Round-Trip to a Changed World

If you had been lucky enough to sleep through 2020, and woke up simply to compare the yield-to-maturity on your BBH portfolio at year-ends 2019 and 2020, you might conclude nothing much had happened. Market valuations and opportunities are broadly similar to last January as we start 2021. However, we begin this year with 70 percent of global bond supply yielding less than one percent, a new President, a new Treasury Secretary, a changed majority in Congress, a very different growth outlook in many economic sectors, massive amounts of new government stimulus and corporate borrowing, and a long list of uncertainties very different from what was top of mind a year ago.

While we are glad to put last year behind us, it was good to us in a few respects. 2020 was process-affirming, and we generated strong investment performance. We have always understood that periods of high volatility present us with unusual opportunity, and last Spring was one of those moments. In this Quarterly Strategy Update, we’ll discuss how our process guided us through 2020 and how we view our opportunity set today. Then we’ll discuss some of these uncertainties likely to drive the fixed income markets in 2021 and beyond, and the outlook for some of the key economic sectors to which our portfolios are exposed.

Valuations: there and back again

March 2020 was the worst month for investment grade (IG) credit ever – replacing September 2008. In the middle of March, credit valuations went from expensive to intensely attractive in about 10 trading days. In our process, large volatility in valuations typically leads to more trading activity. Our trading volume in credit was up 40% over 2019, as we purchased corporates in the summer and then rotated into new issuance of structured products (asset-backed securities, commercial mortgage-backed securities, collateralized loan obligations) in the fall. These sector allocation changes, driven entirely by the valuations of individual bonds, were the primary driver of strong excess returns in 2020. Sector exposures led returns through the first, while positive security selection improved performance in the second half of the year as volatility diminished.

As shown in the above chart on the left, index-level corporate valuations made a fast round trip from the beginning of the year to the end, with less than 10% of the IG index in our “buy” zone¹ at the start and end of 2020, but nearly 90% in the buy zone in late March.

However, a security merely being above our buy level is only part of the story. It is also important to know how far into the buy zone its valuation has improved. For that we must introduce another output of our model, one we call Gross Mean Reversion or “Gross MR”.² Think of this as the spread plus a modeled return, or a measure of cheapness or intensity in valuation.

Higher is better.

While the number of securities with positive “Gross MR” in the index (i.e. “Buys” or “Holds” in our framework) was about the same at the beginning and end of 2020, there was somewhat greater dispersion in valuations. For instance, there were more securities with higher Gross MR levels at the end of the year than at the beginning of the year, as shown in the above chart on the right.

Not only do some of the opportunities in corporate valuations have potentially higher returns, but structured products continue to offer higher spreads than at the beginning of the year, and tend to out-yield corporates at shorter durations. Investing in select corporate valuation opportunities and structured products are two important components of improving the potential excess return of our client portfolios. You can see the better opportunity set we find today reflected in our representative core account by looking at the weighted average Gross MR in the portfolio at each month opening through the year (see the chart on the right). The portfolio’s weighted average Gross MR was 2.18% (or 218 basis points) at the beginning of 2020, ranged over 10% at the beginning of April, and stands at just under 3% as we start 2021.

Putting this all together, we show the total modeled return of the core representative portfolio in the chart on the following page, including the dramatic drop in Treasury yields early in 2020, and the fall in spreads through the rest of the year. The portfolio’s total modeled potential at the end of the year is about the same as January 2020, but the spread components are much larger and the Treasury-equivalent yield is much smaller. Note that the blue and yellow components of the chart add up to the portfolio yield, the yellow and green components add up to the Gross MR, while the green portion contains our modeled assumptions. While a yield of just over 3 percent for December 2020, and a Gross MR modeled return of 3.7%, doesn’t sound high, it is significant when the Bloomberg Barclays US Aggregate yield stands at 1.13%, and 70% of the broader fixed income universe yields less than 1%.

