October 2012 » Putnam Perspectives

Fixed-Income Outlook  

Key takeaways

•Investors regained risk appetites in Q3, sending spread sectors higher •The Fed’s highly anticipated QE3 announcement may ultimately lower mortgage rates, but interest-rate risk remains unattractive

•Fundamentals in the corporate debt space appear solid heading into 2013 •Policy uncertainty still a risk in the municipal bond market, whatever the outcome of November’s elections

Putnam’s outlook
Asset class Negative Slightly negative Neutral Slightly positive Positive


U.S. government and agency debt U.S. tax exempt Tax-exempt high yield Agency mortgage-backed securities Collateralized mortgage obligations Non-agency residential mortgage-backed securities Commercial mortgage-backed securities U.S. floating-rate bank loans U.S. investment-grade corporates Global high yield Emerging markets U.K. government Eurozone government Japan government

l l l l l l l l l l l l l l

Dollar/yen Dollar/euro Dollar/pound

Favor dollar Neutral Favor dollar


OCTOBER 2012 | Fixed-Income Outlook

In a reversal from the second quarter, investors bid up risky assets, sending spreads tighter Fixed-income markets were benign in the third quarter, as investors shrugged off tepid global growth prospects and focused on accommodative policy responses from central banks. That is not to say the large-scale issues worrying investors have been resolved; rather, they seem less potentially catastrophic than they once appeared. The European sovereign debt situation, which has dominated headlines for much of the past 12 months, appears to have stabilized. Europe’s fiscal problems have by no means been solved, but it now appears rather unlikely that the Continent is facing an imminent financial meltdown, or that the European Union is on the verge of disintegration. An economic slowdown in China was another big concern for investors in recent months. At Putnam, we believe we are in the early stages of China’s transitioning from an exportdriven economy to a more domestic-focused one, and while that may mean China’s economy won’t continue expanding at 10% per year, we don’t anticipate that the slowdown will be so severe as to usher in another global recession. Lastly, tensions in the Middle East are obviously running high at the moment, but if there is a silver lining, it is that what recently appeared to be a looming conflict between Israel and Iran has calmed somewhat.

The takeaway for investors is that many segments of the bond markets, by our analysis, were priced for bleaker scenarios, and absent any shocks to the financial system, so-called “risk assets” appear attractively valued. Investors came to the same conclusion in the third quarter, and a variety of risk assets rallied. European financial meltdown appears increasingly unlikely Since 2010, as the stresses in the European sovereign debt market increasingly came to light, our central thesis has been that the near-term liquidity problems in Europe were manageable, while the longer-term structural challenges were the real issue facing the region. The liquidity issues may have been a bigger threat than we originally believed, but today the chances of an EU breakup appear much lower than they did a year ago. In general, we believe the situation is slowly improving. The recent introduction of a new and potentially unlimited bond-buying program is an improvement over previous iterations of central bank support, and investors have tended to view it as such. The biggest hurdles today are time and a lack of a clear consensus. The longer European policymakers take to begin to address the structural problems facing member states, the harder those problems become to solve. Moreover, unlike in the United States

Figure 1. Spread sectors rallied in Q3 amid renewed investor optimism
6% 5 4 3 2 1 0 -1 -2 -3 Barclays U.S. Barclays Municipal Aggregate Bond Index Bond Index Barclays Barclays Bond: U.S. Mortgage Muni Backed High Yield Securities Index Barclays CMBS Index S&P/LSTA Loan Index Barclays U.S. JPMorgan Credit Global Corporate High-Yield Index Index JPMorgan Barclays Barclays Barclays Emerging Sterling Pan European Japanese Markets Aggregate Aggregate Aggregate Bond Index Bond Bond Bond Index Global Diversified Index Index

2Q 12 3Q 12

Source: Putnam research, as of 9/30/12. Past performance is not indicative of future results. 2


Figure 2. The Treasury yield curve steepened in Q3 in part due to increased inflation expectations
3% 9/30/12 6/30/12 2




rs 1m 3 on m 6 on th m th on s 1   ths ye ar 2 ye ar 3 s ye ar s ye a ye a ye a 20 30 10 5 7 ye ar s rs rs rs ye a

