Q2 Highlights
|
Q2 2024 Commentary
Treasury rates continued to adjust with investors’ forward-looking views on Federal Reserve (Fed) interest rate decisions. Strong economic data and still-high inflation data caused investors to shift towards a “higher for longer” outlook for the remainder of 2024. Investors still believe the Fed will cut rates by 50 basis points1 during 2024, but the anticipated amount of rate cuts was 150 basis points at the start of the year. Longer-term interest rates increased across the yield curve to reflect the change in expectations. The Fed last met on June 12th and kept the target range of the federal funds rate unchanged at 5.25% - 5.50%. The Fed’s next announcement is scheduled for July 31, 2024. The Fed’s campaign of shrinking its portfolio of assets acquired through open market operations by a maximum of $95 billion per month continues.
Shorter duration fixed income indexes generated positive returns during the second quarter while longer duration indexes experienced negative total returns. Returns to credit generally exceeded Treasuries with two notable exceptions: agency mortgage-backed securities (MBS) and long duration corporate bonds. These are two large market segments that our Valuation Framework2 flagged previously as being broadly unattractively valued, and we allocated very little capital of our clients’ portfolios to those parts of the market.
Credit conditions remain accommodative. High yield default rates remain subdued and continue to be concentrated among CCC-rated issuers, although default rates for all rating categories are below their respective long-term averages. Economic data remained strong, with inflationary pressures persisting and few signs of recession on the horizon. Headline consumer inflation prints have been declining, but wage growth and job openings remain higher than historic averages and could still exert upward pressure on inflation. The Chicago Fed National Activity Index remains above its recession indicator. The U.S. consumer appears to be strong, with personal loan delinquency rates generally rising off very low bases but not indicating widespread issues. Auto loan delinquency rates rose to their highest levels since 2009 but are well below levels that could cause impairment to auto asset-backed securities (ABS). Business loan performance appears healthy, as delinquency rates are low and default rates are declining. In commercial real estate, office delinquency rates remain elevated, while non-office commercial mortgage delinquency rates rose moderately. Return to office dynamics remain weak and continue to pressure office real estate values. The weakening office market has not had an outsized impact on banks’ commercial real estate loan portfolios to date, as delinquency rates and charge-offs have been muted, and many large regional banks are more concentrated in multifamily rather than office within their commercial loan portfolios.
Credit issuance was robust during the second quarter as issuers took advantage of narrow credit spreads, a clearer economic condition, and heavy demand for credit to refinance looming maturities and issue ahead of any uncertainties that may prevail later this year. Gross investment-grade corporate bond issuance increased 19% from 2023’s pace, although 56% of issuance was for refinancing existing debt. Corporate loan issuance increased 182% while high yield bond issuance increased 77% year-over-year, with 83% of issuance used to refinance existing debt. ABS volumes have been record-setting and eclipsed last year’s pace by 37%, while commercial mortgage-backed security (CMBS) issuance jumped 148% off a low base in 2023 driven by single asset, single borrower (SASB) deals.
The issuance that occurred within the high yield credit (bond and loan) and CMBS markets calmed some concerns about a maturity “wall” that existed earlier this year. We long believed that maturity “walls” should not a cause of concern for credit investors, because markets will cycle through individual credits seeking refinancing. We believe that 2024 issuance activity serves as an illustration for why such concerns tend to be overblown.
We are finding fewer opportunities in traditional segments of the credit markets as risk spreads remain narrow and net issuance is low. According to our Valuation Framework, the percentage of investment-grade corporate bonds that screened as a “buy” remained near to 13%, and the percentage of high yield corporate bonds that screened as a “buy” increased to 20% from 16% at the start of the quarter. No cohort of 30- or 15-year agency MBS met our Valuation Framework for purchases at quarter-end.
There remain opportunities in select subsectors of the market. The percentage of corporate loans that screened as a “buy” according to our Valuation Framework stood over 70% at quarter-end. Investment-grade corporate bonds in several interest rate sensitive subsectors, such as life insurance, banking, and finance companies, continue to offer attractive opportunities. In the structured credit markets, we continue to find opportunities in select sectors despite the general recent narrowing of risk spreads. Opportunities are arising in the CMBS market as investors are differentiating among property types with differing credit dynamics.
An environment like this can test the resolve of credit investors. Credit conditions appear relatively benign, and issuance is robust, leading even the most disciplined investors to question the virtues of a valuation discipline when many visible risks – including the U.S. election and geopolitical conflicts – have not triggered a sell off. Opportunities remain, yet the importance of calibrating valuation and credit discipline is of utmost importance when investors seem implacable.
1 Basis points (bps) is a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.
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.
Past performance is no guarantee of future results.
Index Definitions
Ice BofA U.S. Corporate Index tracks the performance of USD denominated investment grade corporate debt publicly issued in the U.S. domestic market.
Bloomberg U.S. Corporate Bond Index represents the corporate bonds in the Bloomberg US Aggregate Bond Index, and are USD denominated, investment-grade (rated Baa3 or above by Moody’s), fixed-rate, corporate bonds with maturities of 1 year or more.
Bloomberg U.S. Aggregate Bond Index covers the USD-denominated, investment-grade (rated Baa3 or above by Moody’s), fixed-rate, and taxable areas of the bond market. This is the broadest measure of the taxable U.S. bond market, including most Treasury, agency, corporate, mortgage-backed, asset-backed, and international dollar-denominated issues, all with maturities of 1 year or more.
Uniform Mortgage Backed Security (UMBS) means a single-class MBS backed by fixed-rate mortgage loans on one-to-four unit (single-family) properties issued by either Enterprise which has the same characteristics (such as payment delay, pooling prefixes, and minimum pool submission amounts) regardless of which Enterprise is the issuer
“Bloomberg®” and the Bloomberg indexes are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indexes (collectively, “Bloomberg”) and have been licensed for use for certain purposes by Brown Brothers Harriman & Co (BBH). Bloomberg is not affiliated with BBH, and Bloomberg does not approve, endorse, review, or recommend the BBH Strategy. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to the fund.
The Indexes are not available for direct investment.
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.
Single-Asset, Single-Borrower (SASB) securities lack 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.
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.
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.
The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option.
Traditional ABS include prime auto backed loans, credit cards and student loans (FFELP). Non-traditional ABS include ABS backed by other collateral types.
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 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. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2024. All rights reserved.
NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE MONEY
IM-15025-2024-07-25 Exp. Date 10/31/2024
