We may look back on early 2019 as an inflection point for fixed-income markets, as the Fed communicates a more patient policy stance and yields have been mostly range-bound. Investors seeking income may need to look for new opportunities for income generation and diversification.
Securitized bonds represent a largely untapped sub-sector of fixed income beyond the BBG Barclays Aggregate Bond Index. They offer the potential to pursue different risk exposures in a portfolio.
Underutilized fundamental diversification
Securitized debt derives returns primarily from mortgage credit and prepayment risk. The Fixed Income team at Putnam Investments continues to find securitized debt an attractive way to complement, and even replace, exposure to corporate, government, and other types of traditional fixed-income sectors.
Michael Salm, Co-Head of Fixed Income at Putnam, has expertise in securitized debt and has utilized them as a Portfolio Manager of Putnam Income Fund (PNCYX), a fund recently recognized by Lipper with a Fund Award for superior 10-year performance in its Core Bond category. Salm highlights three key securitized subsectors:
- Commercial mortgage-backed securities (CMBS) includes both investment-grade securities that are a small piece of the Aggregate Index, and subordinated BB- or BBB-rated securities. Putnam’s team believes the latter offers a particularly attractive opportunity in part because of excessive pessimism about commercial real estate.
- Non-agency residential mortgage-backed securities (RMBS) is a sector with less than $500 billion in market value (and it is shrinking due to no new issuance), but offers many securities with attractive spreads.
- Agency collateralized mortgage obligations (CMOs), such as interest-only and principal-only bonds (IOs and POs), inverse floaters, and inverse IOs, allow a manager to isolate the prepayment risk premium. Each of these structures comes with its specific return profile and risks, which require specialized expertise on the part of the manager.
By adding securitized debt into a broader asset allocation framework, Salm sees an opportunity to diversify and balance a fixed-income portfolio, while also potentially improving returns.
Different from traditional high yield or EM debt diversifiers
Putnam has developed expertise in securitized debt because of its philosophy of constructing portfolios that feature broad investment diversification. Instead of focusing on sectors, the teams at Putnam look to allocate efficiently to four types of risk — interest rates, credit, prepayment, and liquidity.
“Our sector specialists are tasked with allocating by risk, investing where they perceive relative value within sectors and in individual securities and where they believe they are being adequately compensated for the risks they take,” says Salm.
Currently the team finds various securitized sectors to be attractive from an overall valuation perspective, as well as versus other competing risky fixed-income assets. Yields and expected returns in securitized bonds compare favorably to high-yield corporate credit and emerging-market debt.
The patient Fed of 2019
Income investors are looking at a different environment compared with a year ago, when tax cuts lifted GDP growth to levels of 4.2% in the second quarter. While growth in the fourth quarter of 2018 was still strong at 2.6%, it has decelerated to just over 2%.
At their March meeting, the Federal Open Market Committee (FOMC) reiterated the neutral stance on interest rates that they began to discuss at the beginning of the year, partially in response to the sell-off in risk assets. Equity markets have rallied during the first couple of months of 2019, and bond yields have been mostly stable.
A balanced strategy for a late-cycle expansion
The Fed is navigating the same terrain as income investors — the deceleration of the global economy with low inflation amid persistent geopolitical uncertainties. In Putnam Income Fund, which is benchmarked against the Aggregate Index, the team tries to balance the four sources of risk where they routinely hunt: interest rates, credit, prepayment, and liquidity. This distinguishes the fund from its benchmark. “A byproduct of our process is low correlation to the Agg,” Salm notes.
Diversification for the road ahead
Balanced diversification may make sense given this economic backdrop. More traditional go-to diversifiers such as high yield and emerging-market debt may be relatively unattractive towards the end of an economic cycle. Securitized debt provides an exposure to a different source of returns — the household balance sheet — than either corporate or government bonds, as well as a history of low correlations to other areas of fixed income and equities.
Diversification does not guarantee a profit or ensure against loss. It is possible to lose money in a diversified portfolio.
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