Source: U.S. Department of the Treasury, as of 9/30/12.

where a two-party system drives the political process, the EU must navigate a number of disparate interest groups, which may share little common ground. Unfortunately, we have tended to see progress at the negotiating table only when market stresses come to the forefront; when crisis appears to have been averted, the parties involved tend to be more aggressive in defending their positions. We’re not overly optimistic on the situation in Europe, and few investors are. But the expectations are generally so low that if policymakers can avoid disaster, we believe the markets will interpret that as a positive signal going forward. QE3 may push certain rates lower, but a longduration stance remains an unattractive proposition This year has been rather unusual for the fixed-income markets in that both risk assets — such as corporate or emerging-market debt — and safe-haven Treasuries have performed quite well. This rarely tends to be the case. Typically, the tightening of spreads in risk assets is accompanied by a strengthening economy and often-rising Treasury yields. The fact that both Treasury yields have fallen and spread sectors have tightened is, in many ways, a testament to how aggressive central banks have been in injecting liquidity into financial markets. Looking specifically at the third quarter, Treasury rates finished about where they started after falling, rather quietly, to record lows in July.

It is worth pointing out how difficult it would be for this trend of solid performance in the Treasury market to continue. As recently as April 2010, the yield on bellwether 10-year Treasuries was 4%, and today it is less than half that. Yields would need to drop essentially to zero for Treasury returns over the next two years to approach those of the past two. Even if that were to happen, Treasury returns would likely be lower going forward because the income generated — which is one of the two pieces of a bond’s total return — is so much less today than it was two years ago. The short end of the yield curve, as has been the case since late 2008, continues to be anchored at near-zero levels, and after the most recent meeting of the Federal Reserve, it announced its intention to keep those rates in place until sometime in 2015. The other announcement, widely anticipated by investors, was the launch of a third round of quantitative easing, commonly referred to as “QE3.” The aim of this latest initiative is to keep interest rates low in order to encourage investor risk taking and investment in the economy. Like the two rounds of easing that preceded QE3, the Fed will purchase bonds, targeting in this iteration the agency mortgage-backed securities market. The Fed intends to purchase approximately $40 billion in assets per month, and while the length of the bond-buying program is uncertain, it will likely continue until the labor market shows substantial improvement.

OCTOBER 2012 | Fixed-Income Outlook

Figure 3. Central bank balance sheets have expanded dramatically since the financial crisis
35% ECB total assets % GDP 30 25 20 15 10 5 2007 2008 2009 2010 2011 2012
Sources: Bank of England, Federal Reserve, European Central Bank, as of September 2012.

BOE total assets % GDP Federal Reserve total assets % GDP

The effect that QE3 will ultimately have on the economy and the markets depends on, first, the velocity of money, or how quickly credit is able to move through the financial system; and, second, the psychological signal that the Fed is sending. Investors have come to expect that the Fed will do everything within its power to pursue its dual mandate of stable prices and maximum employment, and launching QE3 has thus far been interpreted as an encouraging sign. However, investors understand that these forms of market stimulus are on some level inflationary: In the months after QE1 and QE2 were announced, long-dated Treasuries actually saw their yields rise. Although the increase since the announcement of QE3 has been rather small, the possibility of a larger jump does exist: We feel the greatest potential cause of a significant rise in long-term interest rates would be if investors came to believe that the flow of federal stimulus were being wound down too quickly for other market participants to pick up the slack in the demand for Treasuries and agency mortgages. For many months now, we’ve maintained an underweight duration exposure relative to our funds’ benchmarks. Duration, as a reminder, measures a portfolio’s sensitivity to interest-rate changes. One of our goals over the past quarter was to position the funds so that interest-rate movements — in either direction — were not the dominant

