Putnam Perspective: Fixed Income Outlook Q2 2014

Putnam fixed-income viewsArrows in the table indicate the change from the previous quarter.

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Agency mortgage-backed securities l

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Global high yield l

Emerging markets l

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CURRENCY SNAPSHOT

Dollar vs. yen: DollarDollar vs. euro: DollarDollar vs. pound: Dollar

The era of new policy-guidance regimesIn the opening months of 2014, we learned a thing or two about how developed-market central banks are seeing the world today. In the United States, the Federal Reserve’s March meeting, followed by the first press conference of the Yellen era, was more hawkish than markets had expected. In Europe meanwhile, the European Central Bank (ECB) continues to promise much but do little, though the promises now carry a new hint of substance that we did not foresee. And in Japan, we believe the Bank of Japan (BoJ) is in a wait-and-see mode, even as Japanese markets stumble awkwardly through a correction in response to softer economic data in China and the complexities of enacting structural economic reform.

The waiting over, stimulus reduction gets under wayTelegraphed in May 2013, the Fed’s transition from stimulus finally began in the first quarter of 2014, and while the $10 billion monthly bond-buying reductions were well communicated to the markets, remarks on the unfolding of future Fed action — particularly increases in the federal funds rate — amplified rate volatility. In short, the Fed’s March meeting suggested the possibility of aggressive action sooner than most market observers had anticipated. The pace of tapering the bond-buying program was maintained, and it became clear that the hurdle for changing the pace is high. But following the meeting, various Fed officials delivered comments and speeches ranging from more hawkish to more dovish, and the net effect of this has created some uncertainty in rate markets.

Key takeaways• We expect rate volatility to remain high as Fed tapering

continues and as the U.S. labor market struggles to normalize.• In Europe, the European Central Bank has moved a step closer

to easier monetary policy, which may drive further spread compression in peripheral sovereign bonds.

• Recent stability in emerging-market asset markets suggests better data for developing countries could be on the horizon.

• Our outlook for credit, prepayment, and liquidity risks remains positive.

Fixed-Income OutlookQ2 2014 » Putnam Perspectives

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Q2 2014 | Fixed-Income Outlook

In our view, the Fed wants to maintain an accommodative policy, but it may also desire that the market begin to discount the possibility of a less accommodative stance. Alternatively, as some market observers have noted in the wake of the release of the March meeting minutes, the Fed may have come off more hawkish than it had intended. Whatever the Fed’s intention, markets have generally regrouped around the expectation that rates could rise somewhat sooner than people could have forecasted in the pre-Yellen era.

U.S. economic data are improving, but wages are still a wildcardBy the end of the first quarter, U.S. economic data began to improve somewhat from what had been winter-related economic weakness. After disappointing results from various sectors of the U.S. economy, higher auto sales, improving business activity, and overall job creation that is generally in line with forecasts have helped shape expectations for a comparatively better spring. In our view, as the U.S. economy continues to strengthen in 2014, Treasury yields, particularly in the intermediate part of the yield curve, are likely to move higher. However, we don’t believe rates are likely to rise so quickly that the shift will undermine economic growth.

Figure 1.  Fixed-income asset class performance

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rate bank loans

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backed securities

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backed securities

Tax-exempt

high yield

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exempt

U.S. government

Source: Putnam research, as of 3/31/14. Past performance is not indicative of future results. See page 10 for index definitions.

Fixed income delivered strong performance across most sectors in the first quarter of 2014.

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We continue to think that, with the economy looking better, the key to the pace of normalization can be found in the labor market. Chair Yellen repeated her view that much of the decline in labor participation is cyclical rather than structural. This view is reflected in the March labor report, as it showed a rise in participation that one would expect from a normalizing economy.

The questionable factor in this formula for normaliza-tion, we believe, is rising wages. If Yellen is correct, the economy should be able to grow strongly for a longer period before inflationary pressures emerge in the labor market. But if she is wrong and participation does not continue to rebound, higher wages among a smaller population of skilled workers could begin to push up labor costs that may not be offset by higher productivity. If this should come to pass, we think the stance of monetary policy would have to shift quickly, potentially leading to a faster and more dramatic rise in rates than the market currently expects.

