Q3 2020 Putnam Diversified Income Trust Q&A
- Risk assets performed well for most of the quarter amid consistent investor demand.
- Corporate credit holdings and strategies targeting prepayment risk drove the fund’s positive performance.
- We believe it will take an extended period to fully overcome the damage caused by the pandemic.
How did the fund perform for the three months ended September 30, 2020?
The fund’s class Y shares rose 1.48%, outpacing the 0.04% return of its cash benchmark, the ICE BofA U.S. Treasury Bill Index. The fund also outperformed the broad investment-grade fixed income market, as measured by the 0.62% gain of the Bloomberg Barclays U.S. Aggregate Bond Index.
What was the market environment like during the third quarter of 2020?
Risk assets broadly gained in July and August, though a surge in COVID-19 infection rates, mixed economic data, and heightened geopolitical tensions stoked increased volatility. Positive earnings reports from several sectors, vaccine developments, and supportive policy — including a historic stimulus package passed by the European Union — generally supported risk appetites. A shift in the U.S. Federal Reserve’s inflation framework — which would enable the Fed to allow inflation to exceed its 2% target and further support the economy — helped contribute to investor optimism.
Risk assets pulled back moderately in September, partly due to increased global economic concerns stemming from an upsurge in virus cases in Europe. Fading hope for another U.S. stimulus package and uncertainty surrounding upcoming U.S. elections also weighed on investor sentiment.
Credit spreads tightened during the quarter. Meanwhile, interest rates were range bound, with the yield on the benchmark 10-year U.S. Treasury note finishing the quarter at 0.68%, close to where it began.
Reflecting investor demand for risk, high-yield corporate credit outpaced investment-grade corporate bonds and the broad investment-grade fixed-income market. Emerging-market [EM] debt also performed well, but gained only about half as much as high-yield credit, in U.S.-dollar terms. Accordingly, more defensive areas of the market lagged, including U.S. government securities and agency mortgage-backed bonds.
Which holdings and strategies fueled the fund’s performance?
Our corporate credit holdings — primarily high-yield bonds and convertible securities — added the most value this quarter. Following a sizable tightening of spreads in the second quarter, spreads continued to compress in the third quarter. [Spreads are the yield advantage credit-sensitive bonds offer over comparable-maturity U.S. Treasuries. Bond prices rise as spreads tighten and decline as spreads widen.]
Strategies targeting prepayment risk also meaningfully contributed, led by our mortgage basis positioning. Mortgage basis is a strategy that seeks to exploit the yield differential between 30-year agency pass-throughs and 30-year U.S. Treasuries. The strategy added value as spreads on agency pass-throughs tightened throughout the quarter [meaning their prices rose relative to Treasuries]. Holdings of securities backed by reverse mortgages also contributed, aided by an improving supply-and-demand backdrop in that market segment.
EM debt was a further notable contributor, primarily positions in the Dominican Republic, Indonesia, and Mexico. As noted above, the sector rallied in step with healthier risk dynamics and demand for higher-yielding securities.
What about detractors?
The fund’s interest-rate and yield-curve positioning hampered performance this quarter. The portfolio was positioned to benefit if the U.S. yield curve flattened in July and August. However, the curve steepened during that time.
Within our mortgage credit holdings, commercial mortgage-backed securities [CMBS] — both cash bonds as well as synthetic exposure via CMBX — modestly detracted. [CMBX includes a group of tradeable indexes that reference a basket of 25 CMBS issued in a particular year.] Our positions faced a headwind in July amid fears about a possible second wave of COVID-19 and the negative impact that could have on cash flows in various segments of the commercial real estate market. Beginning in August, however, these fears receded and our holdings began to slowly rebound.
Our investments in agency credit-risk transfers securities [CRT] were similarly challenged in July before recovering during the remainder of the quarter.
What is your near-term outlook?
Recent data have shown recovery in key sectors of the global economy, including manufacturing, housing, and consumer spending. However, the service sector continues to be constrained by the limitations resulting from the pandemic. We expect this trend to continue until a vaccine becomes widely available.
We are not anticipating a V-shaped economic recovery. While we expect intervals of rapid growth, we believe it will take an extended period of time for the global economy to fully recover from the damage done by the mobility restrictions spawned by the pandemic. Also, renewed virus outbreaks are likely to constrain the service sector and limit growth.
How was the fund positioned as of September 30?
We think measures by the Fed and other central banks to shore up marketplace liquidity amid the COVID-19 crisis may keep U.S. interest rates range bound for an extended period of time. As a result, we shifted the fund’s duration from positive to close to zero during the quarter. In our view, having a positive portfolio duration [greater interest-rate sensitivity] in the current environment is not an effective hedge against credit risk within the portfolio.
We have a relatively positive medium-term outlook for corporate credit. While acknowledging the risks mentioned above, we believe there are factors that will be supportive for the U.S. corporate credit market. These include demand for comparatively higher yields in the face of much lower yields globally. Also, investors know that the Fed is prepared to provide further support to the market via its bond purchase facilities if necessary. So far, the central bank has invested only a small portion of the $750 billion earmarked for corporate debt purchases. However, knowing that the Fed stands ready to step in if needed has provided an important boost to market sentiment. As of quarter-end, the fund was modestly underweight investment-grade debt. Our emphasis here continues to be on security selection.
In high-yield credit, we are closely watching sectors vulnerable to the disruption caused by the pandemic, including energy, gaming, lodging & leisure, and retail. Within these groups, we are focusing on the health of issuers’ balance sheets and liquidity metrics, as well as the increasing risk of defaults or credit-rating downgrades.
COVID-19 created significant headwinds for the CMBS market due to the negative impact on commercial real estate. That said, during the quarter, we began to see some improvement in higher-rated cash bonds. We continue to have conviction in the fund’s CMBX positions, which we believe fairly compensate investors for current risk levels.
Within the residential mortgage market, we believe the agency CRT sector directly benefits from the efforts of the federal government, as well as government-sponsored enterprises such as Fannie Mae and Freddie Mac, to keep people in their homes. We also believe the dislocations that occurred in March have been mitigated by U.S. monetary and fiscal policy and the gradual reopening of the economy. Consequently, we continue to find value in various segments of the CRT market as well as in the non-agency residential mortgage-backed market.
In non-U.S. sovereign debt, we continue to favor countries that we believe have responded effectively to COVID-19. We also like countries with younger populations and those with more-favorable prospects for economic growth, as well as reasonably effective debt management.
In prepayment-sensitive areas of the market, despite a recent increase in refinancing activity leading to faster prepayment speeds on underlying securities, we continue to find value in agency interest-only collateralized mortgage obligations and inverse IOs backed by more seasoned collateral. We also believe IO securities structured from reverse mortgages continue to offer value.
More in: Fixed income,