driver of relative performance, and we were successful in making that the case in the third quarter. Corporate, prepayment, and mortgage credit sectors offer most attractive opportunities for investors looking forward Investment-grade corporate bonds continued to perform well during the third quarter. Coming out of the financial crisis in 2008–2009, corporations took aggressive steps to shore up their balance sheets and rein in expenses, and today they are running very lean, profitable organizations, with the added benefit of having record levels of cash on hand. It has been a very attractive combination for investors, especially given the record-low yields in the Treasury markets, and our investment-grade positions benefited performance in the funds for the quarter. The story in the high-yield corporate space is essentially the same: The 2008 credit crisis served to purge the high-yield universe of the least stable companies, and the remaining cohort has performed extremely well since, with defaults well below the long-term average for the asset class. One area that we find particularly attractive is among those companies on the verge of being upgraded from the high-yield to the investment-grade space — the BB-rated universe. As you would expect, the financial outlook for these types of companies is solid, and we find



the yield advantage of these securities attractive relative to the potential risks. Performance in both the agency-backed and non-agency RMBS space was solid in the third quarter. The mortgage market in general had performed well throughout the quarter as investors became more willing to take risk. Once the Fed announced the details of QE3, mortgage-backed securities received an additional boost, and that included non-agency securities that lie outside the scope of the Fed’s purchase plan. Interest-only collateralized mortgage obligations, or CMO IOs, also gained ground. As the name suggests, these securities are derived from the interest payments on those pools of residential mortgages. Essentially, the longer it takes for homeowners to repay the principal on their mortgages, the more money a bondholder will make from interest payments on that loan. Over the past several quarters, with home prices still under pressure and refinancing difficult for many homeowners to obtain, IO securities have performed quite well. IOs gave back some of their gains in September as mortgage spreads tightened, leading

to fears of higher prepayment rates if mortgage rates for homeowners were to decline significantly. Lastly, commercial mortgage-backed securities (CMBS) spreads moved tighter. CMBS tend to key off the strength of the macroeconomic environment in the United States, and while growth has been frustratingly slow, it has proven to be less fragile than investors had feared earlier in the year. Moreover, the supply and demand characteristics have been supportive of the sector, and we have continued to see buy-and-hold investors entering the CMBS market in recent months, which has helped lend further stability. Within these spread sectors, we do not have a strong bias in favor of either credit risk or prepayment risk. Both appear attractively valued at the moment, and within credit risk specifically, we are relatively neutral on corporate versus mortgage credit. While the “risk-on/risk-off” trade tended to dominate market movements in 2012, we believe that large macroeconomic events are less likely to be a significant driver of returns over the near term, and that in such an environment, security selection will be of increased significance.

Figure 4. Current spreads relative to historical norms
Average OAS 12/31/97– 12/31/07 34 56 130 511 89 123 150 425 Month-end OAS 9/30/12 30 27 156 551 113 450–700 700–1000 332
-93 –4 –29 26 40 24 327 550 577 850

Sector Agencies Agency MBS Investment-grade corporates High yield AAA CMBS Non-agency RMBS Agency IOs Emerging-market debt


Sources: Barclays, Putnam, as of 9/30/12. Data are provided for informational use only. Past performance is no guarantee of future results. All spreads are in basis points and measure optionadjusted yield spread relative to comparable maturity U.S. Treasuries with the exception of non-agency RMBS, which are loss-adjusted spreads to swaps calculated using Putnam’s projected assumptions on defaults and severities, and agency IO, which is calculated using assumptions derived from Putnam’s proprietary prepayment model. Agencies are represented by Barclays U.S. Agency Index. Agency MBS are represented by Barclays U.S. Mortgage Backed Securities Index. Investment-grade corporates are represented by Barclays U.S. Corporate Index. High yield is represented by Barclays U.S. Corporate High Yield Index. AAA CMBS are represented by Aaa portion of Barclays Investment Grade CMBS Index. EMD is represented by Barclays Global Emerging Markets Index. Non-agency is estimated using the average market level of a sample of below-investment-grade securities backed by Alt-A collateral. Agency IO is estimated from a basket of Putnam-monitored interest-only securities. Option-adjusted spread (OAS) measures the yield spread over duration equivalent Treasuries for securities with different embedded options. 5

