Given the extraordinary turbulence in credit and equity markets over the last few weeks, we are writing you to provide an unusual mid-month update on the Limited Duration Fund.
As we write this, on the morning of March 20, the Fund is down -3.27% year-to-date. For the last six months, the Fund is down -2.57%, underperforming our objective of keeping principal intact over six month periods.
Credit markets, particularly short-term credit markets, are enduring a sell-off similar to the financial crisis. Spreads, or the amount of extra credit yield (over U.S. Treasuries) demanded for credit, have widened as much as they did in all of 2008 leading up to the failure of Lehman Brothers, but they have done so in only 20 days. Increases in spreads drive the price of bonds and notes down, while time, with accruing interest, helps offset downdrafts. This has been an unprecedentedly sharp movement in very little time – larger, even, than the three weeks after Lehman Brothers failed. A broad investment grade corporate index is down -12.84% month-to-date, and the two largest exchange traded funds(ETFs) of short-term corporate bonds are also both down over 12% this month.
According to pricing services, AA and A bonds of 1-3 years maturity have decreased 1% -3% in price, while similar BBB bonds are off 3%-7% in price; however, liquidity is so erratic that there is considerable uncertainty around those quoted prices, indicated by the huge discounts and negative performance on ETFs.
We entered this month with a record amount of cash and equivalents, primarily Treasury Bills (approximately 25%), and we have over 15% of cash and equivalents (mostly U.S. Treasury Bills) as of March 19, as part of the 48% of the Fund that is in AAA-rated obligations. We have had minimal outflows, but have made some incremental purchases of high quality credit at these very elevated yields. In addition to our cash balance, the Fund has a ladder of maturities and paydowns of anywhere from 1% to 3% of Fund assets in cash every month. The portfolio yield, net of estimated Fund expenses, stands at about 3.3%, the highest it has been since the end of 2018.
The sell-off in short term credit appears to be driven by a few things:
- Forced redemptions causing mutual funds to sell things with the lowest dollar price impact. That leads to selling the shortest paper possible
- Several large corporate holders of high quality, short-term credit have been liquidating – large technology companies with $100+ billion portfolios.
- So-called “Risk Parity” funds appear to be in a leveraged unwind. Typically, these funds hedge short-term credit with long Treasuries, a strategy that has recently done very poorly. These funds are receiving margin calls.
There is no doubt that there are some fundamental concerns about lower quality credit at this point, but there is clearly a huge inventory of high quality, short-term credit due to these technical selling pressures. The energy, travel/aviation, and retail sectors, as well as small service businesses, are likely to see downgrades and defaults. For the most, downgrade and distress is already priced into markets now, with many energy credits trading below 60% of par value and most of high yield trading at distressed levels. We have no energy exploration and production or airline credits in the portfolio, but related sectors, such as electric generation, pipelines, secured aircraft leasing, and hotel real estate combined make up 4.4% of the Limited Duration Fund portfolio. Every credit in which we invest has been subject to a severe stress-test prior to purchase. The portfolio is over 80% high grade (rated A or above), and of our 4.8% in high yield, all but 0.2% is BB, the highest rating tier.
Many of the AAA-rated securities in the portfolio are asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS), which comprise over 40% of the Fund. These notes are secured by legally separate pools of loans and leases and their issuers typically hold 10% to 30% equity of these loan pools beneath our notes. The ABS in the Fund are short, averaging only 1.5 years tenor, and they tend to build equity underneath our exposure over time.
Because of their high perceived credit quality and lower price volatility, short ABS and CMBS have been subject to the same selling pressures as short corporates, serving as a source of liquidity for investors during the present turbulence in credit markets. Selling volumes in ABS have swelled over the last week, pushing compensation available over Treasuries up by about 2% in AAA ABS and CMBS in March.
It is difficult to predict when this wave of selling will end, but the Fund should recover rapidly as soon as spreads stop widening, as these shorter-term instruments are likely to pay their coupons and march toward a par price. The end may arrive by a leveling of Coronavirus cases in the United States, orderly intensive-care units, or a massive government program involving purchases of corporate debt – which appears to be on a list of policy-maker options. But at some point, investors will see the other side. While past performance is no guarantee of future results, each time spreads have moved out this much, returns in the Fund have been outsized in the following months.
In the meantime, we are focused on the aspects we can control. This includes monitoring the durability of credits in the Fund, and the incremental investment of our cash and flow of maturities in our portfolio at these higher yields. There are many high quality credits on offer at extraordinary yields, and a lot of economic uncertainty, so we see little point in going down in credit quality at this point.
We are not pleased to see this kind of market movement materialize. These are price moves that only existed in our most extreme stress tests and the months after Lehman Brothers failed in 2008. Our cash buffer should help us preserve capital while prices reach equilibrium, but the reduction in net asset value (NAV) has been outside of our expectations.
The Portfolio Managers, Partners, and Managing Directors of BBH&Co. have substantial amounts of our own net worth in our managed strategies, including the Limited Duration Fund, and that will remain the case throughout this episode. Rest assured we remain aligned with you and focused on maintaining a portfolio of credits that can mature in an orderly fashion, even in a more severe pandemic scenario.
Thank you for investing alongside us, and we hope you remain safe and healthy through these difficult times.
Neil Hohmann, PhD
Portfolio holdings and characteristics are subject to change.
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, maturity, call, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed.
Bond prices are sensitive to changes in interest rates and a rise in interest rates can cause a decline in their prices.
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 security being structured in ways that give certain investors less credit risk protection than others.
Foreign investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards.
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.
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.
There is no assurance that the Fund’s investment objectives will be achieved.
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.
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