Interest-rate volatility challenges bond markets

Q3 2023 Putnam Income Fund Q&A

  • Duration positioning was the largest contributor to the fund’s relative outperformance.
  • In the near term, we expect U.S. inflation to be around 3.0%–3.5%, above the Fed’s 2% target rate. We believe interest rates will remain higher for longer.
  • Many prepayment-sensitive assets now offer an attractive risk-adjusted return at current price levels.

How were market conditions in the third quarter?

Persistent volatility challenged bond markets, and most fixed income benchmarks posted negative returns for the three months ended September 30, 2023.

In July, U.S. bond yields rose after the Federal Reserve raised interest rates by 0.25%. The cost of borrowing reached a 22-year high of 5.25%–5.50%. Inflation eased, while the U.S. economy continued to grow. The probability of a near-term recession declined, and risk assets rallied. Investment-grade [IG] and high-yield credit spreads began to tighten. [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.] In August, the yields on U.S. Treasuries soared after Fitch Ratings downgraded the U.S. government’s credit rating.

In September, the Fed held interest rates steady but indicated one more rate hike was possible in the fourth quarter. U.S. inflation remained above the central bank’s target rate of 2% and supported the Fed’s rhetoric to keep rates “higher for longer.” Investors pushed expectations for a U.S. recession to mid–2024.

The yield on the 10-year U.S. Treasury note climbed from 3.84% on June 30 to 4.59% on September 29. Short-term yields rose even more, keeping the yield curve inverted. IG corporate bonds, as measured by the Bloomberg U.S. Corporate Bond Index, returned –3.09% for the quarter. High-yield corporate credit fared better, with the JPMorgan Developed High Yield Index returning 0.71%.

How did the fund perform for the three months ended September 30, 2023?

The fund’s class Y shares returned –2.83%, outperforming the benchmark Bloomberg U.S. Aggregate Bond Index, which returned –3.23%.

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

The fund’s duration positioning was the largest contributor to relative performance. U.S. Treasuries sold off significantly, particularly on the long end of the curve. As rates rose, interest-rate volatility increased, which benefited the fund’s term structure positioning. Prepayment risk strategies also contributed to relative returns, driven by exposure to agency interest only [IO] securities. Agency IO securities continued to benefit from low prepayment speeds.

Mortgage credit exposure was a modest contributor to relative returns, led by positioning in residential mortgage-backed securities. The residential mortgage market has benefited from stabilization. Despite higher mortgage rates, supply remains constrained. Corporate credit strategies also were a modest contributor, led by our positioning in collateralized loan obligations [CLOs]. Exposure to high-grade CLOs was additive to results, as spreads on CLOs rated AAA and AA tightened over the quarter and underlying loan prices traded higher.

What is the team’s near-term outlook?

We believe headline inflation in the U.S. has likely bottomed as base effects are fading. Sticky inflation has become our base case scenario. In the near term, we expect the U.S. inflation rate will fall to the 3.0%–3.5% range, interest rates will remain elevated, and spreads will be flat to slightly tighter. We believe a U.S. recession is possible in the second half of 2024. That said, central bank action will continue to play an important role. We believe the Fed will have to keep rates higher for longer as tightening continues. If the U.S. avoids a recession in 2024, we believe the Fed may not cut rates at all. As liquidity continues to be withdrawn, financial market risks will increase, in our view.

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

U.S. Treasury yields have traded up since the resolution of the U.S. debt ceiling in May. We expect that interest rates will stay higher for longer on the back of increased Treasury supply and hawkish Fed rhetoric.

In corporate credit, healthy market technicals, and supportive macroeconomic data have kept IG credit spread volatility low. This allowed the high-yield market to perform strongly alongside other risk assets. Year to date, corporate fundamentals have shown resilience as second-quarter results surpassed market expectations. Technicals also are improving as inflows increased in recent months. Low new issuance in high yield, combined with a high volume of rising stars [companies that show the potential to improve their credit quality ratings], has created a supportive technical backdrop, in our view. Valuations appear to be attractive. Credit spreads are pricing in a continued increase in defaults along with slower growth. These conditions do not point to a harsh recession, in our view. Year to date, IG spreads have tightened 12 basis points [bps] to 118 bps, leaving little room for error. Risks to our outlook include macro forces of high inflation, central bank tightening, slowing growth, and heightened geopolitical tension.

The commercial real estate sector is facing meaningful headwinds and increased risks, including the effects of a post-pandemic shift in office demand and rising costs of capital. Property values will likely face pressure over the medium term, but prices will vary significantly by geography and property type. However, this scenario is more daunting for the equity investor, in our view. Debt holders only need the borrower to pay off the remaining interest and principal owed, which we believe limits the impact on commercial mortgage-backed securities. We believe much of this risk is already reflected in the market given the significant spread widening in the past 12 months. The most attractive relative value opportunities require detailed loan-level analysis and security selection, in our view.

We believe U.S. homeowner balance sheets are well positioned. Many homeowners are benefiting from locked-in, ultra-low mortgage rates and substantial home price appreciation in recent years. We expect home prices to remain stable for the rest of 2023. However, certain locations that became overheated may be susceptible to retractions, in our view. While sector spreads have tightened compared with 2022, they remain wider compared with 2021. At current levels, we believe attractive risk-adjusted return opportunities can be found across the capital stack.

We maintain a neutral to slightly long position to the mortgage basis overall but remain tactical. [The mortgage basis is the difference between longer-term U.S. Treasury yields and the interest rates on 30-year home mortgages.] The systemic risk posed by regional bank failures in March 2023 appears to be behind us, and market supply should taper down in the near term. However, future bank demand remains uncertain and may hinge upon regulatory changes.

We expect prepayment speeds will be stable going forward. The sector may provide good protection against a recession scenario that negatively impacts home prices or employment. In our view, many prepayment-sensitive assets now offer an attractive risk-adjusted return at current price levels and significant upside potential if rates stabilize and volatility declines.