Floating-rate bank loans outperform fixed income markets

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Q2 2023 Putnam Floating Rate Income Fund Q&A

• Security selection in bank loans and a tactical allocation to high-yield corporate bonds aided fund performance.
• We believe the U.S. leveraged loan market may be at, or very close to, a price dispersion inflection point, when loan prices will begin a sustained recovery.
• Company-specific fundamentals will continue to make credit selection, position sizing, and timing key factors for fund performance in the second half of 2023.

How did the fund perform for the three months ended June 30, 2023?

The fund’s class Y shares gained 3.00%, performing roughly in line with the benchmark Morningstar LSTA US Leveraged Loan Index, which returned 3.15%.

What was the market environment during the first quarter?

Market conditions were mixed. Fixed income rallied in April 2023. Even as a U.S. recession remained a possibility, expectations about the future path of the Federal Reserve’s monetary policy changed. Investors hoped a continued economic slowdown might give the Fed room to ease monetary policy.

In May, fixed income encountered headwinds. Lingering concerns about the failure of a few regional banks in March 2023, the U.S. debt ceiling, and higher U.S. Treasury rates weighed on investor sentiment. At its May 2023 meeting, the Fed raised its benchmark interest rate by 0.25% to a range of 5.00%–5.25%. In its commentary, the Fed suggested that future interest-rate hikes would be dependent on the effect of past rate hikes on the economy. In late May, Congress and the White House agreed to a debt ceiling deal.

In the final weeks of the quarter, sentiment improved. A cooler-than-expected inflation reading for May 2023 led to expectations that the Fed might hold interest rates steady at its June meeting. At that meeting, the Fed skipped an interest-rate hike to allow time to assess the effects of its monetary policy and to potentially avoid tipping the U.S. economy into a recession. Fed policymakers added that two more interest-rate hikes remained a possibility this year.

Credit spreads mostly tightened during the quarter. [Credit spreads are the yield advantage credit-sensitive bonds offer over comparable-maturity U.S. Treasuries. Bond prices rise as yield spreads tighten and decline as spreads widen.] The Bloomberg U.S. Aggregate Bond Index returned –0.84%. High-yield corporate bonds fared better, with the JPMorgan Developed High Yield Index posting a return of 1.86%. As noted before, floating-rate bank loans, as measured by the fund’s benchmark, delivered a 3.15% gain for the quarter.

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

Security selection within bank loans was the key driver of fund performance in the second quarter, as the fund kept pace with the market and did well avoiding defaults. The price dispersion of loans increased, meaning the difference between the worst and best performers grew. This presented the team with attractive idiosyncratic opportunities for credit selection.

The fund also had a tactical allocation to high-yield corporate bonds. Spreads, represented by the JPMorgan Developed High Yield Index, tightened 65 basis points during the quarter. However, our modest allocation in the fund weighed slightly on returns. Going forward, we believe tactical, proactive trading will be beneficial. Price dispersion remains elevated, and company-specific fundamentals will continue to make credit selection, position sizing, and timing key factors for fund performance in the second half of 2023.

What is the team’s near-term outlook for the bank loan market?

We expect loan price dispersion to remain high, thereby creating more opportunities for fund outperformance given our active, credit-driven strategy. New issuance activity also presents attractive investment opportunities, particularly with issuers that must address loan maturities.

The second quarter of 2023 witnessed 14 company defaults, impacting $22.7 billion in bonds and loans, and bringing the loan default rate to 1.71%. Loan price dispersion, which reached a year-to-date high of 14.86% at the end of May, dipped to 14.13% at the end of June. Of note, the leveraged loan market has continued its positive momentum into July, with the Morningstar LSTA US Leveraged Loan Index hitting 94.5 on July 10, which is 160 bps higher than the end-of-May reading when price dispersion had seemingly peaked. We believe the U.S. leveraged loan market may be at, or very close to, a price dispersion inflection point, when loan prices will begin a sustained recovery. We expect the leveraged loan market to generate returns in 2023 that are above their long-term annual average. In this environment, prudent credit selection will be an important driver of alpha. Most non-investment-grade issuers continue to be challenged by shrinking profit margins due to inflationary pricing and a more discerning consumer. By the same token, however, we are encouraged by the resilience and operational countermeasures to these macro headwinds from many of our portfolio companies as they seek to preserve cash flow and maintain durable balance sheets.

More broadly, we expect volatility to continue across fixed income markets given macro-driven risks, including a further tightening of monetary policy, ongoing geopolitical turmoil, and the impact of higher interest rates on all debt market activity.

See the fund's information page.