Significant challenges stand in front of the municipal market. The true human and economic tolls of the Coronavirus (COVID-19) will unfold over time, and only then will we be able to assess its depth and longevity. We typically welcome market volatility and the opportunities it generates with open arms. Extreme medical concerns have elicited an unprecedented response by global governments. Focusing on our investments provides us some respite against the alarming news headlines. Forced selling, similar to what we have seen in the past few days, often results in high quality assets being sold at attractive yields. Last week, high yield municipal bond funds experienced record outflows, yet the yields on the highest-rated securities also spiked.
Capital protection will always be our highest priority. We won’t even think about a bond’s yield until we are comfortable it will be money-good. This philosophy guides our investment activities for all of our Private Clients, Institutional clients, and BBH’s own balance sheet. We expect our credits to remain resilient over a wide range of economic and political circumstances. Our credits must finance essential services or assets, be well run with appropriate leverage, and offer sufficient transparency in their documentation so that we can fully understand what we’re buying. We also factor in Environmental, Social, and Governance (ESG) considerations as part of our overall credit research. The current environment is likely to provide significant credit challenges. There is no monetary policy cure for the economic and human challenges ahead.
Over the past several years, many funds have feasted on lower-quality debt. They also helped fund projects that were not creditworthy in our opinion. One example is the $1.1 billion bond deal, issued six months ago, to fund the American Dream Mall in New Jersey, formerly known as “Xanadu”. A retail and entertainment-oriented project that depends on rosy forecasts of future sales-tax growth to remain solvent would never be a credit for us. We do not deviate from our approach. Our Fund represents a collection of high-quality credits that stands in contrast to the average municipal bond fund.
We expect the municipal market’s more cyclical sectors to struggle. Ports, airports, tourist destinations, mass-transit, and state and local governments with poorly-funded pensions and weak financial positions will have difficulty under current circumstances. The nation’s hospital systems could also face meaningful headwinds. Lastly, periods of market stress usually have an adverse impact on the valuations of bank-supported obligations, even if they remain sound credits. The large Wall Street banks have always played an important role in the muni market. The impact of these banks is wide and diverse, from originating new securities and secondary market trading, to liquidity support for money market securities, and credit support for securities like prepaid natural gas. To the extent that these banks face additional challenges, it will impact the municipal bond market.
We have relatively low exposure to the aforementioned mass transportation and trade-related sectors. For example, the Fund’s airport and mass-transit holdings, combined, are less than 5%. Beyond this, we view our hospital holdings as strong. Many other funds own continuing-care facilities which could face acute problems because of COVID-19. We have never invested in continuing-care bonds.
We do own a couple of states with weaker pensions, specifically New Jersey and Connecticut. New Jersey is in year 7 out of 10 in its ramp-up to make full contributions to its plan and we have confidence they will continue to do so. A couple of years ago, New Jersey pledged the net revenues of its state lottery system to its pensions for 30 years. Beyond that, the state is contemplating yet another income tax hike to supplement its contributions. Lastly, unlike Illinois, whose bonds we have avoided, New Jersey is a reform-friendly state, in terms of pension benefits.
Although Connecticut has struggled relative to other states in recovering from the Financial Crisis, the state remains top-notch with respect to its wealth and income metrics. As a state, Connecticut also offers good access to a well-educated workforce and access to major centers of employment. Although not as friendly as New Jersey, Connecticut also has a supportive court system that has helped pension restructuring. Just like New Jersey, Connecticut is one of only a few states that service their teacher pensions at the state level, rather than at a local level. Connecticut’s support of schools at the state level is a main reason for their relatively high level of indebtedness.
The Fund does possess a roughly 10% exposure to securities supported by major banks, largely in the form of prepaid natural gas securities. These tax-exempt bonds fund long-term contracts for the delivery of natural gas to municipal entities at discounted prices. The Financial Crisis drove many changes in bank regulations, leading to improvements in capitalization and liquidity. We view the major banks as much more resilient from a credit perspective than they were during the Financial Crisis.
The Fund entered this period of heightened uncertainty and volatility with relatively conservative positioning. Indiscriminate selling to satisfy redemption requests often produces opportunities to purchase high quality securities at higher yields than they should offer. We have already invested in a few of these opportunities and are carefully looking for more.
We appreciate your ongoing trust and confidence during these trying times.
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 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 rating organizations.
There is no assurance the investment objective will be achieved.
Investors in the Fund should be able to withstand short-term fluctuations in the fixed income markets in return for potentially higher returns over the long term. The value of portfolios changes every day and can be affected by changes in interest rates, general market conditions and other political, social and economic developments.
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.
Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax.
The Fund also invests 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 stock or bond investments.
As the Fund's exposure in any one municipal revenue sector backed by revenues from similar types of projects increases, the Fund will also become more sensitive to adverse economic, business or political developments relevant to these projects.
Asset allocation decisions, particularly large redemptions, made by an investment adviser whose discretionary clients make up a large percentage of the Fund's shareholders may adversely impact remaining Fund shareholders.
For more complete information, visit www.bbhfunds.com for a current Fund prospectus. You should consider the fund's investment objectives, risks, charges and expenses carefully before you invest. Information about these and other important subjects is in the fund's prospectus, which you should read carefully before investing.
Shares of the Fund are distributed by ALPS Distributors, Inc. and is located at 1290 Broadway, Suite 1000, Denver, CO 80203. Brown Brothers Harriman & Co. ("BBH"), a New York limited partnership, was founded in 1818 and provides investment advice to registered mutual funds through a separately identifiable department (the "SID"). The SID is registered with the U.S. Securities and Exchange Commission under the Investment Advisers Act of 1940. BBH acts as the Fund Administrator and is located at 140 Broadway, New York, NY 10005.
NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE
IM-07691-2020-03-16 BBH002917 Exp. Date 06/30/2020