Credit holdings contribute but falling rates become headwind

Credit holdings contribute but falling rates become headwind

Q2 2021 Putnam Diversified Income Trust 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 performance, while investments in high-yield corporate and mortgage credit 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 -1.48%, trailing the 0.00% result of its cash benchmark, the ICE BofA U.S. Treasury Bill Index. The fund also lagged the broad investment-grade fixed-income market, as measured by the 1.83% result of the 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 headlines subsiding, 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 note 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 stand to benefit the most from the reopening of the economy — such as airlines and leisure-related goods/services — declined after posting strong gains during previous quarters in anticipation of reopening.

The price of oil on global markets rose 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 Fed, should inflation continue to move higher.

Which holdings and strategies hampered the fund’s performance?

Strategies targeting prepayment risk detracted the most this quarter. Faster-than-anticipated prepayment speeds of the mortgages underlying our holdings of interest-only [IO] and inverse IO collateralized mortgage obligations worked against their returns. Our mortgage-basis positioning — a strategy that reflects our view on the yield differential between prevailing mortgage rates and U.S. Treasuries — was another headwind amid an environment of falling interest rates and a flatter yield curve.

Our active currency strategy also detracted. A short position in the euro, which strengthened against the U.S. dollar, hurt our positioning, as did long exposure to the weakening Australian dollar and Norwegian krone. A long position in the advancing Swedish krona provided a positive offset to the overall negative impact of our strategy.

What about contributors?

Corporate credit was the largest contributor in the second quarter. Consistent investor demand for yield boosted high-yield bonds, while convertible securities benefited from stock market strength.

Our mortgage-credit holdings also meaningfully aided performance. Commercial mortgage-backed securities [CMBS] — both cash bonds and synthetic exposure via CMBX — as well as agency credit-risk transfer [CRT] securities, performed well as spreads tightened. [CMBX is a group of tradeable indexes that each reference a basket of 25 CMBS issued in a particular year.]

Positions in emerging-market debt provided a further lift, led by bonds issued by the government of Argentina. Holdings in Brazil, Egypt, Ghana, and Senegal also added value.

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 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?

Looking first at corporate credit, we have a positive outlook for the fundamentals and overall supply-and-demand backdrop for high-yield bonds. Our view on valuation is more neutral, however, given the relative tightness of yield spreads as of quarter-end. Within the high-yield market, we are continuing to closely monitor issuers’ balance sheets and liquidity metrics, with an eye toward default risk or a credit-rating downgrade.

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 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 CRT 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.

In non-U.S. sovereign debt in both developed and emerging markets, we think the economic recovery will be strongest in countries with large service sectors and effective vaccine distribution. We also prefer countries that can contain government expenditures despite political pressures to raise them.

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