Mortgage-market rumors and Putnam's fixed
income strategy

Daniel Choquette, Portfolio Manager, 8/18/10

There has been much speculation over the past few weeks about the possibility of the Obama Administration working with government-sponsored housing entities Fannie Mae and Freddie Mac to ease restrictions on mortgage refinancing rules. While there are a number of plans the administration may be considering, most fall into one of two varieties.

While we acknowledge the benefits of government-aided stimulus, our belief remains that any additional program introduced will target the most at-risk borrowers. To the extent that a more encompassing policy is introduced, we believe there are still relatively attractive ways to extract return through the manner in which we implement our strategies. After considering the policy uncertainty, we believe that valuations still favor prepayment-based strategies.

Putnam has been monitoring government policy risks for years
The possibility of such a large government intervention in the mortgage market is something the fixed-income team at Putnam has been actively debating and discussing for some time. While the form of potential government intervention is constantly evolving, planning for scenarios like this has been a part of our analysis and investment decision-making process for the better part of the past two years.

Funds are positioned to minimize the impact of government-sponsored refinancing
Since any program, if enacted, would introduce new uncertainty to the mortgage backed securities market, our funds have been focused primarily on securities that we believe will be less sensitive to government-induced refinancing. In particular, Putnam funds have been focusing on interest-only securities, whose prices have still not recovered completely from the deleveraging of 2008, in our opinion. We believe these securities are still pricing in faster prepayment speeds than are likely to materialize, and are therefore undervalued. In addition, we have been targeting very specific types of income-only securities that offer what we believe are the most attractive characteristics in this environment:

• Securities with lower loan balances: The lower the loan balance, the less of an impact a lower mortgage rate has on the borrower's monthly payments. The fixed costs of refinancing are higher today than they have been in the past few years, so the time it takes to break even cost-wise can make refinancing unattractive to lower-balance borrowers. Having to put up the cash to refinance a loan is a further disincentive in these tougher economic times.
• GNMA collateral: The speculation around loan modifications and broad refinancing has been focused on Fannie Mae's and Freddie Mac's loan portfolios. If anything, the rhetoric from GNMA has been consistent for the past year; that is, the underwriting process coming from the originators through the GNMA program needs to be more stringent going forward than it had been prior to 2010. If a new government program is introduced, owning GNMA securities could help insulate the funds from market repricing.
• Lower coupon securities: Borrowers in lower coupon pools pay a lower mortgage interest rate, and therefore have less incentive to refinance, which can often be expensive. In cases where we do own higher-coupon securities, they are likely to be derived from lower-balance mortgages, GNMA borrowers, or originating in Puerto Rico.

Maintaining an opportunistic approach

Although our prepayment strategy has already proven quite profitable, we remain opportunistic investors in this and other sectors. Acting quickly — and prudently — in response to changes in market valuations is a core principle behind the investment philosophy of all of Putnam's fixed-income funds, and one that we believe has helped us generate solid returns over time.