Loans outperform most fixed income assets amid market turbulence

Loans outperform most fixed income assets amid market turbulence

Q2 2022 Putnam Floating Rate Income Fund Q&A

  • Despite posting negative performance, leveraged loans outpaced most other credit-sensitive fixed income categories amid increasing economic uncertainty.
  • Positioning in housing, along with security selection in technology and diversified media, detracted from relative performance this quarter. Positioning in food & beverages, as well as underweights in retail and telecom, aided relative results.
  • We have a moderately positive outlook for the loan market overall, but in light of multiple uncertainties, we anticipate continued bouts of volatility.

How did the fund perform for the three months ended June 30, 2022?

The fund’s class Y shares returned –5.46%, trailing the –4.45% result of the benchmark S&P/LSTA Leveraged Loan Index.

What was the fund’s investment environment like during the second quarter of 2022?

The period began on a positive note. While other asset classes remained in negative territory after a challenging first quarter, loans registered a slight gain in April. A shift to a more restrictive interest-rate policy by the U.S. Federal Reserve sparked demand for floating-rate debt.

The market context changed markedly in May. Loans declined sharply amid mounting concerns about the ability of corporations and consumers to withstand rising inflation, higher interest rates, and tighter monetary policy. Against this backdrop, loan funds [mutual funds and exchange-traded funds] experienced their first outflows in 18 months.

The asset class fell further in June. Investors shifted their focus to risks of slowing economic growth and possible recession as the Fed announced plans for larger rate increases at upcoming policy meetings. Heavy withdrawals from loan funds continued. Concerns about growth also fueled a moderate dispersion across industry groups, with sectors such as housing, consumer products, and telecommunications lagging.

For the quarter overall, despite registering a negative return, loans handily outpaced high-yield corporate bonds and also topped investment-grade credit.

Within the fund’s benchmark, all industry cohorts posted losses, although utilities, energy, and cable & satellite held up considerably better than the index, with each group returning about –1%. Retail [–6%], housing [–5%], and consumer products [–5%] were the biggest laggards. From a credit-rating perspective, lower-quality loans were the poorest performers, reflecting investor risk aversion. Meanwhile, mid-tier and higher-quality credits outperformed the benchmark.

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

Overall positioning in housing, along with security selection in technology and diversified media, hampered performance versus the benchmark. On the plus side, positioning in food & beverages, as well as underweight allocations in retail and telecom, modestly contributed.

What is the team’s outlook for the bank loan market over the coming months?

We have a moderately positive outlook for the loan market. However, in light of tightening monetary policy, the ongoing war in Ukraine, and lingering supply chain disruptions due to Covid-19, we anticipate continued bouts of volatility.

As of quarter-end, we were continuing our efforts to assess the impact of these and other factors on the companies in our investment universe. In our view, the majority of loan issuers have sufficient capital to absorb the pressure that higher interest rates place on free cash flow.

Loan issuers are emphasizing that major supply chain glitches and inflationary costs are leading to higher working-capital investments. Companies are also grappling with when to pass these increased costs along to customers. Following record loan issuance in 2021, we believe companies generally have sufficient liquidity to fund these working-capital investments.

Including distressed exchanges, the U.S. leveraged loan default rate ended the quarter at 1.14%, still well be-low the long-term average of 3%. Based on first-quarter 2022 corporate financial reports, along with a manageable amount of debt maturities over the next two to three years, we do not anticipate a spike in defaults. Rather, we expect a gradual increase toward the long-term average.

From a supply/demand standpoint, year-to-date [YTD] net new loan issuance [net of issuance for refinancing purposes] was down 34% from the same period last year. Loan funds reported YTD inflows totaling $16.5 billion. Institutional demand from CLOs remained steady, albeit below last year’s levels. [CLO stands for collateralized loan obligation. These vehicles bundle corporate loans and sell slices of the debt to institutional investors.]

How was the portfolio positioned as of June 30, 2022?

During the second quarter, the fund remained well diversified across issuers and industries, with no single industry accounting for more than 20% of the fund. The fund’s largest industry exposure was technology, which was held at a roughly equal weight to the benchmark.

Our credit analysts are sector specialists and cover the full ratings spectrum, from investment-grade to lower-quality, more-speculative issuers. As of June 30, the corporate ratings distribution for the portfolio was 5.1% BBB, 35.2% BB, 49.9% B, and 1.8% CCC and below.

We continue to actively diversify the fund through security selection. At the same time, we remain cognizant of the lower liquidity profile of loans relative to corporate bonds. We manage portfolio liquidity by appropriately sizing positions and by maintaining a modest cash allocation. As of June 30, the fund’s cash position was about 8%.

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