive but should not be too surprising. The cumulative ABS impairment rate through the GFC, for instance, was just 0.03%. ABS are generally from long-standing industries – associated with strong, experienced management teams and enjoy substantial equity cushions and structural protections against even Depression-level economic stress.

In CMBS and CLOs, investment-grade (IG) tranches are also likely to perform well. Some below-IG tranches though (and certain BBB-rated conduit CMBS) still face performance pressures from concentrations to COVID-affected industries and property types (malls and hotels in particular).

The absence of Fed, foreign, and many large U.S. buyers has always distinguished the appealing opportunity set available to Structured Credit investors. The following chart shows spreads on offer today across non-traditional ABS and CMBS sectors³ compared to the corporate indices. With no direct Fed purchases to overheat these sectors, these valuations are likely to persist. One case in point is a representative portfolio for BBH’s Structured Strategy (the “Strategy”), an investment-grade portfolio of bonds constructed from a wide range of more than 20 ABS subsectors that today yields 5.2%.⁴ This represents a 496 bps spread over Treasuries, an unusually sizable lift over high-quality credit alternatives, with an average single A-credit rating, and demonstrated credit performance through the COVID downturn.

ABS issuance rebounds strongly in Q3, providing a multitude of attractive opportunities for investors

The third quarter saw a pickup in ABS issuance, with new issuance volumes ending a surprising 12% ahead of Q3 2019. Year-to-date, total issuance still lags last year by 20%. The higher issuance helped provide more transparency to the market, driving spreads tighter from 10 bps to more than 100 bps, depending on sector. The recovery in spreads broadened to sectors that lagged the rebound in the second quarter. For traditional ABS, where spreads had already largely retraced in the second quarter, the pace of tightening slowed. Solid credit fundamentals have generally been supportive for the spread tightening.

In CMBS, investors are still working through loan data to assess credit changes in loan collateral, this has resulted in slower price recovery for seasoned CMBS paper. New issue deals, on the other hand, include fewer of the retail- and hotel-backed loans that are less favored in this environment. As such, the new issue market has already recovered from its widest option-adjusted spread (OAS) levels in Q2 with 10-year AAA CMBS tightening from approximately 340 bps to 90 bps by the end of September and BBBs rallying from approximately 1,100 bps to 410 bps over the same period.

Given the combination of heavy issuance and attractive spreads, BBH was highly active in structured markets last quarter, purchasing more than $1 billion of non-traditional ABS and CMBS across portfolios. Below are some of the quarter’s more notable additions.

Container ABS was particularly strong this quarter, with many of the world’s leading container lessors coming with multiple issues. Container lease terms are long; new container supply has been minimal this year; and supply typically corrects quickly as trade fluctuates – all of which help keep technicals in balance. Textainer issued a 5-year BBB-rated tranche at a spread over Treasuries of 485 bps for a yield of 5.5%. Similarly, Seaco issued a 5-year tranche rated a notch higher at BBB+ at 323 bps spread, for a yield of 3.8%.

We also took advantage of new issue in venture debt ABS. Historical losses for this type of lending are very low - less than 1%. Seasoned lender MidCap issued BBB-rated notes with a 3.4-year weighted average life at a spread of 430 bps for a 4.5% yield.

We added personal consumer loan ABS issued by Regional Management and Republic Finance. Both companies have more than three decades of profitable operations with branch office networks across the southern U.S. The notes rated BBB were issued at spreads over Treasuries of 350 bps and 375 bps, respectively, representing yields of 3.8% and 4.1%, respectively.

DRSLF 2020-86A is a new-issue CLO portfolio comprised of broadly syndicated loans selected for low exposure to COVID-19 stresses by a top-tier manager, Prudential Financial. The BBB-rated floating-rate bonds with a three-year reinvestment period were purchased at a 425 bps spread over 3-month London Interbank Offering Rate (LIBOR).

ANTR 2020-1A is a new-issue middle market CLO managed by Antares Capital Advisors. Antares is a highly experienced lender to middle market borrowers that specializes in true first lien underwriting and holds all the equity beneath their CLO debt. The BBB-rated tranche was issued at a spread of 540 bps to 3-month LIBOR.

Oxford Finance is the largest independent venture-debt lender focused exclusively on the healthcare industry, and is a repeat holding in the portfolio. Oxford’s existing unsecured bonds with two years remaining to maturity became available in the secondary market, and we purchased the B+ rated notes at a spread of 950 bps for a yield of 9.6%.

