High-yield gains modestly amid rising interest rates

Putnam Investments, 04/21/21


Q1 2021 Putnam High Yield Fund Q&A

  • High-yield bonds gained about 1% in the first quarter, aided by demand for higher-yielding securities but dampened by rising interest rates.
  • Security selection in health care, telecommunications, and technology aided performance versus the benchmark. Conversely, picks in energy and services, along with overall positioning in gaming, lodging & leisure, detracted.
  • We have a generally positive intermediate-term view on the market’s fundamental environment and supply-and-demand backdrop.

How did the fund perform for the three months ended March 31, 2021?

The fund’s class Y shares rose 0.73%, trailing the 1.38% return of the benchmark JPMorgan Developed High Yield Index.

What was the market environment like for high-yield bonds during the first quarter of 2021?

High-yield bonds posted a modest gain for the quarter, aided by better-than-expected corporate earnings. Encouraging vaccine news bolstered investor optimism about the strength of the economic recovery in 2021. A $1.9 trillion Covid-19 aid package signed into law by President Biden in early March provided a further boost to market sentiment. Rising prices for stocks and commodities also helped lift the overall market environment. However, concerns about the potential inflationary impact of additional stimulus on top of an already-recovering economy led to an exodus from government bonds. This drove longer-term interest rates higher and placed a degree of pressure on the high-yield market. After beginning 2021 at 0.93%, the yield on the benchmark 10-year U.S. Treasury note reached 1.74% by March 31.

New issuance of high-yield debt reached a quarterly record during the period, as issuers sought to capitalize on historically low yields. Also, although high-yield funds reported a net outflow for the quarter overall, the last two weeks of the quarter saw net inflows.

Relative to other asset classes, high-yield bonds modestly lagged high-yield bank loans but outpaced the broad investment-grade fixed-income market.

Industry cohorts within the fund’s benchmark generated mixed results the past three months. On the positive side, the top performers were transportation [+5%], energy [+5%], and gaming, lodging & leisure [+3%]. Conversely, utilities, cable & satellite, and broadcasting were the biggest underperformers, each returning about -2%. From a credit-rating perspective, lower-quality debt registered the highest gains, signaling a comfort level with risk as investors sought higher yields.

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

Security selection in health care, telecommunications, and technology added the most value versus the benchmark. On the downside, picks in energy and services, along with overall positioning in gaming, lodging & leisure, detracted on a relative basis.

What is your outlook for the high-yield market over the coming months?

We have a generally positive outlook overall. Although we expect the ongoing global health crisis to affect the high-yield market, we have a constructive intermediate-term view of corporate fundamentals and the market’s supply-and-demand backdrop. Also, even though bond spreads retightened following their sizable widening in March 2020, and compressed further on favorable vaccine news, we think valuations remain relatively attractive. [Spreads are the yield advantage high-yield bonds offer over comparable-maturity U.S. Treasuries.]

From a fundamental perspective, we continue to closely monitor sectors that were heavily affected by the pandemic, such as energy, gaming, lodging & leisure, and retail. 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.

Due to Covid-19, high-yield defaults in 2020 exceeded our expectations. In 2021, however, we believe broad vaccine distribution and fewer defaults in the energy sector should lead to a reduced level of defaults.

As for supply/demand dynamics, new issuance of high-yield debt totaled $158.6 billion in the first quarter of 2021, more than doubling the $72.9 billion of issuance during the same period in 2020. On the demand side, high-yield funds [mutual funds and exchange-traded funds] experienced outflows of $10.3 billion in the quarter, substantially below the $15.4 billion that left the asset class during the first three months of 2020. As evidenced by the final weeks of the quarter, we believe high-yield funds may resume attracting inflows in 2021.

From a valuation standpoint, the average yield spread of the fund’s benchmark tightened to about four percentage points over U.S. Treasuries as of March 31, below the long-term average of six percentage points. The benchmark’s yield was at 4.72% as of quarter-end, a record low. Optimism over continued government stimulus and vaccine distribution drove bond prices higher and yields lower. Despite tighter spreads and lower yields, we think the market’s income potential remains attractive in the face of much lower global yields.

How was the fund positioned as of March 31?

Relative to the benchmark, the portfolio had overweight exposure to the higher-quality segment of the market and an underweight allocation in lower-quality bonds. From an industry perspective, we favored cable & satellite, housing/building products, and broadcasting.