Q3 Highlights
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Q3 2024 Commentary
Treasury rates continued to respond to investors’ predictions for future Federal Reserve (Fed) interest rate decisions. The Fed cut the federal funds rate by 0.50% during the quarter, and investors’ predictions for Fed interest rate decisions shifted to more aggressive rate cuts of 75 basis points (bps)1 before year-end. Yields declined across all tenors as expectations of larger and faster rate cuts became reflected in Treasury rates, and fixed income indexes experienced strong total returns as interest rates declined. Excess returns to credit were broadly positive as credit spreads in mainstream indexes narrowed from already low levels to cyclical lows.
Economic data remained strong, with inflationary pressures waning 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 exert upward pressure on inflation. The Chicago Fed National Activity Index remains above its recession indicator.
Corporate default rates remain subdued, are below their respective long-term averages, and continue to be concentrated among CCC-rated issuers. Business loan performance appears healthy, as delinquency rates are low and default rates are declining.
The U.S. consumer appears strong, with loan delinquency rates and loan loss rates rising back towards historical norms. Non-prime auto loan and credit card losses are normalizing towards pre-pandemic levels. Consumer loans are also experiencing lower losses due to tightened underwriting standards since 2022. Rising loss statistics remain well within expected ranges for asset-backed securities (ABS).
Commercial real estate headlines remain disconnected from property-level dynamics. High quality properties are refinancing and there have been minimal losses in commercial mortgage-backed securities (CMBS) deals. Commercial real estate woes have not materially impacted banks’ commercial real estate loan portfolios. Office delinquency rates remain elevated as return-to-office dynamics remain weak, pressuring office real estate values.
We are finding few opportunities in traditional segments of the credit markets. The percentage of potential “buy” opportunities according to our valuation framework2 is near cyclical lows across most sectors. The percentage of credits that screened as a “buy” decreased to 7% from 13% for investment-grade corporate bonds and to 19% from 20% for high yield corporate bonds. Only 1% of the mortgage-backed securities (MBS) market screens as a “buy” candidate.
Supportive credit conditions seem disconnected from the U.S. political headlines garnering attention. Inflation, corporate defaults, loan losses, and loan delinquencies have normalized to manageable levels. Risk spreads have decreased to cyclical lows, suggesting investors are not truly concerned about a recession. The Fed’s rate cuts do not appear to be driven by immediate concerns over a weak economy. Rather, the cuts remove restraints that have been imposed upon consumers and businesses for a long time, and this may be a positive for many borrowers given already-strong credit conditions in many sectors. The biggest risk facing credit investors may not be losses driven by macroeconomic weakness, but rather inattentiveness to valuations and durability during a period of ebullience. We believe the valuation and credit disciplines embedded in our bottom-up process are essential for navigating this environment.
1 Basis point (bp) 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.
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.
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IM-15529-2024-10-29 Exp. Date 01/31/2025
