Bank loans rise with demand for yield

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Q3 2020 Putnam Floating Rate Income Fund Q&A

• Bank loans rose about 4% in the third quarter, aided by demand for higher-yielding securities.
• Security selection in gaming, lodging, & leisure contributed the most versus the benchmark. Conversely, positioning in technology, services, and health care detracted from relative performance.
• Despite ongoing uncertainty, we have a moderately constructive intermediate-term view on the market’s fundamental environment and supply-and-demand backdrop.

How did the fund perform for the three months ended September 30, 2020?

The fund’s class Y shares returned 3.14%, trailing the 4.14% result of the benchmark S&P/LSTA Leveraged Loan Index.

What was the fund’s investment environment like during the third quarter of 2020?

The loan market posted solid gains in July and August. Supportive factors included positive developments on a potential COVID-19 vaccine, progress on a new economic relief package, corporate earnings that came in above consensus expectations, and an overall stronger environment for risk assets. These dynamics boosted sentiment despite heightening U.S.–China tensions and rising virus case counts across parts of the globe.

The market rally moderated in September, partly due to increased global economic concerns stemming from an upsurge in virus cases in Europe. Fading hope for another U.S. stimulus package and uncertainty surrounding upcoming U.S. elections also weighed on the asset class.

Reflecting renewed investor demand for risk, high-yield bank loans outpaced investment-grade corporate bonds and the broad investment-grade fixed-income market. Loans moderately trailed high-yield bonds.

Within the S&P/LSTA index, all cohorts posted gains, led by retail [+7%], industrials [+6%], and automotive [+6%]. Conversely, the more-defensive utilities group [+2] was the weakest performer versus the index. Transportation, cable & satellite, and broadcasting also lagged, each registering returns of about 3%. From a credit-rating perspective, lower-quality loans generated the highest gains, reflecting increased risk appetite on the part of investors and demand for higher yields.

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

On the plus side, security selection in gaming, lodging, & leisure added the most value versus the benchmark. A sizable overweight allocation in housing also helped. On the downside, adverse positioning in technology, services, and health care detracted from relative performance.

What is your outlook for the bank-loan market over the coming months?

We have a moderately constructive outlook overall. The biggest risk on the horizon continues to be the impact of COVID-19 on economic growth, corporate earnings growth, and cash flows.

That said, except for the energy sector, we have a fairly positive intermediate-term view on corporate fundamen-tals and the market’s supply-and-demand backdrop. Also, even though loan spreads retightened following their sizable widening in March, we think valuations remain relatively attractive. [Spreads are the yield advantage loans offer over comparable-maturity U.S. Treasuries.]

From a fundamental perspective, we are closely watching sectors vulnerable to the disruption caused by the pandemic. In addition to energy, we are monitoring the impact on gaming, lodging, & leisure, retail, and several other cohorts. Within these groups, we are focusing on the health of issuers’ balance sheets and liquidity metrics, as well as the increasing risk of defaults or credit-rating downgrades.

As for supply/demand dynamics, on a year-to-date basis through September, loan new-issue volume totaled $313.2 billion, a 25% increase over the same period in 2019. However, net new issuance [net of new loans issued to refinance existing debt] was low, with only $119.7 billion of net issuance in the first nine months of 2020. This compares with $153.8 billion during the same period last year. On the demand side, loan funds [mutual funds and exchange-traded funds] saw outflows of $25.4 billion year to date.

Collateralized loan obligations [CLOs] remained a comparative bright spot for loan demand, despite lower year-over-year volume. [CLOs bundle corporate loans and sell slices of the debt to institutional investors.] CLO issuance picked up in September, rising to its highest monthly total since February. Year to date through Septem-ber, CLO volume totaled $85.9 billion compared with $126 billion for the first nine months of 2019. CLOs now ac-count for roughly two-thirds of the total assets in the loan market, while retail funds represent only about 10%. As a result, despite continued fund outflows, we think the market’s technical environment is favorable. Decreased net new loan issuance is being met by relatively consistent CLO demand.

From a valuation standpoint, the average spread of the fund’s benchmark rose 4.9 percentage points during March to about 10 percentage points over Treasuries. This was the highest spread level since mid-2009 and was well above the 11-year average of 5.7 percentage points. The benchmark’s average yield spiked to 10.5% during this time. At the end of the third quarter, spreads had tightened back close to their long-term average and the benchmark’s yield was at 6%. In our view, spreads at this level continue to offer a broad range of attractive relative-value investment opportunities. Moreover, we think the market’s yield remains compelling in the face of much lower global yields.