Simply Unprecedented

BBH Intermediate Municipal Bond Fund Class I (“the Fund”) had a total return of -0.17% during the first quarter of 2020, compared to a return of -0.50% for the benchmark Bloomberg Barclays 1-15 Year Municipal Index.

The first quarter of 2020 brought back stark memories of the Global Financial Crisis (GFC), and the accompanying Great Recession. For those of us who actively invested through the GFC, the term “unprecedented” was used so often that it became trite. Today, the word unprecedented has acquired a new meaning as the COVID-19 pandemic spreads globally. Most Americans are sheltering in place, and our economy is projected to contract at depression-level rates. For much of March, financial markets struggled with enormous selling pressure, forced unwinds of leveraged positions, and poor liquidity as fear-stricken investors fled for safety. Unlike 2008, monetary and fiscal policy actions cannot provide a cure. “Normalcy” will not return until we overcome the health hazard and fear of the virus.

chart 1 MuniQ120

During times like this, we believe it is important to remember our core investment principles. It is our goal to protect our investors’ capital and generate strong risk-adjusted returns. We strive to achieve this goal by building portfolios of durable credits[1] that offer attractive yields. As value investors, we try to take advantage of opportunities in which valuations become disconnected from an issuer’s fundamentals. Today, the challenges we face as a nation and as investors are simply unprecedented.

For well over a year, we had bemoaned the stretched state of fixed income valuations, in general, and those in the Municipal market, in particular. In a matter of three weeks, everything changed. Up until March 9, the Municipal market had behaved like a traditional “safe-haven[2]” sector. Two- to five-year yields fell to as low as 0.5%. The selling pressure that ensued for the next week-and-a-half was broader and more intense than we experienced during the GFC. In its wake, only nominal Treasuries generated positive returns as all other sectors declined.

From March 9 through March 20, yields on the safest and highest-rated credits increased approximately 200 basis points[3]. The Aaa-rated 5-year that bottomed at a 0.5% yield peaked at 2.5%, generating a 9% price decline. The price declines for low-rated bonds were far worse. Two popular exchange-traded funds (ETFs), HYD and MUB, designed to replicate the Bloomberg Barclays Capital Municipal High Yield Index and the Investment-grade Municipal Index, fell 25% and 17%, respectively. These declines exceeded the 13% drop in the S&P 500. Typically, the Municipal sector is one of, if not the least, volatile fixed income sectors.

chart 2_3 MuniQ120

Never before have we witnessed such a large disconnect between the market for federal debt (Treasuries) and that for state and local government debt. Municipal yield ratios relative to Treasuries spiked to record highs, easily eclipsing the prior peak during the GFC. We do not view today’s ratios as sustainable and expect them to decline. Historically, Municipal bonds have performed very well following periods of intense volatility and elevated ratios. After the Federal Reserve (Fed) cut its target rate to near-zero on Sunday, March 15, we were surprised to see the market for short-to-intermediate maturity high-quality Municipal bonds offering yields of 1.5% to 2%, or more, when the yield on short Treasuries was less than 0.5%.

For all of 2019 and the first two months of this year, strong technical factors supported the Municipal market. Up until March, Municipal bond funds had experienced 60 consecutive weeks of inflows. This, along with relatively constrained new issuance, drove valuations on both high-grade and credit-sensitive bonds to historical highs. The turnaround has been dramatic. Toward the end of March, investors withdrew a record amount of capital from muni funds for two consecutive weeks. The selling pressure began with high-yield funds and ETFs, and soon spread to traditional investment-grade funds. There was a distinct pattern to the selling, that extended even to the taxable corporate market – managers would sell the shortest, highest quality paper they had available. This was a primary reason why high-quality securities experienced such a significant shock. The record-sized redemption requests also placed significant pressure on Municipal money-market securities known as Variable Rate Demand Notes (VRDNs).

While longer-term funds struggled, a fear-driven flight to government money market funds, and out of prime money market funds, also reduced demand for VRDNs. As a result, VRDN rates shot up to their highest levels since the Lehman Brothers bankruptcy filing in September 2008. VRDNs with weekly interest rate resets reached yields above 5%. We owned some VRDNs with daily resets whose yields hit 9% for a short period of time! While investors with extra cash accrued benefits, investors who borrowed in the short-term market to fund leveraged positions suffered.

