Loans outperform amid continued market weakness

Q3 2022 Putnam Floating Rate Income Fund Q&A

  • In the third quarter, leveraged loans outpaced most other credit-sensitive fixed income categories amid increasing economic uncertainty.
  • An overweight allocation in energy contributed versus the benchmark, while overall positioning in services, along with security selection in technology and health care, dampened relative results.
  • We have a moderately positive outlook for the loan market overall, but in light of multiple uncertainties, we anticipate continued bouts of volatility.

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

The fund's class Y shares gained 1.45%, performing about in line with the 1.37% return of the benchmark Morningstar LSTA US Leveraged Loan Index.

What was the fund's investment environment like during the third quarter of 2022?

Loans rallied sharply in July and August. Expectations for a shallower tightening cycle from the U.S. Federal Reserve, better-than-expected corporate earnings growth, and a decade low for supply boosted the market's performance. Steady demand from collateralized loan obligations [CLOs] was another positive. [CLOs bundle corporate loans and sell slices of the debt to institutional investors.]

Loans' strong run stalled in September as market participants concluded that monetary conditions would continue to tighten with additional large rate hikes that could push the U.S. economy into a recession. Despite the downturn, continued light new issuance and resilient CLO origination supported the market from a technical perspective.

For the quarter as a whole, loans handily outpaced high-yield corporate bonds and investment-grade credit.

Within the fund's benchmark, all industry cohorts posted gains, led by utilities [+7%], diversified media [+6%], cable & satellite [+5%], and services [+4.5%]. Conversely, consumer products, telecommunications, and health care lagged the benchmark, with each group returning about 1%. From a credit-rating perspective, lower-quality loans were the poorest performers, reflecting investor risk aversion. Meanwhile, mid-tier and higher-quality credits outperformed the benchmark.

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

An overweight allocation in energy contributed versus the benchmark, while overall positioning in services, along with security selection in technology and health care, dampened relative results.

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

We have a moderately positive outlook for the loan market. However, in light of tightening monetary policy, the on-going war in Ukraine, and lingering supply chain disruptions due to Covid-19, we anticipate continued bouts of volatility. We expect increased volatility to persist throughout the remainder of this year. As a result, we believe security selection will be paramount and will be a key performance differentiator, especially as third-quarter earnings results are released.

As of quarter-end, we were continuing our efforts to assess the impact of these and other factors on the companies in our investment universe. In our view, the majority of loan issuers have sufficient capital to absorb the pressure that higher interest rates place on free cash flow.

Loan issuers are emphasizing that major supply chain glitches and inflationary costs are leading to higher working-capital investments. Companies are also grappling with when to pass these increased costs along to customers. Following record loan issuance in 2021, we believe companies generally have sufficient liquidity to fund these working-capital investments.

Including distressed exchanges, the U.S. leveraged loan default rate ended the quarter at 1.63%, still well below the long-term average of about 3%. Based on year-to-date [YTD] corporate financial reports, along with a manageable amount of debt maturities over the next two to three years, we do not anticipate a spike in defaults. Rather, we expect a gradual increase toward the long-term average.

From a supply/demand standpoint, YTD new loan issuance [net of issuance for refinancing purposes] was down 50% from the same period last year. Growing recession concerns due to the Fed's aggressive policy approach has led to a collapse in new issue volume. Loan funds reported YTD inflows totaling $1.9 billion. Institutional demand from CLOs remained steady, albeit below last year's levels.

How was the portfolio positioned as of September 30, 2022?

During the third quarter, the fund remained well diversified across issuers and industries, with no single industry accounting for more than 20% of the fund. The fund's largest industry exposure was technology, which was held at a roughly equal weight to the benchmark.

Our credit analysts are sector specialists and cover the full ratings spectrum, from investment-grade to lower-quality, more-speculative issuers. As of September 30, the corporate ratings distribution for the portfolio was 5.7% BBB, 34.6% BB, 50.3% B, and 1.7% CCC and below.

We continue to actively diversify the fund through security selection. We manage portfolio liquidity by appropriately sizing positions and by maintaining a modest cash allocation. As of quarter-end, the fund's cash position was about 8%.