Fixed Income Outlook  |  Q2 2022

Sector views

Putnam Investments

Sector views

Corporate debt: Investment grade and high yield

The potential effects of inflation and supply chain bottlenecks are considerations for our overall and sectoral positioning. The first quarter correction in bond prices — and yields — generally leaves the investment-grade and high-yield credit markets in a place where the securities have better convexity.

Investment-grade corporate credit was among the poorer performers during the first quarter, given its relatively high interest-rate sensitivity. Still, we have a constructive outlook for investment-grade bonds. We have a positive view of corporate fundamentals, while having a more neutral outlook for the market's supply-and-demand backdrop and valuation level.

In high-yield corporate credit, our view is moderately constructive. We have a positive outlook for high-yield market fundamentals and the overall supply-and-demand backdrop. That said, 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. Our view on valuations is more neutral, given the relative tightness of yield spreads in the market as of quarter-end. Spreads widened during the quarter but remain tight by historical standards.

The U.S. high-yield default rate remained very low as of March 31. As for supply/demand dynamics, new issuance of high-yield debt totaled $46.5 billion in the first quarter. This represented a 71% decline from the same period in 2021. Despite tight spreads, we think the market's income potential is attractive in the face of much lower global yields.

Trends in the mortgage markets

In the commercial mortgage-backed securities (CMBS) market, we believe the fundamental environment will continue to improve as workers return to offices, consumer traffic increases at retailers, and hotels welcome back business and leisure travelers. Our emphasis on investment opportunities in the U.S. broadly isolates us from geopolitical risk. With real assets serving as collateral and the potential for rent adjustments, CMBS have historically performed well during periods of rising inflation. CMBS spreads widened during the quarter. The increased liquidity premium enhanced the appeal of select market segments.

Risk assets sold-off amid heightened geopolitical tensions and higher Treasury rates

Excess returns* relative to Treasuries, Q1 2022

Risk assets sold-off amid heightened geopolitical tensions and higher Treasury rates

Risk assets sold-off amid heightened geopolitical tensions and higher Treasury rates

* Excess returns are calculated relative to comparable maturity U.S. Treasuries for each index. Excess return does not always mean "outperformance."

In residential mortgage credit, we believe high demand and low inventory of available homes is likely to push prices higher. We are aware that affordability has become a constraint for many prospective buyers as home prices and mortgage rates have risen. Consequently, we think the pace of home price appreciation is likely to moderate in 2022. Wider spreads have created better value among mid-tier and lower-rated securities. We are finding attractive investment opportunities in that area of the market, as well as among higher-rated securities.

The Fed's shift toward tighter monetary policy may likely accelerate its sales of mortgage-backed securities (MBS). A faster pace of MBS tapering may reduce home price inflation, helping to boost the Fed's inflation-fighting mandate. We believe many prepayment-sensitive securities may offer attractive risk-adjusted returns from current price levels and may offer upside potential if mortgage prepayment speeds slow. In our view, prepayment strategies could benefit from an economic slowdown, a shift to supportive fiscal policies, or a sustained increase in mortgage rates.

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The first quarter was a challenging time for global financial markets.