Every investor needs a port in the storm when market conditions turn bad, as they did in 2008. High-grade fixed income can provide that safety, says Peter Coffin, founder and president of Breckinridge Capital Advisors in Boston.
Breckinridge has been providing high-grade fixed income in separately managed accounts for some 20 years. Recently, Coffin and his investment team moved their game up a notch by introducing a formal sustainability-modeling framework that rates corporate and municipal bonds in its portfolios.
They did this after concluding they could mitigate a borrower’s risk by assessing how environmental, social and governance factors impacted future costs. “We believe that future costs associated with unsustainable practices have to be recognized and reflected in the price of the bond,” he says.
Coffin was managing a large municipal bond portfolio at an East Coast mutual fund company in the early 1990s when he decided to start his own firm. “I believed I could deliver a better product at a better price,” he says. He thought a separately managed account was a better vehicle for high-grade fixed income and for sizable investors. It could be customized, and there was an advantage to owning bonds directly and having a more predictable and reliable cash flow.
He was also growing concerned that the fee structure his firm was offering might not be viable over the long term. “I thought one needed to deliver high-grade, fixed-income management more efficiently,” he says.
By 1993, the advent of “Bloomberg Box” data and other tools had leveled the playing field, allowing a solo player to hang out a shingle. Coffin started Breckinridge Capital Advisors in Boston with a focus on tax-free municipal bonds offered in separate accounts to taxable investors, mainly individuals.
Early on he found that working through dealer platforms and a national network of consultants and RIAs rather than directly with individual clients was the most effective way for a relatively unknown manager to gather assets, and Breckinridge continues to employ that business model. Today, the firm manages some $18 billion—$16.5 billion for individuals and the rest for institutions and businesses.
High-Grade Fixed Income
Breckinridge offers high-grade, fixed-income strategies exclusively. The majority of assets are in municipal bonds, along with corporate bonds, Treasurys, supranational bonds and agencies. “Every investor at some level needs a foundation of their portfolio that provides a safe, reliable source of capital,” Coffin says. “High-grade, fixed-income management needs an approach that’s faithful to that.”
Remaining true to that mandate paid off during and after the financial crisis, he says. “We got through it quite well and had good performance because we hadn’t strayed into a lot of the strategies or practices that got people into trouble,” he says. On the credit side, Breckinridge scrutinized underlying obligors and did due diligence on the credit. On the interest rate side, it said it ran an intermediate strategy.
When disruption hit the market, Breckinridge’s transparency in its separate accounts helped allay clients’ anxiety. Coffin would explain to them why the bond issuers in their portfolio were safe, reliable borrowers and were going to continue to pay principal interest when it was due.
Mitigating Risk
Two years ago, Coffin and his investment team decided to develop a formal sustainability modeling framework for rating municipal and corporate bonds. “Sustainability to us is all about trying to know our borrower better,” says Coffin. In fact, he says, the firm has always integrated ESG considerations into its research because municipal bonds often align with a sustainable mission. Many water and sewer bonds, for example, improve the environment by bringing local systems into compliance with EPA standards by cleaning up rivers and streams.
The Breckinridge investment team looks at three things that support credit quality in municipal bonds: the financial resources and ability to pay; the security structure that protects a bondholder; and the taxpayer support, which says amounts to a willingness to pay.
“The more focused a project is on something that’s core to the government’s providing for the education, health care and well being of its citizens, the safer the bond is,” Coffin says. Defaults in the municipal bond market often involve stadiums, housing projects and industrial developments where public support was ambivalent, he notes.
As the firm ventured more into the corporate market, the investment team realized that looking beyond a borrower’s financial fundamentals to ESG factors would help identify risks within a company’s operating model. “When we invest in corporates, we’re nervous because corporations are riskier than municipals historically,” says Coffin. “We want to be careful and look beyond just recent financial results.”
Corporate bonds are subject to “event risk,” which may take the form of regulatory, litigation or reputational risk. Management risk is when, for example, management suddenly decides to lever up its balance sheet or do an acquisition that may diminish creditors’ security. “Municipal bonds have their problems, but they tend to be slow train wrecks,” says Coffin. “A corporate credit can deteriorate much more quickly.”
The Breckinridge investment team thinks a company with a diversified board and separate chairman and CEO roles may be more accountable. If executive pay is not off the charts, the board is likely to be stronger and exercise better oversight. Similarly, a company may be less likely to behave recklessly and irresponsibly toward the environment if it sets hard targets for reducing its carbon footprint or its water consumption or in some way establishes firm, measurable targets that demonstrate it’s trying to be more sustainable.
