Fund outperforms on credit selection

Q4 2022 Putnam Floating Rate Income Fund Q&A

  • The fund outperformed its index in a quarter when fixed income markets generally rallied on signs of falling inflation.
  • Fund performance benefited from our credit selection decisions as the price dispersion of loans increased in late 2022.
  • We expect price dispersion to continue to create opportunities for our active strategy, although expected further tightening of monetary policy and weakening economic conditions could cause volatility.

How did the fund perform for the three months ended December 31, 2022?

The fund’s class Y shares gained 3.32%, outperforming the benchmark Morningstar LSTA US Leveraged Loan Index, which returned 2.71%.

What was the market environment during the fourth quarter?

Fixed income markets advanced in the final three months of the year, the first quarterly gain since 2021, on higher investor optimism concerning the pace of Federal Reserve policy going into 2023. Bonds began to rally in early November following a Consumer Price Index report that showed a larger-than-expected decline in the pace of inflation. The Fed also signaled it was considering a reduction in the pace of future interest-rate hikes while measuring the impact of previous hikes.

Bond prices rose and yields fell in most areas of the market. The Bloomberg U.S. Aggregate Bond Index returned 1.87%. It was the first positive quarterly return for the broad-based benchmark since the fourth quarter of 2021. High-yield corporate credit fared better in the quarter than the broader index as credit spreads tightened. Gross domestic product reports showed the economy steadying, and consumer spending stayed solid going into the holiday season. The JPMorgan Developed High Yield Index posted a 3.76% result. Floating-rate bank loans, which had outperformed in the third quarter, posted a 2.71% return in the final three months of the year, as represented by the Morningstar LSTA US Leveraged Loan Index.

Inflation remains elevated in many regions and continues to be a challenge to central banks. In December, the Fed scaled back its monetary tightening with a 50-basis-point rate hike after four 75-basis-point hikes. Still, Fed Chair Jerome Powell noted that rate hikes would continue in 2023.

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

In the fourth quarter, price dispersion of loans increased. This means that the difference between the worst performers and best performers grew, and it helped to create more idiosyncratic opportunities. Fund performance benefited from our credit selection decisions.

Additionally, the team selectively added high-yield corporate bond exposure into the portfolio in the quarter, as we did in the third quarter. We made these moves opportunistically based on the attractiveness of relative value opportunities between high-yield bonds and loans. This tactical trading proved beneficial to performance, as high-yield corporate bond spreads tightened 64 basis points during the quarter. The fund remained 83.74% invested in leveraged loans versus 10.59% in high-yield bonds as of December 31, 2022.

What is the team’s outlook for the bank loan market in the months ahead?

We expect loan price dispersion to remain high and possibly increase heading into next year, thereby creating more opportunities for fund outperformance given our active, credit-driven strategy.

Our outlook is informed by a recent analysis our team did, looking at the three most significant periods of volatility in the U.S. leveraged loan market over the last 15 years: the global financial crisis [2008–2009], the energy sector sell-off [2015–2016], and the Covid–19 pandemic [2020]. The purpose was to evaluate the relationship between loan market volatility, defaults, and market returns. Our analysis indicates that loan market volatility as measured by price dispersion [the difference between the worst and best performers] is highly correlated with the level and the change of returns rather than default rates. While the investment team expects default rates to gradually increase throughout the course of 2023, loan market prices can actually move higher in such scenarios [and have historically done so]. More specifically, our analysis demonstrates that loan prices, as represented by the Morningstar LSTA US Leveraged Loan Index, begin a sustained recovery phase once price dispersion inflects.

Loan price dispersion hit 13% at the end of 2022, its highest reading since the onset of the Covid–19 pandemic in Q2 2020, yet there were no defaults in Q4 2022 and the number of loan gainers outnumbered decliners in the quarter. We believe the U.S. leveraged loan market may be at, or very close to, a price dispersion inflection point and poised for attractive returns in 2023, which are likely to be above the long-term annual average returns. Prudent credit selection will continue to be paramount for generating alpha. Corporate fundamentals, generally speaking, were decent for Q3 2022. However, most non-investment-grade issuers remain challenged to maintain or recover margins impacted by inflation and a much more discerning consumer.

More broadly, volatility may continue in fixed income markets given expected further tightening of monetary policy, ongoing geopolitical risks, and how higher interest rates are affecting all debt market activity.