Bank loans rise with demand for yield

Putnam Investments, 01/22/21


Q4 2020 Putnam Floating Rate Income Fund Q&A

  • Bank loans rose about 4% in the fourth quarter, aided by demand for higher-yielding securities.
  • Overweight allocations in housing and broadcasting contributed the most versus the benchmark. Conversely, adverse positioning in technology and services, along with security selection in financials, detracted.
  • 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 December 31, 2020?

The fund's class Y shares returned 3.10%, trailing the 3.81% result of the benchmark S&P/LSTA Leveraged Loan In-dex.

What was the fund's investment environment like during the fourth quarter of 2020?

The quarter began on a positive note, as hopes for a COVID-19 vaccine and additional fiscal stimulus led to a modest gain in October.

The high-yield loan market rallied strongly in November, gaining about 2% for the month. Encouraging vaccine news bolstered investor optimism about the strength of the economic recovery in 2021. The U.S. election outcome — a Biden victory and what appeared at the time would be a divided Congress — also boosted market sentiment. The asset class continued to rally in December amid increasing positivity about economic growth in the New Year.

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

Within the S&P/LSTA index, all cohorts posted gains, led by transportation, energy, and broadcasting, each of which gained about 6%. In contrast, the more-defensive utilities and paper & packaging groups were the weakest performers versus the index, with each returning about 2%.

From a credit-rating perspective, lower-quality loans generated the highest gains, signaling 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, overweight allocations in housing and broadcasting added the most value versus the benchmark. Conversely, adverse positioning in technology and services, along with security selection in financials, detracted from relative performance.

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

As we move into 2021, we have a moderately constructive view overall. Although we expect the ongoing global health crisis to affect the high-yield loan market, we have a fairly positive intermediate-term outlook for corporate fundamentals 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 high-yield 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. We are monitoring the impact on energy, 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 risk of defaults or credit-rating downgrades.

As for supply/demand dynamics, net new issuance of loans [net of issuance for refinancing purposes] totaled $192.7 billion, slightly above net issuance of $192.2 billion in 2019. On the demand side, loan funds [mutual funds and exchange-traded funds] saw outflows of $26.9 billion in 2020. However, loan funds reported an inflow of $521 million in December 2020, the first inflow since September 2018.

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.] For 2020, CLO volume totaled $125.1 billion compared with $161.2 billion in 2019. CLOs now account for roughly two-thirds of the total assets in the loan market, while retail funds represent only about 10%. As a result, despite fund outflows, we think the market's technical environment is neutral to favorable. Steady net new loan issuance is being met by relatively consistent CLO demand.

From a valuation standpoint, the average spread of the fund's benchmark tightened to about 4.9 percentage points over U.S. Treasuries as of period-end, below the long-term average of six percentage points. After tightening from March's extremely wide level, loan spreads compressed further on recent vaccine news. The benchmark's yield was at 5.10% as of December 31, its lowest level since mid-2014. Optimism over continued government stimulus and vaccine distribution drove loan prices higher and yields lower. Despite tighter spreads and lower yields, we think the market's yield and overall total return potential remain attractive in the face of much lower global yields.