Yield-curve strategy hurt amid mounting uncertainty

Q3 2021 Putnam Global Income Trust Q&A

  • Investors faced a growing number of concerns during the quarter.
  • The fund's interest-rate and yield-curve strategy detracted from performance, while mortgage-credit holdings contributed.
  • We are closely monitoring the U.S. Federal Reserve as we anticipate the beginning of the end of its massive bond-buying program.

How did the fund perform for the three months ended September 30, 2021?

The fund's class Y shares returned -1.63%, underperforming the -0.88% result of the benchmark Bloomberg Global Aggregate Bond Index.

What was the market environment like during the third quarter of 2021?

Investors had to navigate a number of uncertainties during the quarter. These included an uptick in Delta-variant Covid-19 cases alongside concerns that higher inflation — driven, in part, by surging energy prices — would persist longer than initially expected. Investors also began anticipating when the U.S. Federal Reserve would start reducing the vast bond-buying program it launched to help support the economy as lockdowns impeded growth last year. Also dogging markets were fears of contagion from debt-laden property developer China Evergrande Group, as well as data showing that U.S. economic growth is starting to slow. Uncertainty in Washington over the U.S. House of Representatives vote on a $1 trillion infrastructure bill weighed on investors' minds as well.

The yield on the benchmark 10-year U.S. Treasury note fluctuated in a narrow range for most of the quarter, before staging a six-day rise to above 1.50% at the end of September. The move came after the Fed indicated it was ready to begin reversing its pandemic stimulus programs as early as November and was considering raising its target for short-term interest rates next year.

Within this environment, risk assets generated muted results. High-yield corporate credit was among the leaders, gaining about 1% even though yield spreads widened modestly. [Spreads are the yield advantage credit-sensitive bonds offer over comparable-maturity Treasuries. Bond prices rise as yield spreads tighten and decline as spreads widen.] Investment-grade credit posted flat performance, hampered by the late-period rise in longer-term interest rates. Outside of credit, Treasuries and other U.S. government securities were marginally positive. However, Treasury Inflation-Protected Securities [TIPS] advanced 1.75%, fueled by inflation reaching multiyear highs.

Which strategies detracted from performance?

The fund's interest-rate and yield-curve strategy was the primary relative detractor. The portfolio was positioned to benefit if inflation declined and real interest rates rose. Unfortunately, the opposite occurred during the quarter, as inflation remained elevated and real rates declined to start the period. While real rates reversed course later in the quarter, it was not enough to move our strategy into positive territory. [Real interest rates adjust for the effects of inflation by subtracting the actual or expected rate of inflation from nominal interest rates.]

Our interest-rate and yield-curve strategy is intended to provide a degree of protection against underperformance of risk-based assets. Historically, nearly all episodes of risk-asset underperformance occurred during periods of declining inflation or rising real interest rates. However, the Fed's ongoing bond-buying program has disrupted these typical patterns, in our view. Looking ahead, we believe the tapering of Fed bond purchases may aid the performance of our interest-rate and yield-curve strategy.

Strategies targeting prepayment risk also proved negative this quarter. Homeowners have been refinancing mortgages faster than market expectations throughout 2021, placing pressure on our positions in agency interest-only collateralized mortgage obligations [IO CMOs]. Spreads on IO CMOs continued to widen in July and August, as mortgage providers extended their efforts to attract borrowers who had not refinanced their loans.

Despite the challenging environment for prepayment-related strategies so far in 2021, we continue to have conviction in this allocation for both its return potential and diversification benefits. It is also important to note that prepayment strategies were the largest contributor to the fund's relative performance in September, as refinancing volumes began to slow. We believe this trend is likely to continue going forward.

Which holdings and strategies aided the fund's relative performance?

Our mortgage-credit holdings added the most value versus the benchmark, led by our holdings of commercial mortgage-backed securities [CMBS]. Our positions benefited from an improving outlook for hotels and other property types.

Our active currency strategy also contributed, fueled by favorable positioning in the euro, the British pound, and the Japanese yen.

Solid security selection within investment-grade corporate credit provided a further boost versus the benchmark.

What is the team's near-term outlook?

As of period-end, U.S. economic growth expectations had moderated somewhat. However, we believe gross domestic product will continue to grow at a rate above the longer-term trend into 2022. We were encouraged that, as of September 30, U.S. cases of, and hospitalizations from, Covid-19 continued to steadily decline. The country seems to be moving past a July surge caused by the highly transmissible Delta variant.

We think these factors will support continued solid growth in corporate earnings. Strong cash-flow generation has helped boost companies' earnings and enabled them to reduce debt, creating an overall positive backdrop for credit fundamentals, in our view.

In light of the Fed's shift in tone, we think less bond buying by the central bank is likely to nudge both real and nominal Treasury yields higher in the months ahead. That said, we think the trend toward higher rates will be gradual as bond investors adjust their growth and inflation outlooks, leading to periods of market volatility.

What are your current views on the various sectors in which the fund invests?

Looking first at corporate credit, we have a positive outlook for the fundamentals and overall supply-and-demand backdrop of high-yield bonds. Our view on valuation is more neutral, however, given the relative tightness of yield spreads as of quarter-end. Within the high-yield market, we are continuing to closely monitor issuers' balance sheets and liquidity metrics, with an eye toward default risk or a credit-rating downgrade.

In the CMBS market, we believe there are attractive risk-adjusted investment opportunities available amid an improving fundamental backdrop. We continue to find value among issues that have been on the market for a few years. At the same time, we are also investing in newer issues backed by relatively long leases and what we consider to be strong underwriting.

Within residential mortgage credit, given low mortgage rates, high demand, and a declining inventory of available homes, we think home prices are likely to continue rising. Given that prices have already risen substantially, we are aware that affordability has become a constraint for many prospective buyers. Against this backdrop, even with tighter yield spreads, we are finding value in investment-grade securities backed by non-agency residential loans. We also see value in legacy residential mortgage-backed securities and lower-quality segments of the agency credit-risk transfer market.

As noted above, we believe prepayment-sensitive areas of the market serve as important sources of diversification for the fund. In our view, IO CMOs and other types of prepayment-related securities offer attractive risk-adjusted return potential at current price levels if refinancing activity recedes and mortgage prepayment speeds slow.

In emerging markets, we are seeking opportunities in countries that we think are better positioned to benefit from a global recovery and are less exposed to domestic policy risks.