Rating The Issuers
By mid-2012, the investment team had developed a sufficient understanding of ESG risks to include a sustainability analysis in every research report.
Breckinridge’s sustainability model uses 16 metrics and five categories of factors to evaluate state and local government issuers, plus additional measures for corporate borrowers. It aggregates data from MSCI, Bloomberg and Sustainalytics and combines these with proprietary measures to evaluate extra-financial ESG factors.
Breckinridge ranks bond issuers from S-1 (acceptable social/environmental and minimal environmental, economic, social and governance risks) to S-4 (unacceptable social/environmental and high EESG risks).
At present, the firm manages some $100 million for investors who have said they want a high standard of sustainability in their portfolios. Every bond must be rated S-1 or S-2, or it can be an S-3 that has demonstrated a significant improving trend. “Then the question is, what about in the rest of the money we manage?” says Coffin. “Why are we noting whether something is an S-1 or an S-4? The reason is that it does play a role.”
Can Breckinridge buy an S-4 bond? “In theory, yes,” he says. “But in practice, we would have to feel compensated for that risk because we think that all else being equal, an S-4 is riskier than an S-1.” He says the question is whether the market is paying it for the lack of sustainability. The answer in most instances is no, not enough. But there’s no hard rule. Take Berkshire Hathaway, which does not score highly. “And yet, we have a pretty reliable company. We would not exclude Berkshire bonds, nor would most of our clients want us to. The vast majority of our clients want us to assess risk relative to return, and they want us to use our best judgment. Sustainability for the vast majority is just another metric.”
Breckinridge is educating its clients about sustainability investing in high-grade fixed income, and is seeing an upward trend in gathering assets into that pot. “We think it’s a very easy entry point for an institution or individual who wants to consider sustainability, but has been reluctant to jump in with both feet, especially on the equity side, for fear of reducing their returns,” he says.
Coffin notes that the priority for investors in high-grade fixed income is minimizing risk, not enhancing return. “Sustainability aligns well with that investment objective,” he says. Because returns are independent of the market, the investor can look beyond short-term market results, more so than an equity manager who depends on the market to get his capital back.
Ranking bond issuers on ESG factors is not about screens, Coffin says. “We say we want to reward good actors. We say this is something that can help focus on companies that may be exposed to uncertainties and risks,” he says.
What if an investor wants a specific ESG focus? “Sustainability is all about having a conversation with the investor and what matters to them,” says Coffin. Breckinridge generally will provide the desired bias, he says, but only to the extent that the manager remains confident that the portfolio has ample diversity and an opportunity to achieve a return that’s in line with the rest of the portfolios it manages with those objectives.
Current Bond Market Environment
A high-grade, fixed-income manager’s job these days is not easy. “It’s a market that’s not functioning like a market because the yields are engineered by central banks, and so fundamentals have taken a back seat,” says Coffin. “That makes it very difficult to manage a portfolio in a period when you know interest rates, especially out in the five-, 10-, 15-, 20-year maturity range, are not reflecting underlying fundamentals.” Investors, he says, are boxed in and this circumstance could persist longer than anyone would have expected.
“Our job is to manage portfolios,” says Coffin. “Part of managing portfolios in terms of interest rate risk is to try to keep the right balance.” This means that if 1% or lower 10-year government bond yields persist for more than a decade (see Japan), Breckinridge has hedged that risk by maintaining exposure out on the longer end. Conversely, if inflation and interest rates rise faster and higher than people expect, the firm is not too locked in. He thinks a five-year average maturity, which is Breckinridge’s typical portfolio, is the right balance—a neutral exposure.
Coffin doesn’t subscribe to the notion of a bond bubble. “Bubbles are people chasing returns, and I don’t get that sense. There’s a healthy level of angst in the market. But again, it’s not functioning like a market because you’ve got the Chinese, the Japanese and Bernanke really manipulating it. People sense that,” he says.
At the same time, investors ask him, why be in this asset class in such a low-return environment. Coffin’s response harks back to the reason he started Breckinridge: “In some respects in high-grade fixed income, our role is to enable investors to pursue higher returns in alternative asset classes,” he says. “You need some portion of your portfolio you can feel confident in when the world looks like it’s turning to dust. A separate account of individual bonds that are paying principal and interest and have a reliable cash flow enables investors—individuals and institutions—to venture into more aggressive investments where there’s hopefully higher returns.”