OCTOBER 2012 | Fixed-Income Outlook

Fundamentals in corporate debt remain attractive, and defaults could potentially remain below average for the foreseeable future Our outlook on fundamentals in the corporate credit space remains solid, particularly within high yield. Historically, after a period of heightened defaults in the high-yield market, the default rate among the remaining companies in the high-yield universe has tended to remain relatively low for anywhere from five to ten years. Today, we are only three years out from the most recent peak in defaults in 2009, so we have reason to believe this trend could continue for some time. Moreover, we are not seeing significant levels of issuance for mergers and acquisitions or for leveraged buyout activity. Today, as much as two thirds of new high-yield issuance is being used to refinance existing bank debt. And as a result of that trend, about 25% of the high-yield market is now secured, as that bank debt collateral has been transferred to the new bonds. In addition, many high-yield issuers have been very conservative with their use of capital because economic growth has been so slow, adding to their cash reserves, for example, instead of investing in new infrastructure or seeking to expand their businesses through acquisitions. This behavior has been good for bond investors, who have benefited from improving corporate balance sheets and stable revenues. The floating-rate debt space, meanwhile, has seen strong demand throughout 2012, which has helped create price stability. Individual investors often have used floatingrate-loan funds as a hedge against rising short-term rates. But that is a much less compelling reason to own the asset class with the Federal Reserve recently announcing that short-term rates will be locked essentially at zero until 2015. More compelling is the protection that floating-rate loans can offer from volatility on the long end of the yield curve. With the announcement of QE3 and Europe kicking off its own open-ended bond-buying program, there is reason to believe that both economic growth and inflation could tick up, which would likely result in higher long-term rates. Floating-rate notes would be less affected than other segments of the bond markets in such an environment. Our base case calls for a continued slow growth recovery in the United States, which would be conducive to solid

performance in the corporate debt markets. While spreads ended the quarter tighter and are closer to their long-term averages, they remain attractive relative to defaults, which have been low and stable. All in all, we believe high-yield and floating-rate bonds remain attractive options for investors in a low-rate world. Policy risks represent uncertainty for municipal bond investors, but the fiscal cliff is unlikely to derail year-long gains Throughout 2012, municipal bonds have benefited from the fact that they offer higher yields than Treasuries but still entail relatively low risk of default. Investors have flocked to the asset class, pouring nearly $40 billion into the municipal bond market to date, among the highest flows in the past 20 years. Supply, meanwhile, has been relatively limited, especially within high-yield municipal bonds. In 2006 and 2007, nonrated bonds were being issued at a rate of $5 billion to $6 billion a year, our research shows. Today, new issuance is roughly $1.8 billion through September of this year. On the investment-grade side, a significant majority of issuance in 2012 has been for the purpose of refinancing existing debt at lower interest rates. This inequity between supply and demand has helped keep upward pressure on prices. As has been the case for some time now, one of the biggest threats to the municipal bond market is the so-called “fiscal cliff,” and the closer we get to the November elections, the more attention we believe the issue will get. Obviously, investors would prefer the issue be addressed
Figure 5. Spread sectors posted solid gains over Treasuries








U.S. agency

Source: Barclays, as of 9/30/12. Past performance is not indicative of future results.


sooner rather than later. We believe it is highly unlikely any progress will be made prior to November 6, and it is anyone’s guess as to whether the lame-duck session of Congress will put together legislation before January. There is certainly incentive to take up the issue soon: The Congressional Budget Office estimates that the combined effect of the spending cuts and tax hikes would negatively impact GDP. The market is hopeful that an extension deal can be reached after the election, and that a longer-term solution to debt levels and tax rates can be taken up in the first part of 2013. From a positioning standpoint, we have continued to focus our investments on essential service revenue bonds, which we believe are more insulated from fiscal pressures at the municipal level. While tax receipts have been gradually improving, considering the slow growth we’re seeing in the broader economy, we believe local debt — and particularly local general obligation debt — is more vulnerable to any bumps on the road. Our preference remains for the A-rated and BBB-rated segments of the market, which, even after more than three years of spread tightening, continue to appear attractively valued compared with other segments of the municipal bond market. We continue to be optimistic on the outlook for municipal bonds, given strong market technicals, and maintain our overweight to essential service revenue bonds. While spreads are well off their wides, they remain attractive. Supply is likely to experience a seasonal increase in October and November, but demand for bonds remains strong given cash flows into the asset class, and December and January will once again bring the potential for increased reinvestment demand. Currency outlook continues to favor U.S. dollar and targeted positions in commodity-sensitive currencies One of our main strategies throughout 2012 has been a significant overweight to the U.S. dollar, which was trading at the end of September essentially where it began the year. The recent weakness is somewhat surprising given the global context. Given an outlook of positive U.S. growth and continued struggles in Europe, U.S. markets — particularly the high-yield and equity markets — look quite attractively

