Bonds see mixed results amid Fed policy uncertainty

Bonds see mixed results amid Fed policy uncertainty

Q2 2023 Putnam Income Fund Q&A

  • Positioning in mortgage and corporate credit augmented returns relative to the benchmark.
  • We believe the Fed is nearing the end of its monetary tightening cycle but will stay vigilant in its efforts to tackle inflation.
  • The fund remains positioned at the lower end of the risk spectrum, with lower spread duration across credit sectors.

How were market conditions in the second quarter?

Market conditions were mixed. Fixed income rallied in April 2023. Even as a U.S. recession remained a possibility, expectations about the future path of the Federal Reserve’s monetary policy changed. Investors hoped a continued economic slowdown might give the Fed room to ease monetary policy.

In May, fixed income encountered headwinds. Lingering concerns about the failure of a few regional banks in March 2023, the U.S. debt ceiling, and higher U.S. Treasury rates weighed on investor sentiment. At its May 2023 meeting, the Fed raised its benchmark interest rate by 0.25% to a range of 5.00%–5.25%. In its commentary, the Fed suggested that future interest-rate hikes would be dependent on the effect of past rate hikes on the economy. In late May, Congress and the White House agreed to a debt ceiling deal.

In the final weeks of the quarter, sentiment improved. A cooler-than-expected inflation reading for May 2023 led to expectations that the Fed might hold interest rates steady at its June meeting. At that meeting, the Fed skipped an interest-rate hike to allow time to assess the effects of its monetary policy and to potentially avoid tipping the U.S. economy into a recession. Fed policymakers added that two more interest-rate hikes remained a possibility this year.

Credit spreads mostly tightened 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. Corporate Investment Grade Index returned –0.29%, while the JPMorgan Developed High Yield Index returned 1.86%.

How did the fund perform for the three months ended June 30, 2023?

The fund’s class Y shares returned –0.61%, outperforming the benchmark Bloomberg U.S. Aggregate Bond Index, which returned –0.84%.

Which strategies and holdings had the biggest influence on fund performance relative to the benchmark?

Mortgage credit strategies were positive for returns in the second quarter, thanks to the fund’s exposure to both residential and commercial mortgage credit. Within residential mortgage-backed securities, positioning in credit risk transfer securities continued to be a tailwind. Market spreads tightened across the capital stack due to the well-positioned U.S. homeowner balance sheet, very limited supply of available homes, and generally uninterrupted access to mortgages even through the regional banking crisis. [Capital stack is the structure of all debt issued in a deal across the credit rating spectrum.] This limited the likelihood of a distressed housing scenario, in our view. Meanwhile, the commercial mortgage-backed security [CMBS] market stabilized somewhat after the bank stress experienced in March and benefited from higher yields.

Within our corporate credit strategies, exposure to high-yield corporate credit and collateralized loan obligations [CLOs] also helped relative returns, along with positioning in investment-grade corporate credit. High-yield and investment-grade corporate spreads, represented, respectively, by the JPMorgan Developed High Yield Index and the Bloomberg U.S. Corporate Investment Grade Index, tightened 64 basis points [bps] and 15 bps during the period. Additionally, exposure to high-grade CLOs aided relative returns, as underlying loan price recovery benefited the portfolio’s positioning in CLOs rated AAA and AA.

What is the team’s near-term outlook?

We believe the Fed is nearing the end of its monetary tightening cycle but will stay vigilant in its efforts to tackle inflation. Volatility may persist in fixed income markets, in our view. High interest rates are likely to weigh on corporate balance sheets while the financial market digests the probability of a recession. With this scenario in mind, the fund remains positioned at the lower end of the risk spectrum, with lower spread duration across credit sectors.

What are your current views on the sectors in which the fund invests?

U.S. Treasury rates traded up and down within a rather wide range in the first half of 2023. We expect this to continue in the near term. Currently, we do not expect the Fed to cut interest rates in 2023.

We have a cautious view on the U.S. investment-grade corporate credit market, although we continue to find pockets of idiosyncratic opportunities. Corporate fundamentals were better than feared in the first half of 2023. Market technicals also held up well. Domestic inflows were strong, while supply was manageable. At the end of the second quarter, valuations were trending in neutral territory, with investment-grade yield spreads largely unchanged year to date. [Yield spreads are the yield advantage credit-sensitive bonds offer over comparable-maturity U.S. Treasuries. Bond prices rise when spreads tighten and fall when spreads widen.] While spreads are still well inside of recessionary levels, we are seeing more divergence across sectors, with banks underperforming after the sector’s turmoil this past spring. Risks to our outlook include macroeconomic forces of high inflation, central bank tightening, slowing growth, and geopolitical impacts on energy supplies.

Commercial real estate is facing meaningful headwinds and increased risks, in our view. We believe the risk of recession remains relevant through 2024, as the Fed continues to combat inflation by raising the cost of capital. Recent bank turmoil will likely result in a tighter lending channel and higher capital costs. We believe property types that can adjust rents [e.g., hotels and apartments] will hold their value better, while property types with longer leases and greater exposure to rising capital costs and/or needs for capital investment will face pressure. We believe some of these risks are priced into the CMBS market, which has experienced significant credit spread widening. The most attractive relative value opportunities require detailed analysis and security selection.

U.S. homeowner balance sheets are solid, in our view. They are supported by a combination of locked-in, ultra-low mortgage rates and the substantial home price appreciation they have experienced in recent years. We expect home prices will be flat in 2023, followed by tepid growth in subsequent years, as affordability pressures limit demand and supply gradually increases. Residential mortgage credit spreads widened significantly in 2022 and continue to offer attractive risk-adjusted return opportunities despite some tightening in 2023.

The fund had a neutral-to-slightly long mortgage basis position. [Mortgage basis is a strategy that seeks to exploit the yield differential between current-coupon, 30-year agency pass-throughs, and 30-year U.S. Treasuries.] Uncertainty related to bank demand remains a focus. However, the FDIC’s sale of mortgage holdings following the failure of two U.S. regional banks in March 2023 has seen robust interest, which has been encouraging. We remain tactical and actively trade the basis as new information emerges and events occur.

In our view, many prepayment-sensitive assets now offer an attractive risk-adjusted return at current price levels and significant upside potential if interest rates stabilize and volatility declines. Certain subsectors offer the potential for more upside if prepayment speeds slow further.

See the fund’s information page.

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