Figure 2. Short-term rates remained anchored by the Fed’s monetary policy

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Source: U.S. Department of the Treasury, as of 3/31/14.

Interest rates fell across the intermediate and long portions of a flattening yield curve in the first quarter.

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Q2 2014 | Fixed-Income Outlook

Europe may breathe more easily after allIn Europe, the economy continues to improve along a path of steady growth. In terms of policy, there are new signs of substance. The new Italian government, for example, has advanced an ambitious reform agenda that would not only make important structural changes politically, but also institute an easier fiscal stance to support growth.

In addition, the ECB has sounded a new note of support for quantitative easing measures, perhaps primarily due to policymakers’ discomfort with the region’s very low rates of inflation. ECB President Mario Draghi recently offered a number of dovish remarks on the topic of the euro exchange rate and, most importantly, on the unanimity of support among the central bank’s Governing Council members for adopting unconventional policy measures should the need arise.

Whether the ECB will actually ease policy further, by a negative deposit rate or some other measure, is still an open question. But it does increase our comfort with peripheral European sovereign debt, whose spreads, we believe, will continue to compress in the coming months.

Figure 3. High-yield spreads and defaults generally move in tandem over credit cycles

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’11 ’12 ’13 3/31/14’10’09’08’07’06’05’04’03’02’01’00’99’98’97’96’95’94’93’92’91’90’89’88’87

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Current spread: 435 bps (as of 3/31/14)20-year median spread: 523 bpsAverage default rate: 3.9%

Today, the gap between spreads and defaults remains wide, signaling opportunity for investors.

High-yield default rate

Spread to worst

1Current default rate includes distressed exchanges.

Sources: JPMorgan, High Yield Market Monitor, 3/31/14; Putnam Investments.

Spreads have come in from all-time highs; defaults remain low.

High-yield default rate*

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U.S. high yield and bank loans buoyed by strong fundamentalsAt this stage in the credit cycle, our view is generally positive. Corporations continue to take a conservative approach toward managing their assets and liabilities. Most have refinanced debt and lowered their overall borrowing costs, and many are holding sizable cash balances. As a result, corporate debt defaults remain very low. At 0.61% as of the end of March, defaults are at

their lowest level since December 2007, and considerably lower than the long-term average of 3.90%. In our view, corporate fundamentals should continue to be reasonably sound against the backdrop of a slow-growth economic environment. However, as we enter the second quarter of 2014, we could see the monthly number increase slightly in the short term because of an expected default by a large issuer, but this is by no means a systemic issue going forward.

Figure 4. Current spreads relative to historical norms

n  Average excess yield over Treasuries (OAS, 1/1/98–12/31/07)

n  Current excess yield over Treasuries (OAS as of 3/31/14)

Sources: Barclays, Bloomberg, Putnam, as of 3/31/14.

Data is provided for informational use only. Past performance is no guarantee of future results. All spreads are in basis points and measure option-adjusted yield spread relative to comparable maturity U.S. Treasuries with the exception of non-agency RMBS and mezzanine CMBS, 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 the Barclays U.S. Agency Index. Agency MBS are represented by the Barclays U.S. Mortgage Backed Securities Index. Investment-grade corporates are represented by the Barclays U.S. Corporate Index. High yield is represented by the JPMorgan Developed High Yield Index. AAA CMBS is represented by the Aaa portion of Barclays Investment Grade CMBS Index; mezzanine CMBS is represented by the same index using the AA, A and BBB components. Average OAS for Mezzanine CMBS is for the 2000–2007 time period. Emerging-market debt is represented by the Barclays EM Hard Currency Aggregate Index. Non-agency RMBS is estimated using average market level of a sample of below-investment-grade securities backed by various types of non-agency mortgage collateral (excluding prime securities). Mezzanine CMBS is estimated from an average spread among baskets of Putnam-monitored new issue and seasoned mezzanine securities, as well as a synthetic (CMBX) index. Agency IO is estimated from a basket of Putnam-monitored interest-only (IO) and inverse IO securities. Option-adjusted spread (OAS) measures the yield over duration equivalent Treasuries for securities with different embedded options.

