Bonds rally amid heightened rate volatility

Bonds rally amid heightened rate volatility

Q1 2023 Putnam Floating Rate Income Fund Q&A

  • Fund performance benefited from our security selection in bank loans and positioning in high-yield corporate bonds.
  • We expect the leveraged loan market to generate returns in 2023 above their long-term annual average.
  • Price dispersion will remain high, in our view, creating more opportunities for outperformance given our active, credit-driven strategy.

How did the fund perform for the three months ended March 31, 2023?

The fund’s class Y shares gained 3.14%, slightly underperforming the benchmark Morningstar LSTA US Leveraged Loan Index, which returned 3.25%.

What was the market environment during the first quarter?

Fixed income markets delivered their second consecutive quarter of positive performance amid considerable market volatility. After a strong start in January, markets reversed course in February. This was due to fears that the Federal Reserve might increase interest rates higher than anticipated following the release of rising inflation data and continued labor market tightness in January.

Volatility rose considerably in March, as markets sold off due to a few high-profile bank failures. Quick actions by global central banks to minimize systemic risk, including shoring up bank deposits, prevented contagion across the global financial system. While the turmoil stirred recession concerns, it also led to changing expectations about the future path of Fed monetary policy. Investors hoped that a continued economic slowdown might give the Fed room to ease monetary policy.

With signs that inflation was moderating but still high, the Fed announced 0.25% interest-rate increases on February 1 and March 2. Yields peaked in early March ahead of Fed Chair Jerome Powell’s testimony before Congress about the central bank’s plans for future rate hikes but ended the quarter lower than they were at the start of the year.

Credit spreads widened during the quarter. [Credit spreads are the yield advantage credit-sensitive bonds offer over comparable-maturity U.S. Treasuries. Bond prices rise as yield spreads tighten and decline as spreads widen.] The Bloomberg U.S. Aggregate Bond Index returned 2.96%. High-yield corporate bonds fared even better, with the JPMorgan Developed High Yield Index posting a return of 3.83%. As noted before, floating-rate bank loans, as measured by the fund’s benchmark, delivered a 3.25% gain for the quarter.

Which factors had the biggest influence on the fund’s relative performance?

Security selection within bank loans was sound in the first quarter. The price dispersion of loans increased, meaning the difference between the worst and best performers grew. This presented the team with attractive idiosyncratic opportunities for credit selection and allowed the fund to slightly outperform its benchmark on a gross basis during the period.

The fund also has a tactical allocation to high-yield corporate bonds. Spreads, represented by the JPMorgan Developed High Yield Index, tightened 9 basis points. This was helpful for the fund’s high-yield corporate bond exposure. Going forward, we believe tactical trading will be beneficial, as price dispersion increases, and credit fundamentals show signs of deterioration.

What is the team’s near-term outlook for the bank loan market in the months ahead?

We expect loan price dispersion to remain high, thereby creating more opportunities for fund outperformance given our active, credit-driven strategy.

Loan price dispersion hit 14.35% at the end of March. The first quarter of 2023 witnessed 12 company defaults, impacting $18.4 billion in bonds and loans. The fund, however, did not experience any defaults during the quarter. We believe the U.S. leveraged loan market may be at, or very close to, a price dispersion inflection point, when loan prices will begin a sustained recovery. We expect the U.S. leveraged loan market to generate returns in 2023 that are above their long-term annual average. In this environment, prudent credit selection will be an important driver of alpha. Most non-investment-grade issuers continue to be challenged by inflationary pricing and a more discerning consumer, which has squeezed profit margins.

More broadly, we expect volatility to continue across fixed income markets given macro-driven risks, including a further tightening of monetary policy, ongoing geopolitical turmoil, and the impact of higher interest rates on all debt market activity.

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