Q2 2022 Putnam Income Fund Q&A
- The poor performance of risk assets seen in the first quarter of 2022 continued in the second.
- Overweight allocations in investment-grade and high-yield corporate credit detracted versus the benchmark, while prepayment-related and mortgage-credit holdings contributed.
- We have a generally cautious outlook, given tightening monetary policy and concerns about the Fed’s ability to successfully engineer a “soft landing” for the U.S. economy.
How did the fund perform for the three months ended June 30, 2022?
The fund’s class Y shares returned –5.36%, trailing the –4.69% result of its benchmark, the Bloomberg U.S. Aggregate Bond Index.
What was the market environment like during the second quarter of 2022?
The poor performance of risk assets seen in the first quarter of 2022 continued in the second. Ultimately, there was no place to hide as both equity and bond markets saw broad-based losses due to stubbornly high inflation, increasingly hawkish central bank rhetoric, and geopolitical tensions stemming from Russia’s invasion of Ukraine.
Similar to the first quarter, U.S. Treasury yields rose and the yield curve flattened. Yield spreads widened for both investment-grade [IG] and high-yield [HY] corporate 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 May, the U.S. Federal Reserve approved a half-percentage-point increase in the federal funds rate. It also announced plans to shrink its $9 trillion asset portfolio starting in June, with up to $30 billion in Treasuries allowed to run off [that is, bonds mature and the proceeds are not used to purchase more bonds] in June, July, and August, followed by $60 billion in subsequent months. At their June meeting, Fed officials concluded that they needed to pick up the pace of interest-rate increases because the inflation outlook had deteriorated and, as a result, rates would need to rise to levels designed to deliberately slow economic growth. Consequently, they implemented a 0.75% hike, the largest since 1994.
From a sector perspective, all fixed income categories posted losses. Government-agency securities and securitized categories, such as commercial mortgage-backed bonds and asset-backed securities, held up better than the broad fixed income market. IG and HY corporate credit, meanwhile, were among the weakest performers, given rising interest rates and investor risk aversion.
After surging 35% in the first quarter, U.S. oil prices continued to climb in the second, closing the quarter 10% higher at $105 per barrel.
Which holdings and strategies had the biggest influence on the fund’s performance versus the benchmark?
Given the poor performance of IG and HY credit during the quarter, overweight exposure to these areas worked against the fund’s relative results.
On the plus side, strategies targeting prepayment risk added the most value, driven by holdings of agency interest-only collateralized mortgage obligations [IO CMOs], as well as inverse IO securities. These positions benefited as the higher interest-rate environment led to reduced mortgage refinancing activity and slower prepayment speeds on the underlying securities.
Mortgage credit holdings also helped, led by an allocation to commercial mortgage-backed securities [CMBS]. Our investments consisted of cash bonds along with synthetic exposure via CMBX. By way of explanation, CMBX is a group of tradeable indexes that each reference a basket of 25 CMBS issued in a particular year. Despite concerns about the broad economic backdrop, many types of commercial properties continued to recover. Cash flow forecasts continued to improve, boosted by growth in rents and occupancy rates. Favorable supply/demand dynamics also aided CMBS.
What is the team’s near-term outlook?
In light of tightening monetary policy, higher interest rates, and less liquidity in the marketplace, we have a cautious outlook. We anticipate continued bouts of volatility given the conflict in Ukraine, the pace of Fed rate hikes, and potentially negative effects on energy supplies from sanctions on Russia. We’re also concerned about lingering supply chain disruptions. There is also considerable uncertainty surrounding the Fed’s efforts to contain inflation without pushing the U.S. economy into recession. Moreover, while consumer balance sheets are generally in good shape, in our view, inflation-adjusted wages are beginning to decline.
Markets have quickly discounted multiple rate hikes at upcoming Fed meetings, and U.S. Treasury yields have risen significantly across the curve. Given the upsurge in rates and the number of rate increases already reflected in the market, we believe Treasury yields could stabilize periodically as growth concerns begin to build. However, the Fed will remain data dependent, and more rate increases could be priced in.
What are your current views on the major sectors in which the fund invests?
Looking first at corporate credit, our view is moderately constructive. We have a positive outlook for market fundamentals and believe valuations have improved for both IG and HY credit. However, the supply/demand backdrop is less favorable than it was last year.
We believe the fundamental environment will continue to improve in the CMBS market as workers return to offices, consumer traffic increases at retailers, and hotels welcome back business and leisure travelers. Moreover, with real assets serving as collateral, along with the potential for rent adjustments, CMBS have historically performed well during periods of rising inflation. Consistent with risk markets generally, CMBS spreads have widened during 2022. In our view, the increased liquidity premium has enhanced the appeal of select market segments. At the same time, we think the sector will face headwinds as borrowing costs rise and property values are pressured.
Given that home prices have already risen substantially and mortgage rates have moved up, we are aware that affordability has become a constraint for many prospective buyers. Consequently, we think the pace of home price appreciation is likely to moderate during 2022. Within residential mortgage credit, wider spreads have created better value among mid-tier and lower-rated securities. As of quarter-end, we were finding attractive investment opportunities in those areas of the market, as well as among seasoned collateral that has benefited from higher home prices.
With the Fed beginning the process of reducing the mortgage assets in its portfolio, we believe many prepayment-sensitive securities may offer attractive risk-adjusted returns at current price levels and prepayment speeds. Many of these securities may also offer meaningful upside potential if mortgage prepayment speeds continue to slow. An uptick in demand for alternate loan products that allow homeowners to access equity in their homes, such as home equity lines of credit, could be a catalyst for prepayment speeds to slow further. We think the fund’s prepayment-related strategies provide an important source of diversification in the portfolio. In light of last year’s repricing across the market, we were finding value within a variety of collateral types.
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