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Agency MBS

Agencies

We continue to find compelling investment opportunities in out-of-benchmark sectors, given their relative spread levels and solid underlying fundamentals.

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Q2 2014 | Fixed-Income Outlook

Our view is similarly constructive for bank loans. This is the case in part because we think many companies issuing bank loans today have much-improved credit profiles and are seizing the opportunity to refinance obligations that they accumulated during the 2007–2009 period. In addi-tion, if rates should rise meaningfully higher in 2014, bank loans would stand to benefit from increased demand, as their floating-rate structure allows these loans to pay a higher yield when short-term rates rise. Consequently, absent an external shock to the marketplace, we believe both high-yield bonds and bank loans should be able to continue generating modest, coupon-like returns in the months ahead.

Securitized markets: Regulatory and market changeAs a group, our prepayment strategies, which were implemented primarily with securities such as interest-only collateralized mortgage obligations (IO CMOs), contributed positively to portfolio performance. Lower policy risk coupled with mortgage rates that remained at elevated levels versus those of the past couple of years reduced the likelihood that the mortgages underlying our CMO holdings would be refinanced, and the resulting slower prepayment speeds helped boost the securities’ values.

Figure 5. Excess returns relative to U.S. Treasuries

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MBSCMBSU.S. investment-grade credit

Emerging-market debt (EMD)

High yield

Source: Barclays, as of 3/31/14. Past performance is not indicative of future results.

In the context of a 3.38% return for 10-year U.S. Treasuries, most other sectors outperformed, with high yield and EMD exhibiting particularly strong performance.

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Within mortgage credit, our holdings of commercial mortgage-backed securities (CMBS) and non-agency residential mortgage-backed securities (RMBS) were also major contributors. Within CMBS, the fund benefited from solid security selection in subordinated “mezzanine” bonds rated BBB/Baa, which offered higher yields at what we believed were acceptable levels of risk. Mezzanine CMBS are lower in the capital structure of a package of securities backed by commercial mortgages, and provide a yield advantage over higher-rated bonds along with meaningful principal protection. Our non-agency RMBS investments rebounded from undervalued levels prior to the period, buoyed by investor demand for higher-yielding securities.

Looking forward, we continue to believe segments of the non-agency RMBS market, including prime, pay-option ARM, and Alt-A securities, display attractive relative value for investors. For perspective, the non-agency RMBS market is about three quarters the size of the U.S. high-yield corporate bond market (though currently shrinking), but is still somewhat larger than the current bank-loan market. While we estimate that the non-agency RMBS market will continue to shrink by approximately 10%–15% per year as a result of pay downs and liquidations, we think this decline could eventually reverse with the development of a new issue private-label MBS market with different collateral and structural features than those that existed prior to the financial crisis of 2008.

Global bonds: Opportunity in Europe, consumer discontent in JapanIn Europe, as we discussed, ECB President Mario Draghi offered assurances that the central bank was prepared to engage in unconventional monetary support measures, a development that gives us greater conviction in our posi-tions on peripheral European debt. In the first quarter, we had overweight allocations to government bonds in Italy, Spain, Ireland, and Greece, which were held against a net short position in Germany. This strategy worked well, and in the coming months, we expect spreads will continue to compress. The fact that Greece, for example, dramatically and successfully reentered the longer-term market in April has added to downward pressure on Greek sovereign yields.

In Japan, an anticipated sales tax hike was imple-mented on April 1, and while it was clear some of the economy’s progress in recent quarters was a result of spending being advanced to beat the hike, we cannot yet know how demand will settle down at the new tax level. The timing and extent of any further monetary easing will depend on what the data show in the spring.