Issuance of unsecured business development company (BDC) debt was particularly strong as multiple issuers took advantage of the reopening of the sector. Market leader Ares came with a new 5.5 year BBB-rated deal at a 4% yield. Experienced lenders Blackstone GSO and Golub Capital both came to the market with their first issues, 3.5- and 3-year BBB-rated deals, respectively, at yields of 3.9% and 3.4%, respectively. We purchased the 4-year unsecured bbbp-rated notes of Main Street in secondary at a yield of 4.4%. Finally, Owlrock Technology Finance, which has a spotless historical loan loss record, issued 5-year BBB-rated notes at 5.0% yield.

In CMBS, we participated in GB 2020-FLIX, a $900 million single-asset single-borrower CMBS deal collateralized by four Class A office properties and three studio facilities in Los Angeles, CA. The tenant roster included dominant media companies such as Netflix, ABC, Disney, and CBS/Viacom. The AAA-rated senior note had a notably conservative appraisal LTV of only 27% and priced at LIBOR plus 112 bps.

ABS monthly reports and credit ratings confirm a return to pre-COVID performance levels – except in aviation

While ABS returns can lag corporate movements by a few weeks, ABS credit performance on the other hand is visible earlier and with more frequency than the quarterly cycle of corporate reporting. ABS credit performance is available monthly with granular detail. BBH also benefits from immediate and open access to the senior management teams of ABS issuers who make themselves available for significant investor updates. We believe that our ABS holdings will continue to perform well, even through a harsh recession. Issuer equity cushions beneath ABS debt are, by design, sized conservatively to withstand a depression-level downturn. There are hefty credit enhancement levels of 10% to 50% beneath investors’ notes.

As we noted in last quarter’s Update, the monthly reporting and issuer conversations from spring began to sketch a picture of persistent credit strength across ABS subsectors. Third quarter data now confirms this (see chart below). The monthly non-payment rate (i.e. the unpaid percentage of scheduled principal and interest on loans and leases each month) is a useful performance metric for comparing ABS subsectors. The teal 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 the highest monthly non-payment rates we observed this year, by subsector of the ABS market. These occurred in March and April. By May and June, recovery had commenced. With the benefit of another three months of data, we can now add the black bar, which represents September’s non-payment rates.

The patterns of non-payment rates across subsectors are revealing. Importantly, for all but student loans and aircraft ABS (all the way to the right), credit enhancement levels comfortably cover non-payment rates. Given a still elevated unemployment rate, consumer subsectors like auto and personal consumer loans continue to perform surprisingly well versus the GFC and issuers’ own stress cases. For example, prime and subprime auto ABS delinquency rates rose only moderately in April; by September, non-payment rates had declined back towards pre-COVID levels. Even at their April peak, non-payment rates remained well-covered by the available credit enhancement on these notes (the teal bar). For personal consumer loans from issuers like OneMain Financial, non-payment rates peaked only 20% to 30% higher than pre-COVID, a tiny amount in the context of the ample 50% equity and excess spread cushion beneath these ABS notes. By September, even these small increases had reversed. A couple of management teams have mentioned to us that their loan delinquencies this August were actually lower than last year. They explain that tight underwriting, the reopening of the economy, and the rebound in unemployment and government assistance have all contained underperformance relative to 2009.

Commercial ABS subsectors are also performing well given the depth of the economic downturn with the exception of small business and aviation. Asset types with large corporate lessees – like heavy equipment, railcars, containers, fleet lease, cell tower, and venture debt – continue to experience low, stable lease non-payment rates that are below 3%. These are well-covered by available credit enhancement. Through September we have seen further incremental improvement over April’s subdued non-payment rates. With the national closures of retail in March, there had been worries and negative ratings outlooks for auto dealer floorplan ABS. But auto dealers remained open across most areas of the country in March and April, and new auto sales at dealers recovered this summer. Non-payment rates on auto dealer loans have remained quite low and floorplan ABS credit ratings watches have all resolved positively.