Moving down to the sector level, we can show how our propensity to shift between sectors and individual names may improve the return on the portfolio. Corporate IG Index spreads are below 100, but if you look at some of the larger exposures in our core representative account, you can see securities from various subsectors with much higher spreads, many from structured sectors. This is particularly true in the highest quality ratings (see chart on the next page).

Low treasury yields and index spreads are discouraging for fixed income investors. But, as last year shows, if yields are volatile, the potential for much better returns are still there.

Fiscal policies are likely to be supportive, but tax increases are probably on the horizon

Overall, we are optimistic about economic growth prospects once the pandemic begins to abate, given massive fiscal and monetary stimulus, along with pent-up consumer demand and healthy balance sheets. However, unprecedented government stimulus and fear about near term recovery brings a lot of market uncertainty and rapid revision of economic and sector expectations, so we expect volatility along the way.

Another stimulus bill was passed in December after Trump’s last-minute flirtation with a veto. It includes additional direct payments and unemployment insurance, as well as additional Paycheck Protection Program (PPP) funds and related tax breaks, aid to airlines and mass transit, “medical ‘surprise billing’ ban”, and a variety of other programs, detailed in the accompanying exhibit. In addition, Congress will certainly be contemplating another bill that pays an additional $1,400 to eligible taxpayers in the first weeks of its new term.

The new stimulus is likely to have a similar effect to that in the summer – simultaneously increasing consumer saving and spending. Combined with the potential of vaccines to end the pandemic, stimulus is likely to be supportive of credit in the coming months.

A Democratic majority will certainly bring some new policy proposals that could weigh on markets, such as financial transaction taxes, significant tax increases on investments and high-income earners, and additional financial regulation. However, since the Democrats have only the slimmest possible majority and still a handful of more conservative House members, we expect Biden to preside over a largely centrist policy agenda.

The Fed credit purchase programs are over. Long live the Fed credit purchase programs.

The Fed’s special lending facilities ended December 31st, and the Federal Reserve (Fed) returned unused risk capital to the Treasury. A provision in the stimulus prohibits the Fed from reviving identical programs without congressional approval. However, this provision is symbolic, since the Fed could make small alterations, rename the programs, and still be able to deploy as much as $750 billion in purchasing power. The Fed, determined not to provoke another “taper tantrum” (2013), also announced it would continue Treasury and mortgage-backed security purchases of at least $120 billion per month “until substantial progress has been made” towards its inflation and unemployment goals. With Yellen as Treasury Secretary, we expect much improved cooperation over Fed programs, although perhaps with some social policy strings attached.

Can this torrid demand for credit continue?

The most important sources of marginal demand for U.S. dollar (USD) credit are foreign investors and mutual funds, both of which have gained share in USD credit over the past decade. Both continued to be positive factors in credit prices in 2020, and we expect this trend to continue. Each of these sources of demand is driven by different dynamics.

Foreign investment demand tends to correlate with two related factors: hedging costs and London Interbank Offering Rate (LIBOR)/short-term rates.³ Lower hedging costs tend to be correlated with greater foreign inflows, since the majority of flows are hedged on a long-term basis. Lower LIBOR rates, as the primary element of funding and hedging costs, also tend to be correlated with higher foreign demand for U.S. assets.'

Fed policy is likely to remain accommodative, and the Fed programs for banks aimed at funding costs have not expired, so we expect LIBOR and hedging costs to remain low this year. The Fed will also continue buying Treasuries at a rapid pace for the foreseeable future. These trends are supportive for funds and foreign flows into U.S. credit markets.

Fixed Income exchange traded funds (ETFs) are generally used as exposure vehicles by institutional money managers and large pools of capital. When a large amount of money needs to be deployed or removed from the corporate bond market, ETFs are the vehicle of choice. For this reason, ETFs tend to be sensitive to market sentiment, and will take in money in periods of risk-seeking or shed assets in times of risk avoidance. Given that the U.S. credit markets are still relatively high yielding, the baseline trend in ETF flows is positive.

