Loans post modest gain on continued solid demand


Q4 2021 Putnam Floating Rate Income Fund Q&A

  • High-yield bank loans posted a moderate gain in the fourth quarter, aided by demand for higher-yielding securities offering low interest-rate sensitivity.
  • Security selection in the technology and health care sectors detracted from relative performance this quarter.
  • We have a generally positive outlook for the loan market’s fundamental environment and supply-and-demand dynamics, but are more neutral toward valuation.

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

The fund’s class Y shares rose 0.55%, trailing the 0.75% return of the benchmark S&P/LSTA Leveraged Loan Index.

What was the fund’s investment environment like during the fourth quarter of 2021?

Leveraged loans posted a modest gain in October. During the month, net new issuance of loans reached the highest level in more than 10 years. This robust level of supply was met by continued solid demand from CLOs and steady flows into retail funds. [CLO stands for “collateralized loan obligation.” These vehicles bundle corporate loans and sell slices of the debt to institutional investors.]

After declining slightly in November, loans rebounded in December as concerns about the severity of the coronavirus Omicron variant receded. Strong stock market gains also bolstered the overall risk backdrop in December.

The yield on the 2-year U.S. Treasury note jumped to its highest level since March 2020, reflecting investor reaction to a hawkish pivot by the U.S. Federal Reserve. Both the Fed and investors now anticipate three 0.25% increases in the federal funds rate during 2022. Headlines about higher interest rates continued to spark demand for loans from individual investors. December was the thirteenth consecutive month of flows into loan funds [mutual funds and exchange-traded funds]. For the full year, loan funds achieved inflows of $34.9 billion compared with outflows of $26.9 billion in 2020.

Relative to other asset classes, loans performed in line with high-yield corporate bonds, but topped investment-grade [IG] corporate credit and the broad IG fixed-income market.

Within the fund’s benchmark, every cohort but one generated a positive result, with returns in a tight range. Telecommunications, energy, and technology were the top-performing groups versus the benchmark, with each gaining 1%. Conversely, broadcasting [–1%], automotive [+0.2%], and health care [+0.3%] were the weakest performers. From a credit-rating perspective, returns were comparable among credits rated BBB, BB, and B, and each of these ratings categories outpaced lower-quality loans.

What factors had the biggest influence on the fund's relative performance?

Security selection in the technology and health care sectors hampered performance versus the benchmark.

What is the team's outlook for the bank loan market over the coming months?

We have a positive outlook for loan market fundamentals and the overall supply-and-demand backdrop. Our view on valuation is more neutral, given the relative tightness of yield spreads in the market as of year-end. That said, we think loan spreads are somewhat more attractive than high-yield bond spreads. [Spreads are the yield advantage loans and credit-sensitive bonds offer over comparable-maturity U.S. Treasuries.]

Our positive fundamental outlook is underpinned by the ongoing distribution of Covid-19 vaccines. That said, we continue to closely monitor issuers’ balance sheets and liquidity metrics, with an eye toward default risk or a credit-rating downgrade.

As of period-end, U.S. economic growth expectations had moderated somewhat. However, we believe U.S. gross domestic product will continue to grow at a rate above the longer-term trend in 2022. Following robust corporate earnings growth in 2021, market expectations for 2022 were adjusted down to the low double-digit range. Despite decelerating economic and corporate profit growth, credit metrics and ratings continued to improve for loan issuers, in our view. Moreover, we believe issuers continued to benefit from strong demand for credit risk.

All these factors resulted in a very low default rate. Including distressed exchanges, the U.S. leveraged loan default rate ended the year at 0.65%, well below the long-term average of 3% and down substantially from 4.27% at the end of December 2020.

We believe the leveraged loan and high-yield bond default rates will remain materially below average for at least the next two years, and maybe longer. The most obvious catalyst for low default rates is the robust growth backdrop and rapid improvement in credit fundamentals forecasted for the coming year. We believe debt, which is currently more than five times greater than equity, on average, is likely to drop to below four times by the end of 2022. Additionally, average revenues and earnings are already above pre-pandemic levels. Another dynamic supporting low default rates is the wide-open access to capital markets. Record bond and loan refinancing activity totaling $1 trillion in 2020 and 2021 has improved corporate liquidity. And in that context, we expect capital markets to remain highly accessible in 2022.

As for supply/demand dynamics, new issuance of loans totaled $835.1 billion in 2021, roughly double the amount issued in 2020. About 51% of 2021’s new issuance was used to refinance existing debt. On the demand side, in addition to loan funds, demand from CLOs was robust. In 2021, CLO volume equaled $421.1 billion compared with $125.8 billion in 2020. CLOs now account for roughly two thirds of the total assets in the loan market, while retail funds represent only about 10%.

Despite a substantial increase in loan supply, we think the market’s technical environment is favorable. In addition to demand from CLOs, we have seen strong demand from retail investors. We believe they are seeking assets with relatively low interest-rate sensitivity that provide higher yields compared with other fixed-income alternatives.

From a valuation standpoint, the average spread of the fund’s benchmark tightened to 4.1 percentage points over U.S. Treasuries during 2021, below the long-term average of about 6 percentage points. The benchmark’s yield was 5.27% as of December 31, significantly below its 11-year average of 7.21%. Despite tighter spreads and lower yields, we think the market’s income level remains comparatively attractive versus much lower global yields.

Would you say a few words about progress on phasing out LIBOR as a pricing mechanism for bank loans?

Putnam has a multidisciplinary team that is preparing for the changeover from LIBOR (London Interbank Offered Rate) to SOFR (Secured Overnight Financing Rate). Their efforts will help ensure a smooth transition for our share-holders, clients, and investment process.

The coupons, or stated interest rates, on bank loans are linked to LIBOR, a widely used benchmark for determining interest rates on a broad range of financial products. Global regulators began to question the soundness of LIBOR and the methodologies used to calculate it after the 2008 financial crisis. As a result, a process is underway to phase out LIBOR and replace it with a different benchmark rate.

An industry group convened by the Fed was tasked with finding a replacement for LIBOR. The group selected SOFR as its preferred benchmark. Unlike LIBOR, SOFR represents the actual overnight cost of borrowing in the U.S. Treasury repurchase-agreement (repo) market.

We expect the transition away from LIBOR to occur gradually from now until June 30, 2023, with the number of loans based on SOFR steadily increasing.