Putnam’s veteran fixed-income team offers a depth and breadth of insight
Successful investing in today’s markets requires a broad-based approach, the flexibility to exploit a range of sectors and investment opportunities, and a keen understanding of the complex global interrelationships that drive the markets. That is why Putnam has more than 70 fixed-income professionals focused on delivering comprehensive coverage of every aspect of the fixed-income markets, based not only on sector, but also on the broad sources of risk — and opportunities — most likely to drive returns.
D. William Kohli Co-Head of Fixed Income Global Strategies Investing since 1987; joined Putnam in 1994 Michael V. Salm Co-Head of Fixed Income Liquid Markets and Securitized Products Investing since 1989; joined Putnam in 1997 Paul D. Scanlon, CFA Co-Head of Fixed Income Global Credit Investing since 1986; joined Putnam in 1999

valued relative to other risk assets globally. If the flow of capital into U.S. markets accelerates, as we believe it will, the U.S. dollar should benefit. In a related theme, we have maintained limited exposures to the euro and the Japanese yen, which we believe are likely to experience significant volatility. The other strategy that we have been utilizing is an overweight to commodity-linked currencies, such as the Australian dollar, and currencies sensitive to the global growth cycle, including the Swedish krona. With growth in China slowing in recent months, commodity demand has softened somewhat, although prices remain relatively high on a historical basis. We continue to be optimistic on the secular demand for commodities, even with slower growth in China and in emerging markets more broadly, and have maintained our overweights to currencies that stand to benefit.

OCTOBER 2012 | Fixed-Income Outlook

Barclays Global Aggregate Bond Index is an unmanaged index of global investment-grade fixed-income securities. Barclays GNMA Index is an unmanaged index of Government National Mortgage Association bonds. Barclays Government Bond Index is an unmanaged index of U.S. Treasury and government agency bonds. Barclays Municipal Bond Index is an unmanaged index of long-term fixed-rate investment-grade tax-exempt bonds. Barclays U.S. Aggregate Bond Index is an unmanaged index of U.S. investment-grade fixed-income securities. BofA Merrill Lynch U.S. Treasury Bill Index is an unmanaged index that tracks the performance of U.S. dollar denominated U.S. Treasury bills publicly issued in the U.S. domestic market. Qualifying securities must have a remaining term of at least one month to final maturity and a minimum amount outstanding of $1 billion. JPMorgan Emerging Markets Global Diversified Index is composed of U.S. dollar-denominated Brady bonds, eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities. JP Morgan Global High Yield Index is an unmanaged index of global high-yield fixed-income securities. You cannot invest directly in an index.

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 securities, 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. The views and strategies described herein may not be suitable for all investors. 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. The information provided relates to Putnam Investments and its affiliates, which include The Putnam Advisory Company, LLC and Putnam Investments Limited®. Prepared for use in Canada by Putnam Investments Inc. [Investissements Putnam Inc.] (o/a Putnam Management in Manitoba). Where permitted, advisory services are provided in Canada by Putnam Investments Inc. [Investissements Putnam Inc.] (o/a Putnam Management in Manitoba) and its affiliate, The Putnam Advisory Company, LLC.

Consider these risks before investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Additional risks may be associated with emerging-market securities, including illiquidity and volatility. 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. The use of derivatives involve additional risks, such as the potential inability to terminate or sell derivatives positions and the potential failure of the other party to the instrument to meet its obligations. Funds that invest in bonds are subject to certain risks including interest-rate risk, credit risk, and inflation risk. As interest rates rise, the prices of bonds fall. Long-term bonds are more exposed to interest-rate risk than short-term bonds. Unlike bonds, bond funds have ongoing fees and expenses. If you are a U.S. retail investor, please request a prospectus, or a summary prospectus if available, from your financial representative or by calling Putnam at 1-800-225-1581. The prospectus includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing.
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