Q3 2023 Putnam Floating Rate Income Fund Q&A
- Security selection within bank loans was the key driver of fund performance.
- Floating-rate loans continue to provide stability against interest-rate volatility.
- We expect loan price dispersion to remain elevated, presenting new, attractive investment opportunities.
How were market conditions in the third quarter?
Persistent volatility challenged bond markets. In July, U.S. bond yields rose after the Federal Reserve raised interest rates by 0.25%. The cost of borrowing climbed to a 22-year high of 5.25%–5.50%. Inflation eased, and the U.S. economy continued to grow. The probability of a near-term recession declined, and risk assets rallied. Investment-grade [IG] and high-yield credit spreads began to tighten. [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.] In August, the yields on U.S. Treasuries soared after Fitch Ratings downgraded the U.S. government’s credit rating.
In September, the Fed held interest rates steady but indicated one more rate hike was possible in the fourth quarter. U.S. inflation remained above the central bank’s target rate of 2% and supported its rhetoric to keep rates higher for longer. Investors pushed expectations for a U.S. recession to mid–2024.
Floating-rate loans outperformed other fixed income markets for the third quarter. The Morningstar LSTA US Leveraged Loan Index, the fund’s benchmark, returned 3.43%. IG corporate bonds, as measured by the Bloomberg U.S. Corporate Bond Index, returned –3.09%. High-yield corporate bonds, as measured by the JPMorgan Developed High Yield Index, fared better, with a return of 0.71%. The yield on the 10-year U.S. Treasury note increased from 3.84% on June 30 to 4.59% on September 29. Short-term yields rose even more, keeping the yield curve inverted.
How did the fund perform for the three months ended September 30, 2023?
The fund’s class Y shares returned 2.98%, underperforming the Morningstar LSTA US Leveraged Loan Index.
Which factors had the biggest influence on the fund’s relative performance?
Security selection within bank loans was the key driver of fund performance for the third quarter. While the summer months are typically quieter in the loan market, secondary market activity was robust, which benefited the fund’s tactical loan positioning.
Loan price dispersion [a proxy for risk that is calculated as one standard deviation of loan prices in the benchmark index divided by the index level] rose to 14.86% in May and declined to 12.31% in September, its lowest reading year to date. Consistent with previous periods of significant credit volatility, once loan price dispersion inflects downward from such elevated levels, a longer-term recovery is underway. Moreover, the recovery marches through a period of rising defaults as investors gain confidence for a lower expected default environment.
What is the team’s near-term outlook for the bank loan market?
Floating-rate loans continue to provide stability against interest-rate volatility. If inflation remains high, loans will benefit from higher rates, with elevated SOFR [Secured Overnight Financing Rate] levels providing higher yields. On the other hand, if inflation falls and the Fed begins to reduce rates, floating-rate income will decrease, but prices will generally remain stable.
With loan price dispersion expected to remain elevated, attractive investment opportunities have presented themselves, in our view. That said, prudent credit selection will be an important driver of alpha [excess return on investment relative to the return of a benchmark index]. Most non-IG issuers continue to be challenged by shrinking profit margins due to inflationary pricing and a more discerning consumer. However, we are encouraged by the resiliency of our portfolio companies. Many companies have adopted operational measures to preserve cash flows and maintain durable balance sheets to counter macro-driven headwinds.
We believe confidence is coming back to the leveraged loan market. The loan market currently offers better yields than the high-yield bond market. This is important because while both provide debt exposure to non-IG borrowers, the loan market is senior in the capital structure and secured, while the high-yield bond market is primarily unsecured. The yield to maturity, or the total return anticipated if the bond is held to maturity, was 10.3% for leveraged loans compared with 9.0% for high-yield bonds as of quarter-end.
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