The greatest performance turnarounds we’ve seen this summer have been in small business lending. Smaller businesses face difficult conditions. A September Yelp survey indicates that about 100,000 small businesses have now permanently shuttered. In April, small ticket equipment lessors witnessed a sharp pick-up in deferral requests from borrowers. Non-payment rates came under some pressure, but they remained well below 20% for the leading equipment leasing companies with portfolios diversified across states and industries. By September, with the reopening of the economy, non-payment rates have plunged back below 10%. In another corner of the industry, small business loan ABS administered by the U.S. Small Business Administration (SBA) benefitted from direct federal assistance to borrowers. These loans impressively continue to show impressive 0% delinquencies. Finally, we’ve witnessed a remarkable recovery for the small business ABS issuers outside the SBA program, for example OnDeck Capital and National Funding, Inc. Their non-payment rates on loans peaked at 15% to 25% in April, but they have retreated to a more normal 5% to 15% through September. With new loan originations down temporarily in the Spring, the revolving trusts for these ABS accelerated principal paydowns to investors. In just four months, senior notes are now mostly paid down and junior tranches expected to be retired through year’s end. These swift and orderly paydowns, even while collateral performance has remained reasonable, serve as a useful demonstration of the protective features of ABS structures.

Not surprisingly, aircraft ABS remains the outlier. For aircraft ABS secured by aircraft on long-term lease to commercial airlines, non-payment rates on leases rose to 20% to more than 50% as commercial airlines faced weak domestic traffic and negligible international demand. Leasing companies provided temporary three- to six-month deferrals of lease payments to their airline customers. Through September, the deferrals have begun to expire and many airlines have resumed payment, which should ease cashflow shortfalls in ABS trusts. But as the original leases gradually expire, lease rates may be negotiated downward and bankruptcies may return aircraft to lessors. We do not expect cashflows across trusts to rebound fully back to pre-COVID levels. We do expect senior A tranches across most trusts to perform, and the next priority B notes to perform generally with extended repayment. But many junior-most C tranches of ABS transactions are already deferring note interest and may experience further impairments. BBH has avoided purchasing commercial aircraft ABS for several years on valuation and credit grounds, instead making limited investments in corporate jet and aircraft engine ABS that have been stronger performers through COVID.

Overall CMBS poised to perform, with some weakness continuing in retail and hotel loans

While the retail and hospitality sectors have been hit the hardest during the pandemic, servicers of CMBS loans have been accommodating with loan modifications and forbearances to borrowers in need, softening the COVID-related blow. As of September 2020, 84% of retail and 70% of hotel conduit CMBS loans were still current, compared to 81% and 65% in June (see following figure). Similarly, within single-asset, single-borrower (“SASB”) loans 84% of retail and 79% of hotels were current on principal and interest (P&I) payments, vs. 80% and 75% in June. With retail and hotel accounting for about 40% of CMBS debt, investor focus will be on developments in these segments, such as retailer bankruptcies, infection geographies, leisure and business travel, and policy support from the federal government. Broadly, BBH exposure to both retail and hotel sectors is concentrated either in conduit deals, which benefit from property type diversification, or senior parts of SASB capital structures, which benefit from lower loan-to-value (LTV) ratios and institutional sponsorship.

A Structured Credit Strategy offers yield and credit advantages that are difficult to find today within fixed income

Back in late March, we drew confidence from our many direct conversations with the senior management teams of our issuers. It’s been gratifying to see our credit performance expectations confirmed in monthly remittance reports over the last six months. With the exception of aircraft ABS, we now see little scope for impairments or downgrades across the entire ABS market. We expect investment grade 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 Strategy exemplifies, a short duration portfolio of non-traditional ABS, diversified across 20 subsectors with an average A-rating, can provide today’s investors a yield over 4%.

We look forward to sharing more credit observations and purchase examples with our investors in the coming months.

Sincerely,

Portfolio Management Team

Neil Hohman, PhD
Head of Structured Products

Chris Ling
Structured Products Trading

Andrew P. Hofer
Head of Taxable Fixed Income

Definition

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.

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 failure or 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 ratings from other nationally recognized statistical recognized statistical rating organizations. For purpose of complying with the GIPS® standards, the firm is defined as Brown Brothers Harriman Investment Management ("IM"). IM is a division of Brown Brothers Harriman & Co. ("BBH"). IM claims compliance with the Global Investment Performance Standards (GIPS®). To receive a list of composite descriptions of IM and/or a presentation that complies with the GIPS standards, contact John W. 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 deduction of the maximum investment advisory fees. 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 from 1 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.