Credit and prepayment risks boost performance

Putnam Investments, 04/21/21


Q1 2021 Putnam Diversified Income Trust Q&A

How did the fund perform for the three months ended March 31, 2021?

The fund’s class Y shares rose 0.45%, outpacing the 0.03% 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 –3.37% result of the BBG Barclays U.S. Aggregate Bond Index.

What was the market environment like during the first quarter of 2021?

Encouraging vaccine news bolstered investor optimism about the strength of the economic recovery in 2021. A $1.9 trillion Covid-19 aid package signed into law by President Biden in early March provided a further boost to market sentiment. Rising prices for stocks and commodities also helped lift the overall market environment. However, concerns about the potential inflationary impact of additional stimulus on top of an already-recovering economy led to an exodus from government bonds. This drove longer-term interest rates higher and placed a degree of pressure on the credit market. After beginning 2021 at 0.91%, the yield on the benchmark 10-year U.S. Treasury note reached 1.74% by March 31. Similarly, the 30-year Treasury rose from 1.64% to 2.41%.

Within this environment, ascending bond yields weighed on investment-grade debt despite marginal spread tightening. [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.] High-yield credit, meanwhile, posted a modest gain, aided by better-than-expected corporate earnings and higher oil prices.

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. Reflecting investor demand for risk, primarily in February, spreads on corporate securities continued to tighten during the first quarter. A rising stock market boosted convertibles.

Within our mortgage-credit holdings, commercial mortgage-backed securities [CMBS] provided a further boost to relative performance. Our positions in cash [as opposed to synthetic] CMBS increased in value as spreads tightened.

Strategies targeting prepayment risk also contributed this quarter, driven by our mortgage-basis positioning. This strategy reflects our view on the yield differential between prevailing mortgage rates and U.S. Treasuries. The strategy added value as spreads on agency pass-throughs tightened [meaning their prices rose relative to Treasuries]. Holdings of interest-only [IO] and inverse IO securities also contributed, benefiting from rising interest rates and a steeper yield curve.

What about detractors?

The fund’s interest-rate and yield-curve positioning was the only material detractor. Duration has been a very good risk diversifier and normally benefits during risk-off periods when interest rates decline. During the first quarter, however, our positioning suffered amid rising interest rates.

What is your near-term outlook?

As the economy reopens amid widespread distribution of Covid-19 vaccines, we believe gross domestic product growth will be robust, particularly in the second and third quarters of 2021. We’re also anticipating a strong recovery in corporate earnings growth. Since growth expectations are already built into asset market pricing, we are cautiously watching the coming months for economic data surprises.

In light of expectations for sturdier growth, we believe U.S. Treasury yields could rise further this year. That said, we think the trend toward higher rates will be more gradual, as bond investors adjust their growth and inflation outlooks, leading to periods of market volatility.

In addition to interest rates and Covid-19 vaccine progress, we will also watch inflation metrics. Given base effects from the prior year and the expected demand surge upon re-opening, we feel the inflation surge will be temporary. However, we have few instances in the past twenty years when both monetary and fiscal policy were aligned strongly toward an easing bias. In Q3, we will be monitoring components of the inflation basket for signs of more enduring impulses which may cause the U.S. Federal Reserve to shift its dovish posture sooner than currently expected.

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

Looking first at high-yield bonds, we have a constructive intermediate-term view of corporate fundamentals and the market’s supply-and-demand backdrop, although we expect the ongoing global health crisis to have an effect. Also, even though bond spreads retightened following their sizable widening in March 2020, and compressed further on favorable vaccine news, we think valuations remain relatively attractive.

In investment-grade [IG] credit, it appears that a significant amount of anticipated good news has been priced in by the market. As of period end, IG corporate spreads had tightened considerably, making valuations in this sector less attractive. Consequently, security selection and sector rotation will be of utmost importance as we navigate this market. Additionally, given the increase in interest rates for the US, IG corporate debt is more attractive to non-US investors.

Within the CMBS market, while there continues to be a degree of negative sentiment toward certain property types, the availability of Covid-19 vaccines has sparked optimism that social-distancing measures could be meaningfully eased by the middle of 2021. As a result, we continue to have conviction in the fund’s CMBX exposure. [CMBX is a group of tradeable indexes that each reference a basket of 25 CMBS issued in a particular year.] We believe current valuations fairly compensate investors for existing risk levels and provide an attractive risk premium.

Fundamental credit analysis and security selection are particularly important in the current CMBS market environment. While some parts of the CMBS market will likely continue to struggle, there are CMBS backed by what we consider to be strong underlying collateral that have suffered amid widespread fear of the sector. We think many of these bonds represent attractive investment opportunities.

Within residential mortgage credit, against the backdrop of robust home sales and a rebound in mortgage originations, we continue to find value across numerous market segments.

In prepayment-sensitive areas of the market, we continue to find value in agency IO collateralized mortgage obligations, as well as inverse IOs backed by jumbo loans and more seasoned collateral. Overall, we view prepayment-related opportunities as attractive sources of diversification for the fund.

In non-U.S. sovereign debt in both developed and emerging markets, we think the economic recovery will be strongest in countries with large service sectors and effective vaccine distribution. We also prefer countries that can contain government expenditures despite political pressures to raise them.