In the first two months of 2016, spreads across a number of fixed-income sectors widened dramatically only to reverse trend and narrow significantly by the end of April. This brief window is just an example of the unexpected and sometimes bewildering challenges facing fixed-income investors over the past three years. From the time when the Fed first began withdrawing its unprecedented stimulus measures in 2013 through to its December rate hike, the first of this cycle, the Fed’s efforts have been an exercise in brinksmanship with volatile and uncertain global markets.
As the Fed continues on its path to normalize rates, we believe investors need to think outside of index constraints. One way to insulate portfolios from future rate hikes is through allocations beyond U.S. Treasuries and traditional spread sectors — into sectors such as high-yield credit and, in particular, securitized mortgage debt. These securities provide diversification benefits without the need to sacrifice yield or expected return.
Historically low correlation to many sectors and asset classes
Historically, when the Fed has raised rates, Treasury rates have tended to move higher, and the Treasury yield curve has flattened. In such environments, spreads for other sectors of the fixed-income markets (mortgage-backed securities (MBS), investment grade, high yield, corporate debt, etc.) have generally tightened as a reflection of a stronger economy.
This rate-hike cycle might well be different, as the Fed has shown a reluctant willingness to consider global market volatility as a factor in its decisions. But for those investors who consider Treasuries and traditional spread sectors at risk, our research has shown that mortgage-backed securities offer excellent diversification benefits.
Non-agency residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), and various prepayment strategies, including interest-only (IO), that are available in the agency collateralized mortgage obligations (CMO) market have proven over time to have a low correlation to both corporate credit-related securities (investment grade and high yield) and emerging-market debt, as well as equities. Unlike the various subsectors of the credit markets that have been shown to have a relatively high correlation to equities (i.e., 0.40 to 0.70), the subsectors of the mortgage market have much lower correlations (i.e., 0.00 to 0.25).
In our view, these correlation data indicate the presence of systematic securitized risk factors that differ from those found in various types of corporate credit risk.
In addition, these mortgage strategies — RMBS, CMBS, and IOs — all have low correlations to each other, indicating that investors may benefit by including all three mortgage-backed security types as part of a broad fixed-income portfolio.
We believe the risks in these sectors look attractive from a relative value perspective and for building a more diversified portfolio. In today’s environment, as the Fed embarks on raising interest rates, the low correlations of these strategies can help to build greater resilience into a portfolio.
For informational purposes only. Not an investment recommendation.
This material is provided for limited purposes. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Putnam product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice. The opinions expressed in this article represent the current, good-faith views of the author(s) at the time of publication. The views are provided for informational purposes only and are subject to change. This material does not take into account any investor’s particular investment objectives, strategies, tax status, or investment horizon. Investors should consult a financial advisor for advice suited to their individual financial needs. Putnam Investments cannot guarantee the accuracy or completeness of any statements or data contained in the article. Predictions, opinions, and other information contained in this article are subject to change. Any forward-looking statements speak only as of the date they are made, and Putnam assumes no duty to update them. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties. Actual results could differ materially from those anticipated. Past performance is not a guarantee of future results. As with any investment, there is a potential for profit as well as the possibility of loss.
Diversification does not guarantee a profit or ensure against loss. It is possible to lose money in a diversified portfolio.
Consider these risks before investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Investments in small and/or midsize companies increase the risk of greater price fluctuations. Bond investments are subject to interest-rate risk, which means the prices of the fund’s bond investments are likely to fall if interest rates rise. Bond investments also are subject to credit risk, which is the risk that the issuer of the bond may default on payment of interest or principal. Interest-rate risk is generally greater for longer-term bonds, and credit risk is generally greater for below-investment-grade bonds, which may be considered speculative. Unlike bonds, funds that invest in bonds have ongoing fees and expenses. Lower-rated bonds may offer higher yields in return for more risk. Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk. Commodities involve the risks of changes in market, political, regulatory, and natural conditions. You can lose money by investing in a mutual fund.
Putnam Retail Management.