Data from a recent Japanese household survey reveal a discouraging reception of economic change by consumers. Households are clearly aware that prices have risen, and they expect further increases. But overwhelm-ingly, if not surprisingly, they view this negatively and believe that economic conditions have deteriorated. In fact, incomes have gone down because nominal wages, though rising, have not risen enough to offset the increase in prices. In addition, given the post-Fukushima energy landscape in Japan, in which the amount of imported energy has risen dramatically, a spike in energy prices could worsen sentiment.

In our view, we think the BoJ may shy away from engineering another decline in the exchange rate. The historically lower yen has successfully pushed up prices and produced a profit windfall for the corporate sector. From this point forward, there is less need for the BoJ to lead. Wages, however, need to go up, and this is where we expect Japan’s government to focus its efforts in the coming quarters. On top of that, Japan’s equity market could help boost confidence, assuming it does not stage a repeat performance of its first-quarter correction. A higher stock market would boost confidence, generate some wealth, and — most importantly — help companies feel better about raising wages.

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Q2 2014 | Fixed-Income Outlook

Figure 6: Muni credit spreads have narrowed from historical wides, but remain attractive

Municipal bond spreads by quality rating

AA A BBB

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3/31/14201320122011201020092008200720062005200420032002200120001999

Source: Putnam, as of 3/31/14. Credit ratings are as determined by Putnam.

The most attractive relative values continue to populate in the BBB-rated segment of the muni market.

Emerging-market debt: Bright spots despite geopolitical tensionsEmerging-market (EM) assets, including debt and equity, showed better-than-expected strength in March. In part, this may be because somewhat weaker Chinese data led markets to expect further stimulus from the Chinese authorities. In addition, the strength could stem from the perception that Russia/Ukraine tensions have eased.

Within EM debt, our portfolios in the first quarter benefited most from investments in Argentina, where we held U.S.-dollar-denominated, local-law bonds, along with New York law bonds, which are bonds issued by Argentina that are governed by New York securities laws. Overall, we think the recent stability in EM asset markets and the recovery in global trade suggest we may soon see better data out of EM.

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The conflict in Ukraine may or may not be settling down. The markets, at this time of writing, have appeared to move on. Geopolitical strategists, however, are less sanguine. In our view, the situation will prove to be increasingly less relevant for markets unless missteps occur by either side — for example, if Europe presses hard for more serious sanctions that prompt Russia to restrict its exports of natural resources. In any case, this is an area of distinct energy-price vulnerability that we will continue to watch closely.

Tax-exempt bonds: Still a time for defenseOur cautious and defensive strategies remain in place, since we expect continued pressure on interest rates over the longer term as the Fed unwinds its economic stimulus program and investors adjust their expectations about the central bank’s monetary policy. Consequently, our funds’ duration positioning, or interest-rate sensitivity, remained below that of their Lipper peer groups. This includes maintaining a slightly higher cash position in the funds to help shelter them from price pressures in an interest-rate environment trending higher. Carrying slightly higher-than-average cash balances affords the funds greater flexibility to purchase attractively valued bonds even in a rising-rate environment.

We continue to emphasize essential service revenue bonds, which are typically issued by state and local government entities to finance specific revenue-generating projects. While we believe that conditions are improving at the state and local levels — and we are vigilant for investment opportunities — we continued to underweight local G.O. (general obligation) bonds. These securities rely on the taxing power of the issuer and the health of the local economy to make payments on these bonds.

Despite the strong start for municipal bonds in 2014, we remain cautious and believe that there could be some volatility surrounding supply/demand factors and interest rates in the coming months. Tax-exempt municipal fund outflows for 2013 topped $60 billion [Source: JPMorgan] — the most in 20 years — and put downward pressure on prices. Although we have seen fund flows improve and some direct retail buyers come into the market to help support prices, we think it is unlikely that we will see volatility subside until fund flows turn decidedly positive and rate volatility eases.

