Fund outperforms despite challenging interest-rate backdrop

Putnam Investments, 04/21/21


Q1 2021 Putnam Income Fund Q&A

  • Longer-term interest rates rose substantially in February and March, contributing to an uptick in market volatility.
  • Strategies targeting prepayment risk helped the fund outpace its benchmark. Conversely, positioning in corporate credit detracted.
  • Expectations for a stronger U.S. economic recovery have sparked investor optimism while also raising the alert for possible early signs of inflation.

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

The fund’s class Y shares returned -2.31%, outpacing the -3.37% result of the benchmark Bloomberg Barclays U.S. Aggregate Bond Index. Despite negative absolute performance, exposure to risks outside the benchmark helped the fund outperform on a relative basis.

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. [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 helped the fund outperform the benchmark?

Strategies targeting prepayment risk contributed the most versus the benchmark this quarter, driven by our mortgage-basis positioning. Our mortgage-basis 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.

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.

What about detractors?

A lower-than-benchmark allocation to investment-grade [IG] corporate credit modestly dampened relative performance. IG corporate spreads tightened marginally, resulting in a slight increase in bond prices.

What is your near-term outlook?

As the economy reopens amid the proliferation 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.

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 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 for any change in inflation metrics that may cause the U.S. Federal Reserve to shift its posture sooner than currently expected.

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

Looking first at corporate credit, we have a positive view of fundamentals and the market’s supply-and-demand backdrop, but are more neutral toward valuation.

From a supply-and-demand standpoint, new issuance of IG corporate bonds in 2020 reached a record level of $1.7 trillion. We think new issuance is likely to decline substantially this year. Given that there is still strong demand due to the lack of yield globally, reduced supply could lift prices for existing bonds. Overall, we believe reduced bond issuance should be positive for the market’s technical backdrop.

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.

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 in inverse IOs backed by jumbo loans and more seasoned collateral. Overall, we view prepayment-related opportunities as attractive sources of diversification for the fund.