Security selection drives relative outperformance

Security selection drives relative outperformance

Q4 2022 Putnam Income Fund Q&A

  • Our mortgage basis strategy and agency IO holdings were top contributors to the fund’s relative outperformance.
  • We have a cautious outlook for U.S. corporate credit.
  • We believe prepayment-sensitive securities offer attractive risk-adjusted returns at current price levels and prepayment speeds.

How did the fund perform for the three months ended December 31, 2022?

The fund’s class Y shares returned 2.92%, outperforming its benchmark, the Bloomberg U.S. Aggregate Bond Index, which returned 1.87%.

What was the market environment like during the fourth quarter of 2022?

The U.S. Federal Reserve continued to combat high inflation with aggressive interest-rate hikes. At its November meeting, the central bank made its fourth consecutive rate hike of 0.75% in a concerted effort to quell inflation. Higher borrowing rates curtailed business spending, and home sales declined during the quarter. However, a strong U.S. labor market helped lift consumer spending, which kept inflation elevated.

Investor optimism improved when the Consumer Price Index showed a slight decline in the pace of inflation in November. The Fed signaled it was considering reducing the size of its future interest-rate hikes, while measuring the impact of previous hikes. As expected, the Fed’s next rate hike in December was pared back to 0.50%. This took the federal funds rate to 4.25%–4.50% as of quarter-end, its highest range in 15 years.

Credit spreads, which had widened for much of the year, began to tighten as risk sentiment improved. [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.] After experiencing losses for much of 2022, investment-grade and high-yield credit generated positive returns in the fourth quarter. The Bloomberg U.S. Corporate Investment Grade Index returned 3.63%, while the JPMorgan Developed High Yield Index returned 3.76%.

Oil prices, which soared above $130 per barrel when Russia invaded Ukraine almost a year ago, declined to around $80 per barrel by the end of the fourth quarter. Weaker demand from China, where Covid–19 lockdowns disrupted global trade, along with fears of a recession, pushed energy prices off their peak.

Which strategies and holdings had the biggest influence on fund performance relative to the benchmark?

Prepayment strategies were most additive to fund performance, driven by our mortgage basis positioning [the difference between longer-term U.S. Treasury yields and the interest rates on 30-year home mortgages]. Given the extensive widening of the mortgage basis at the start of 2022, we considered the risk of further widening to be low. During the fourth quarter, we shifted to a long position to the mortgage basis, which aided results as the mortgage basis tightened. Higher mortgage rates and weaker home sales reduced borrowers’ ability to pay their loans, which also provided a tailwind for our agency interest-only [IO] holdings.

Within our corporate credit strategies, exposure to collateralized loan obligations [CLOs] and a modest out-of-benchmark position in high-yield corporate credit also helped fund performance. Strong structural protections, the ability to withstand mild recessionary stress scenarios, and the recent recovery in loan prices pushed CLO spreads tighter in the fourth quarter. These conditions benefited our holdings rated AAA and AA. Our duration positioning strategy, which maintains a long interest-rate volatility position as a macro hedge in the portfolio, also aided results. Our mortgage credit strategies had a neutral effect on fund performance.

What is the team’s near-term outlook?

In the near term, we expect uncertainty to remain high and market volatility to persist. The strength of the U.S. labor market will keep Fed policy hawkish, in our view. However, the labor market remains highly sensitive to inflation data releases for risk demand and interest rates. Therefore, the fund maintains a position at the lower end of the risk spectrum with lower spread duration across credit sectors.

What are your current views on the sectors in which the fund invests?

We expect continued Treasury rate volatility in 2023. Given the surge of higher interest rates and those already priced into the market, we expect Treasury rates to stabilize or rally periodically as growth concerns escalate throughout 2023.

We have a cautious outlook on U.S. corporate credit with an expectation for elevated volatility. Macro forces of high inflation, geopolitical impacts on energy supplies, and central bank tightening remain considerable headwinds to fundamentals and market technicals [supply/demand metrics], in our view. However, we may be nearing a point in the coming months where the interest-rate hiking cycle will start to wind down.

We believe corporate fundamentals remain solid overall, but likely will weaken in the face of slower growth and margin pressure. Technicals have also turned more challenging after a highly supportive period in 2021. That said, valuations have improved and are now trending toward more neutral territory.

Risks to our moderately constructive outlook include policy missteps from global central banks, a more severe economic slowdown or recession than expected, ongoing supply chain disruptions, commodity price volatility, heightened geopolitical tension, and the impact of Covid outbreaks.

Our outlook for commercial real estate is mixed. We expect fundamentals to improve as more people return to travel, offices, and retail stores. This view is tempered by the Fed’s hawkish interest-rate policy, which could cause a recession. We believe those property types that can pass along inflation costs, such as hotels and apartments, will hold their value and perform well in this environment. On the other hand, property types that have longer leases, rising capital costs, or require large capital improvements will come under pressure. We continue to favor seasoned mezzanine tranches on high-quality deals that offer attractive relative value and are insulated from losses or a recession, in our view.

We expect home prices to decline modestly in 2023 and to grow more slowly thereafter. After sharply rising during the pandemic, home price appreciation is slowing due to affordability constraints for many buyers and a gradual increase in supply. Within residential mortgage credit, wider spreads have created better value across all credit tiers. We are finding attractive investment opportunities in higher-quality areas of the market, as well as seasoned collateral that can withstand declining home prices.

Within emerging market credit, we expect global economic conditions to be challenging, but some valuations and countries appear to be attractive. China’s reopening near quarter-end has been a positive development. We will continue to look for opportunities in countries that are less exposed to geopolitical turmoil or global and domestic policy risks.

We believe many prepayment-sensitive securities offer attractive risk-adjusted returns at current price levels and prepayment speeds. Many of these securities may offer meaningful upside potential if mortgage prepayment speeds slow below market expectations, which we believe is likely. We also find value in the mortgage basis, which is now historically wide. We are maintaining a cautious mortgage basis position amid heightened interest-rate volatility. Given last year’s repricing of the sector, we are finding what we believe are compelling investment opportunities across a variety of collateral types.

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