CMBS strategy contributes, but falling rates become headwind

CMBS strategy contributes, but falling rates become headwind

Q2 2021 Putnam Income Fund Q&A

  • Intermediate- and longer-term interest rates declined during the quarter, boosting fixed-income returns across market sectors.
  • Strategies targeting prepayment risk hampered the fund’s relative performance, while exposure to commercial mortgage-backed securities notably contributed.
  • We believe the environment for risk-based fixed-income assets remains generally supportive but also recognize the potential for heightened inflation.

How did the fund perform for the three months ended June 30, 2021?

The fund’s class Y shares returned 0.14%, trailing the 1.83% result of the benchmark Bloomberg Barclays U.S. Aggregate Bond Index.

What was the market environment like during the second quarter of 2021?

After more than a year of pandemic-driven headlines, a massive rollout of Covid-19 vaccines during the second quarter led to an almost full reopening of the U.S. economy. With things slowly returning to normal, there appears to be a significant amount of pent-up consumer demand, which is being further fueled by government stimulus. We see evidence of this, for example, in the most recent consumer confidence levels.

With Covid-19 vaccines greatly reducing the risk of prolonged economic lockdowns, rebounding consumer demand sparked growing concerns about inflation. Despite this, intermediate and long-term U.S. Treasury yields declined during the quarter after rising sharply earlier in the year. The yield on the benchmark 10-year Treasury dropped from 1.74% to 1.45% during the quarter, while the yield on the 30-year Treasury fell from 2.41% to 2.06%. Possible factors behind the decline in rates include strong demand for longer-dated debt from investors overseas, the extent to which the economic reopening is affecting recent inflation data, and the U.S. Federal Reserve’s ongoing bond-purchase program.

Lower interest rates drove fixed-income returns higher across market sectors. Investment-grade bonds managed to recover from losses suffered in the first quarter to post positive performance. High-yield corporate credit did even better, as yield spreads continued to narrow. [Spreads are the yield advantage credit-sensitive bonds offer over comparable-maturity Treasuries. Bond prices rise as yield spreads tighten and decline as spreads widen.]

Financial markets are forward looking. As a result, sectors that previously benefited the most from the reopening of the economy — such as airlines and leisure-related goods/services — declined amid profit-taking and increased inflation risk.

The price of oil rose on global markets by more than 25% during the quarter and, as of June 30, was up roughly 52% for the year, with the summer travel season underway. The prices of other commodities, including lumber, sugar, and corn, also rose markedly during the past year, but cooled off a bit in the second quarter.

Now that the U.S. economy has largely reopened, investors will have a keen eye on corporate earnings during the next few quarters. Market participants will also be watching for any hawkish shift in tone by the U.S. Federal Reserve, should inflation continue to move higher.

Which holdings and strategies hampered the fund’s performance versus the benchmark?

Strategies targeting prepayment risk detracted the most on a relative basis. Faster-than-anticipated prepayment speeds of the mortgages underlying our holdings of interest-only collateralized mortgage obligations worked against their returns this quarter.

The fund’s interest-rate positioning also proved negative. Duration was shorter than that of the benchmark, giving the fund less relative rate sensitivity during a period when interest rates declined.

What about relative contributors?

Exposure to commercial mortgage-backed securities [CMBS] — through cash bonds as well as synthetically via CMBX — notably aided relative performance, as spreads tightened. [CMBX is a group of tradeable indexes that each reference a basket of 25 CMBS issued in a particular year.] Also, bond selection within investment-grade corporate credit modestly contributed versus the benchmark.

What is the team’s near-term outlook?

Overall, we believe the environment for risk assets remains generally supportive. Our optimism is grounded in the rapidly growing percentage of Americans receiving Covid-19 vaccines, sustained government stimulus, and the continuing recovery of the U.S. economy. Risks to our generally constructive outlook include any new negative developments with Covid-19 and policy missteps from global central banks.

In light of expectations for sturdier growth, we believe U.S. Treasury yields could rise further this year. That said, we think the trend toward higher rates will be gradual as bond investors adjust their growth and inflation outlooks, leading to periods of market volatility.

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

Within this environment, we have a positive outlook for the fundamentals and overall supply-and-demand backdrop of investment-grade corporate credit. Our view on valuation is more neutral, however, given the relative tightness of yield spreads as of quarter-end.

In the CMBS market, we believe there are attractive risk-adjusted investment opportunities available amid an improving fundamental backdrop. In our view, borrowers with access to capital will continue to make investments in properties that were performing well before the pandemic hampered their revenue streams.

Near-term inflation expectations are significantly higher than they were prior to the pandemic. We think commercial properties can better absorb inflation pressures compared with other market sectors, such as corporate credit. Consequently, if inflation rises, we believe areas of the CMBS market may offer compelling relative-value opportunities.

Within residential mortgage credit, given low mortgage rates, high demand, and a declining inventory of available homes, we think home prices are likely to continue rising. Even with tighter yield spreads, we have continued to find value in investment-grade securities backed by non-agency residential loans, along with legacy residential mortgage-backed securities and lower-quality segments of the agency credit-risk transfer market.

We believe prepayment-sensitive areas of the market serve as important sources of diversification for the fund. To us, the prepayment sector offers potential benefits in the event of an economic slowdown, changes in fiscal policy, and/or rising interest rates. In our view, many prepayment-sensitive investments offer attractive risk-adjusted return potential at current price levels. In terms of investment selection, we are focused on securities backed by reverse mortgages, jumbo loans, and more seasoned collateral.

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