In Municipals, a common way to attain leverage is through a Tender Option Bond (TOB) structure. Usually in a TOB, an investor places a long-maturity Municipal bond into a trust. The trust then issues a VRDN, freeing up much of the investor’s capital. Under normal circumstances the Municipal yield curve is upward sloping and the long maturity bond would handily out-yield the VRDN, with the investor pocketing the difference. When VRDN rates spiked, the math stopped working and many TOBs needed to be unwound, adding even more selling pressure to an already-stressed market.

The Municipal market has been experiencing more than its fair share of liquidity problems. Recently, the Wall Street Journal characterized Municipals as the “epicenter” of the liquidity crisis. We recognize that these might be early days in this crisis. Although the market’s liquidity problems may have subsided for the time being, we are experiencing an unprecedented shock to our economy, and with it, unprecedented credit challenges. One Fed governor estimated that national unemployment might reach 30%, along with a 50% decline in gross domestic product (GDP). It is for these reasons that both the Federal Government and the Fed have responded with such force. Unfortunately, without a medical solution or more effective and orderly treatment, these policy measures will only soothe the pain to the real economy.

Central to our strategy, we seek to invest in durable credits – those that remain money-good under a wide range of economic and political circumstances. We do not even consider a security’s yield until we are comfortable with its fundamental strength and resilience. We take pride in our underwriting and view our credit research as the foundation of our investment process. We invest in bonds that fund essential services and critical infrastructure (like water and sewer systems), not frivolous “nice-to-haves” (like stadiums or malls). We expect that even bonds that finance essential services and infrastructure will be tested in the current environment and we will rely on our credit research to help protect our investors’ capital.

Volatile markets often generate attractive opportunities, just like today. Once again, indiscriminate selling has been allowing us to purchase high-quality securities at much higher yields than they should offer. We have long considered our client base to be our secret weapon. While the industry was experiencing record redemptions, our clients were seeking to invest more. For our clients as a whole, we invested hundreds of millions of dollars of fresh capital and we are carefully looking for more opportunities. Over the past month, we have emphasized school districts, state obligations, and state housing finance authorities – a consistent theme for us. It is always better to name your price and buy from a forced seller, than to be one.

Our excitement as investors is tempered by the human tragedy that surrounds us. Staying busy with our investments and our client communications has been somewhat therapeutic. We build our portfolios one bond at a time, over many months, if not years. When underwriting prior to the COVID-19 pandemic, we never considered that 90% of our country could be told to shelter-in-place for an extended time. Thankfully, we have always used conservative standards to evaluate credit. This gives us confidence that even during difficult times, our bonds should mature on-time and intact.

There are many reasons to worry these days, but we do not want your Municipal Fund investment at BBH to be one of them. As always, we would be happy to answer any other questions you have, either now or in the future.

We appreciate your trust and hope you stay safe.

Sincerely, 

Gregory S. Steier 
Fund Manager

chart 4 MuniQ120

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. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.

Purchase and sale information provided should not be considered as a recommendation to purchase or sell a particular security and that there is no assurance, as of the date of publication, that the securities purchased remain in a fund's portfolio or that securities sold have not been repurchased.

RISKS

There is no assurance that this investment objective will be achieved.

Diversification does not eliminate the risk of experiencing investment losses.

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.

© 2020 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely.

Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. The Morningstar Rating™ for funds, or "star rating", is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods. The BBH Intermediate Municipal Bond Fund was rated against the following numbers of Muni National Interm category funds over the following time periods: 243 funds in the last three years and 214 funds in the last five years. With respect to these Muni National Interm category funds, the BBH Intermediate Municipal Bond Fund (Class I & Class N), received an Overall Morningstar Rating of 5 stars and 4 stars, respectively. Class I three- and five years periods received ratings of 5 stars and 5 stars, respectively. Class N three- and five-year periods received ratings of 4 stars and 4 stars, respectively.

 

Not FDIC Insured                                  No Bank Guarantee                            May Lose Money

 

IM-07809-2020-04-15                BBH002930        Exp. Date 07/31/2020

[1] Obligations such as bonds, notes, loans, leases, and other forms of indebtedness, except for cash and cash equivalents, issued by obligors other than the U.S. Government and its agencies, totaled at the level of the ultimate obligor or guarantor of the Obligation.

[2] A sector that produces positive returns during a period of high volatility.

[3] 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