Fund lags amid continued market weakness

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Q3 2022 Putnam Income Fund Q&A

• The poor performance of risk assets seen in the first half of 2022 continued in the third quarter.
• The fund’s interest-rate and yield curve positioning, along with prepayment-related holdings, detracted versus the benchmark. Mortgage credit investments and positioning in corporate credit contributed.
• We have a generally cautious outlook, as we believe the Fed’s aggressive approach to fighting inflation is likely to result in a recession.

How did the fund perform for the three months ended September 30, 2022?

The fund’s class Y shares returned –5.94%, trailing the –4.75% result of its benchmark, the Bloomberg U.S. Aggregate Bond Index.

What was the market environment like during the third quarter of 2022?

The volatility experienced in the first half of the year carried over to the third quarter, as markets moved in dramatic fashion. The first half of the quarter began on positive footing with market participants comforted by a belief that inflation had peaked, while markets began to price in the probability of interest-rate cuts in 2023. However, the sentiment began to shift following U.S. Federal Reserve Chair Powell’s comments at the Jackson Hole symposium in late August. Risk assets fell and U.S. Treasury yields rose meaningfully across the curve as concern about recession intensified.

The Fed continued to increase its policy rate aggressively, implementing 0.75% increases at both its July and September meetings, and signaling an additional 1.25% of hikes this year. Given the central bank’s continued hawkish rhetoric, Treasury yields rose and the yield curve inverted. Notably, the yield on the benchmark 10-year Treasury note exceeded 4% intraday for the first time since 2010.

Within this environment, investment grade [IG] corporate credit spreads ended the quarter close to where they began, while high-yield [HY] credit spreads tightened by 0.43%. [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.] The Bloomberg U.S. Corporate Investment Grade Index returned –5.06% while the JPMorgan Developed High Yield Index returned –0.52%.

Oil prices gave back a substantial portion of the gains achieved in the first half of the year, falling nearly 20% to close the quarter at $79 per barrel.

Which holdings and strategies had the biggest influence on the fund’s performance versus the benchmark?

The fund’s interest-rate and yield curve positioning was the biggest relative detractor for the quarter. The portfolio’s interest-rate sensitivity was longer than that of the benchmark. This strategy weighed on returns as rates rose sharply in light of the Fed’s aggressive policy posture.

Strategies targeting prepayment risk also worked against the fund’s relative return, hampered by holdings of agency interest-only [IO] securities. Mortgage refinancing activity has decelerated considerably, resulting in slower prepayment speeds of underlying securities. However, the market has not yet priced in the fundamental improvements that have occurred in the mortgage-backed sector. Investors generally remained risk-averse and wary of prepayment surprises.

On the positive side, mortgage credit investments notably contributed. Commercial mortgage-backed securities [CMBS] led the way, as they continued to benefit from fundamental improvements despite a deteriorating economic backdrop.

The fund’s modest overweight exposure to IG and HY corporate credit also contributed versus the benchmark, driven by exposure in July, when spreads tightened in both categories.

What is the team’s near-term outlook?

In light of the Fed’s aggressive approach to fighting inflation, we have a cautious outlook. We anticipate continued bouts of volatility given the conflict in Ukraine, the pace of Fed rate hikes, and potentially negative effects on energy supplies from sanctions on Russia. We’re also concerned about lingering supply chain disruptions.

Markets continue to price in significant interest-rate increases at upcoming Fed policy meetings this year and next, and U.S. Treasury yields have risen significantly across the curve. Given the upsurge in rates and the number of rate increases already reflected in the market, we believe Treasury yields could stabilize periodically as concerns about economic growth intensify.

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

Looking first at corporate credit, our view is moderately constructive. We have a positive outlook for market fundamentals and believe valuations have improved for both IG and HY credit. However, the supply/demand backdrop is less favorable than it was last year.

We believe the fundamental environment in the CMBS market will be mixed. While travel, office use, and retail spending have rebounded, we believe current Fed policy will likely result in a recession.

Broadly, property categories that can effectively pass along higher costs, such as hotels and apartments, will maintain their value, in our view. At the same time, we think property types that have struggled to gain new tenants without rent reductions will be exposed to rising capital costs. As a result, we believe they will be pressured to refinance loans to maintain property values. Consistent with risk markets generally, CMBS spreads have widened during 2022. From our perspective, the increased liquidity premium has enhanced the appeal of select market segments.

U.S. home prices soared to record highs during the pandemic. Looking ahead, we expect home prices to experience tepid growth during the next few years due to affordability constraints for many buyers and a gradual increase in housing supply. Within residential mortgage credit, wider spreads have created better value across all credit tiers. As of quarter-end, we were finding attractive investment opportunities in higher-quality areas of the market, as well as among seasoned collateral that we believe can withstand declining home prices.

We believe many prepayment-sensitive securities offer attractive risk-adjusted returns at current price levels and prepayment speeds. Many of these securities may also offer meaningful upside potential if mortgage prepayment speeds continue to slow, which we believe is likely. We think the fund’s prepayment-related strategies provide an important source of diversification in the portfolio. In light of last year’s repricing of the sector, we are finding what we consider to be compelling investment opportunities across a variety of collateral types.