Fund outperforms as Fed turns attention to cutting rates

Fund outperforms as Fed turns attention to cutting rates

Q4 2023 Putnam Floating Rate Income Fund Q&A

How were market conditions in the fourth quarter?

While mixed economic data and geopolitical concerns persisted during the fourth quarter, there is increasing optimism about the U.S. Federal Reserve’s ability to achieve a soft landing. In addition, investors closely monitored central bank actions and policymakers’ comments for hints of when the Fed may begin to cut the federal funds rate. For the quarter, corporate credit spreads were tighter than recent averages while the Morningstar LSTA US Leveraged Loan Index marched 150 bps higher to end the year at 96.2.

The Fed left the policy rate unchanged at its November and December meetings. Data showed growth had eased and the labor market had moderated, although the unemployment rate remained low, at 3.7%. Inflation continued to ease but remained above the central bank’s target. In the final weeks of the period, Fed Chair Jerome Powell reiterated that the central bank would continue to be dependent on incoming economic data. At the same time, the Fed’s outlook suggested that rate cuts may be considered in 2024. The 10-year U.S. Treasury note yield of 4.59% on September 29 rose to new highs briefly during the fourth quarter, before declining to 3.88% on December 29.

Floating-rate loans had a positive return but underperformed fixed income markets for the fourth quarter owing largely to the strong shift in the expected path for rates. The Morningstar LSTA US Leveraged Loan Index, the fund’s benchmark, returned 2.84%. IG corporate bonds, as measured by the Bloomberg U.S. Corporate Bond Index, returned 8.50%, and high-yield corporate bonds, as measured by the JPMorgan Developed High Yield Index, returned 6.82%.

How did the fund perform for the three months ended December 31, 2023?

The fund’s class Y shares returned 3.17%, outperforming the Morningstar LSTA US Leveraged Loan Index by 33 bps.

Which factors had the biggest influence on the fund’s relative performance?

Credit selection and, more specifically, our fundamental conviction and HOLD ratings for several companies with loans trading in the 80s, were key factors in the strong Q4 performance. The fund benefited in the quarter from fifteen positions that traded up by five points or more. The largest gain was 8.5 points. These results compared with only three positions that traded down by five or more points. The largest decliner was down 10 points. Of note, 11 of the 15 top gainers were corporate bonds. The fund maintained 9.0%–10.5% corporate-bond exposure throughout the year.

What is the team’s near-term outlook for the leveraged loan market?

During much of Q4 2023 and even early 2024, technical conditions have been quite supportive of leveraged loans. Mutual fund flows have turned positive, collateralized loan obligation (CLO) formation has picked up, and Q3 2023 earnings were encouraging, for the most part. Looking ahead, we believe CLO issuance will be noticeably higher in 2024, owing in no small part to the return of domestic banks as a key investor bloc for AAA liabilities, which should help to restore a favorable cash flow arbitrage for the equity investor. In terms of retail fund flows, we anticipate balancing effects as investors weigh a variety of potentially competing factors, such as the persistence of attractive yields — currently 9.5% — and the positive fundamental impact on leveraged issuers of future rate cuts (lowering debt service costs), against recent Fed guidance of a shift in its rate stance, which is likely to bring the basis or “floating” component of returns lower.

Our twelve-month outlook for loan defaults (including actual defaults and distressed exchanges that result in par losses) across the asset class is 3.75%–4.00% compared to 3.2% currently. It is important to note that general market consensus of expected defaults has come down over the past twelve months. Moreover, loan price volatility has decreased steadily from a peak of 13.7% in April 2023 to 11.5% at year-end. The inflection point in this metric (defined as one weighted standard deviation of loan prices in the Morningstar LSTA US Leveraged Loan Index divided by the Index level) has historically marked the beginning of a sustained recovery in the asset class. This is what we saw in 2023.

Net new issuance remains subdued. In fact, the leveraged loan market contracted in 2023, the first contraction since 2010. Debt issuers are primarily focused on refinancing near-term maturities and taking advantage of tightening spreads to reprice loans lower. With nearly 70% of the loan market trading at 99+, we are expecting the repricing/refinancing wave to continue, which should keep prices range-bound. Stress in the loan market will remain idiosyncratic, and prudent selection of credits remains critical, but overall, we are constructive on loans and see potential for a 9%–10% return year.

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