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Q2 2014 | Fixed-Income Outlook

Currency outlookWe favor a modest overweight to the U.S. dollar. In its March meeting, the Federal Open Market Committee (FOMC) dropped its forward guidance linking future interest-rate hikes to specific levels of unemployment. The Fed continues to hold the view that there is plenty of slack in the labor market and, as such, wage pressure and inflation will only gradually approach its targets over the medium term. If economic growth remains strong, as we expect, this view is likely to be challenged as rate hikes begin to be priced in at a sooner-than-expected date, which should be supportive of the dollar over the course of the year.

The euro is being influenced by the capital flowing from the United States to the eurozone. We believe the euro will trade in a range over the coming months as the inac-tion of the ECB and improving U.S. economic data largely counter each other. The British pound sterling merits a slight underweight, as the pace of the U.K. recovery has slipped a bit.

We also favor a slight underweight to the Japanese yen. It is expected in some quarters that the BoJ will need to undertake new measures to sustain inflation expecta-tions. This should provide further impetus for the U.S. dollar to move higher versus the yen.

Agency mortgage-backed securities are represented by the Barclays U.S. Mortgage Backed Securities Index, which covers agency mortgage-backed pass-through securities (both fixed-rate and hybrid ARM) issued by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).

Commercial mortgage-backed securities are represented by the Barclays U.S. CMBS Investment Grade Index, which measures the market of commercial mortgage-backed securities with a minimum deal size of $500 million. The two subcomponents of the U.S. CMBS Investment Grade Index are U.S. aggregate-eligible securities and non-eligible securities. To be included in the U.S. Aggregate Index, the securities must meet the guidelines for ERISA eligibility.

Emerging-market debt is represented by the JPMorgan Emerging Markets Global Diversified Index, which is composed of U.S. dollar-denominated Brady bonds, eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.

Eurozone government is represented by the Barclays European Aggregate Bond Index, which tracks fixed-rate, investment-grade securities issued in the following European currencies: euro, Norwegian krone, Danish krone, Swedish krona, Czech koruna, Hungarian forint, Polish zloty, and Swiss franc.

Global high yield is represented by the BofA Merrill Lynch Global High Yield Constrained Index, an unmanaged index of global high-yield fixed-income securities.

Japan government is represented by the Barclays Japanese Aggregate Bond Index, a broad-based investment-grade benchmark consisting of fixed-rate Japanese yen-denominated securities.

Tax-exempt high yield is represented by the Barclays Municipal Bond High Yield Index, which consists of below-investment-grade or unrated bonds with outstanding par values of at least $3 million and at least one year remaining until their maturity dates.

U.K. government is represented by the Barclays Sterling Aggregate Bond Index, which contains fixed-rate, investment-grade, sterling-denominated securities, including gilt and non-gilt bonds.

U.S. floating-rate bank loans are represented by the S&P/LSTA Leveraged Loan Index, an unmanaged index of U.S. leveraged loans.

U.S. government and agency debt is represented by the Barclays U.S. Aggregate Bond Index, an unmanaged index of U.S. investment-grade fixed-income securities.

U.S. investment-grade corporate debt is represented by the Barclays U.S. Corporate Index, a broad-based benchmark that measures the U.S. taxable investment-grade corporate bond market.

U.S. tax exempt is represented by the Barclays Municipal Bond Index, an unmanaged index of long-term fixed-rate investment-grade tax-exempt bonds.

You cannot invest directly in an index.

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Putnam’s veteran fixed-income team offers a depth and breadth of insight and an independent view of riskSuccessful 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 focusing 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 KohliCo-Head of Fixed IncomeGlobal StrategiesInvesting since 1987Joined Putnam in 1994

Michael V. SalmCo-Head of Fixed IncomeLiquid Markets and Securitized ProductsInvesting since 1989Joined Putnam in 1997

Paul D. Scanlon, CFACo-Head of Fixed IncomeGlobal CreditInvesting since 1986Joined Putnam in 1999

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®.

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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. Derivatives also involve the risk, in the case of many over-the-counter instruments, of the potential inability to terminate or sell derivatives positions and the potential failure of the other party to the instrument to meet its obligations.

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