However, given ETF’s role as exposure tools, we would not be surprised to see elevated volatility should there be rapid changes in the economic environment, or building investor expectations that the Fed may overshoot its inflation goals.

Speaking of the i-word…

After the run-off election on January 5th, rates spiked, breakeven inflation rates on inflation-indexed bonds increased to just over 2% for 10 years, and the yield curve steepened, a “reflation trade”. Investors have rightfully experienced some fatigue worrying about non-existent inflation since the Global Financial Crisis (GFC). Nonetheless, we believe there may be some reasons to worry about a stronger inflation trend over the coming decade.

First, we are in the midst of unprecedented global expansionist policy coordination, both monetary and fiscal. It isn’t at all clear how much borrowing and spending governments need to do to provoke inflation, but the world’s central banks and governments have certainly stepped up to the plate. The Fed has explicitly targeted average inflation, suggesting they would tolerate periods of higher inflation in order to achieve an average above-two percent for the coming years.

Second, and in contrast to the immediate post-GFC period, globalization is in retreat, and there are significant domestic cost drivers that may play a role in creating inflation. Supply chains are onshoring rather than offshoring, which is likely to push up prices in developing economies. The same goes for stricter environmental and social policies, higher minimum wages, and expanded welfare programs. Finally, record wealth levels and strong asset prices may fuel pent-up demand, and the banking system is well-capitalized and fully capable of a role in the transmission of easy monetary policy.

Housing agencies – never mind!

Until recently, clients have been asking us what will happen to the mortgage agencies. Expectations for the agencies to exit conservatorship probably ended on December 15th, when Treasury Secretary Steven Mnuchin indicated that he would not sign a consent order to make the agencies private again. The Director of the Federal Housing Finance Agency, Mark Calabria published new liquidity rules for agencies as private entities on December 17th, but Calabria is not likely to remain in his post even through the comment period. Meanwhile, the Biden administration’s focus appears to be on extending the mortgage accommodations embedded in the Coronavirus Aid, Relief, and Economic Security (CARES) Act (set to expire on January 31st), and implementing new programs for equitable access to home finance using the profits remitted from the agencies – suggesting that privatization is on the back burner, and the government is more likely to use the agencies as an instrument for social policy subsidies. Agency mortgage-backed securities should remain government-backed credit, at least for the next few years.

What do business managers expect?

Speaking with management teams, we are a little surprised at the optimism we see even in some of the harder-hit sectors. Most pandemic-affected sectors have substantial liquidity and are looking past current conditions to a robust recovery ahead. Spending is surprisingly strong in less-affected sectors. On the following page we provide a summary of the outlook for some of the sectors with larger portfolio exposures.

When will the pandemic end?

On everyone’s mind, of course, is whether the vaccine roll-out will improve from its unpromising start and bring an end to this pandemic by the summer. We believe there is significant pent-up demand among U.S. consumers, and we expect dining, shopping, and traveling activity to pick up sharply as soon as cases appear to taper for a few weeks. Further, there is limited appetite among politicians to strengthen “lockdown” policies in all but the most dire circumstances, so the optimism about economic growth within 2021 seems appropriate.

2020 was a difficult year in many ways, and we are glad to see the back of it. We also would welcome a less chaotic political environment, should that come to pass. But we are very pleased at how our process took us through the gyrations of 2020. Over the past few years, when we’ve built up allocations to Treasuries and cash, or kept our credit exposures in shorter, higher-yielding bonds, clients have asked if we still expect the kind of overshoot in credit that is embedded in our valuation model. Given all the Fed stimulus and low rates around the world, will we enter an era of spread stability? The answer is an emphatic “no”. Bigger government programs and bigger policy uncertainties probably mean greater volatility. This was an extraordinary credit cycle, but by no means the last. As you’ve seen, that bodes well for sticking to our process of purchasing durable credits⁴ when they are available at attractive yields.

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.