Q4 2015» Putnam Perspectives Fixed-Income Outook D. Wiiam Kohi Co-Head of Fixed Income Michae V. Sam Co-Head of Fixed Income Pau D. Scanon, CFA Co-Head of Fixed Income Key takeaways The economic deceeration in emerging markets is unikey to derai goba growth. The Fed may begin raising rates sooner than the market currenty expects. A Fed rate-raising campaign may be muted given U.S.- doar strength. We favor prepayment, credit, and iquidity risks over interest-rate risk. Putnam fixed-income views U.S. government and agency debt U.S. tax exempt Tax-exempt high yied Agency mortgage-backed securities Coateraized mortgage obigations Non-agency residentia mortgage-backed securities Commercia mortgage-backed securities U.S. foating-rate bank oans U.S. investment-grade corporates Goba high yied Emerging markets U.K. government Core Europe government Periphera Europe government Japan government Underweight Sma underweight CURRENCY: U.S. DOLLAR VERSUS EURO POUND YEN OUR VIEW: Neutra Favor doar (unchanged from ast quarter) Sma overweight Overweight Growth concerns temporariy sta Fed action Recent stock market voatiity has been in part a refection of goba uncertainties. Spread widening in credit markets, both investment grade and high yied, refects at east in part the faout from ower commodity prices and the rising defaut risk this entais. These market moves can harm consumer confidence, and they effectivey raise the cost of capita to the corporate sector. But whie market deterioration is unsetting, we don t beieve the recent downturns portend a structura sowdown of growth in the United States. Weakness outside the United States ceary has given the Fed pause as it considers the ever of a rate-raising campaign. But, as we see it, the Fed s mosty positive view of the economy can be set out as foows: U.S. growth is strong enough to aow the abor market to continue to improve. Some wage pressures are aready being fet in parts of the economy, and they may we broaden. Goba deveopments are certainy a headwind for the economy, but the U.S. growth remains domesticay oriented. It woud take a further materia deterioration in the goba outook to cause this U.S. outook to worsen. Favor doar (unchanged from ast quarter) Favor doar (unchanged from ast quarter)
Q4 2015 Fixed-Income Outook Figure 1. Fixed-income performance 2Q 15 3Q 15 4% Renewed risk aversion during the third quarter heped higher-quaity bonds but caused a setback to high yied and emerging markets. 2% 0% -2% -4% -6% U.S. government U.S. tax exempt Taxexempt high yied Agency mortgagebacked securities Commercia mortgagebacked securities U.S. foatingrate bank oans U.S. investmentgrade corporate debt Goba high yied Emergingmarket debt U.K. gov t Eurozone Japan government government Sources: Barcays, JPMorgan, Bank of America Merri Lynch research, as of 9/30/15. Past performance is not indicative of future resuts. From this, we concude that the eventua rate-hiking cyce is ikey to be moderate and that poicy wi remain easy even after a hiking cyce has begun. In the near term, we see the Fed as highy ikey to hike, uness risks to the Fed s outook increase by far more than seems probabe. We continue to think the doar s strength wi effectivey tighten financia conditions, which may mean the Fed wi wind up being cautious in its rate-raising campaign. This has important impications, since a stronger doar bears down on the economy rather differenty than higher interest rates. In short, a stronger doar together with a robust abor market woud squeeze corporate margins. The economy woud then be ikey to shift to a path with stronger consumption gains since the doar wi keep infation and interest rates ow, benefiting househods. Events in China not ikey to spe goba disaster Aside from raising questions about goba economic strength, events in China aso raised the specter of financia contagion. This common concern about the Chinese financia system which worries about emerging-market (EM) economies more broady is not a concern we share. Chinese banks are in disarray, but we beieve their inkages to the goba financia system are too weak to produce a major shock. We think the same is true for EM more generay. European banks have a decent amount of exposure to the EM word, but in our view it does not constitute a systemic threat. Individua EM economies do ook shaky, and there are cear downside risks in Brazi, Indonesia, Maaysia, and South Africa, to name just a few. But it woud take a ot to turn this from a headwind for the goba economy into a constitutive probem. The second concern that grows out of China s current probems focuses on the cost of capita in the United States. If the stock market makes another sharpy ower move and if corporate spreads continue to widen further, then corporations wi be forced to retrench and the abor market wi start to weaken. Consumer confidence wi fa and as the abor market weakness squeezes incomes, spending wi suffer. Again, we do not think that this is a ikey scenario. 2
PUTNAM INVESTMENTS putnam.com High-yied spread widening may have a imit One deveopment worth noting from the third quarter is the pattern of spread widening in the corporate credit market. Spreads are about 150 basis points (bps) wider since the start of the year, and about 100 bps of this widening took pace in September. Unti September, the weakness in high yied was overwhemingy a story of energy and meta & mining. The coapse of commodity prices is ceary threatening the viabiity of some high-yied companies in the exporation & production industries, though defauts rose across the energy compex. In September, however, the pattern in high yied was rather different. Whie commodity-reated industry spreads continued to widen, there were aso idiosyncratic issues associated with the automotives, chemicas, teecommunications, and heath care. In fact, according to JPMorgan, eight different sectors decined more than 200 bps during the month. Among the reasons for the weakness, we beieve, were the technica backdrop associated with fund fows and a genera risk-off perspective. Investors have been seing high-yied exchange-traded funds, and this has ed to the voatiity in prices. It is, of course, possibe that this wi continue, and spreads wi get pushed wider. But at some point, we think the vauations associated with high-yied bonds wi become attractive to some investors. The current outook for the economy does not justify the defaut rates impicit in much wider spreads. Fixed-income asset cass views Within the risk-averse environment of the third quarter, investors shifted capita away from riskier market sectors and into U.S. government bonds. For the quarter, the yied on the benchmark 10-year U.S. Treasury decined from a high of 2.45% reached on Juy 13 to 2.00% on August 24. Deveoped-market foreign government bonds were aso seen as haven assets. For exampe, the yied on 10-year German bunds went from a high of 0.89% on Juy 14 to 0.56% on August 21. Long-term government bonds generated the best returns for the quarter, whie emerging-market debt and high-yied bonds fared the worst. Looking at broad market indicators, the Barcays U.S. Aggregate Bond Index returned 1.23% fueed by its government bond components and the Barcays Goba Aggregate Bond Index rose 0.85% in U.S. doar terms. Figure 2. Rates fe as investors sought safe-haven assets amid goba growth concerns With few exceptions, rates fe across the yied curve during Q3. 4% 3% 6/30/15 9/30/15 2% 1% 0% 3 months 6 months 1 year 2 years 3 years 5 years 7 years Source: U.S. Department of the Treasury, as of 9/30/15. 10 years 30 years 3
Q4 2015 Fixed-Income Outook Figure 3. High-yied spreads and defauts generay move in tandem over credit cyces Among other reasons, spreads gapped wider in Q3 on weakness across the commodities compex. Defaut rate (%) 20 16 12 8 High-yied defaut rate Spread to worst 20-year median spread: 538 bps 1990 91 recession Current spread: 698 bps (as of 9/30/15) Average defaut rate: 3.8% Current defaut rate*: 2.3% 2001 recession Today, the gap between spreads and defauts remains wide, signaing opportunity for investors. 2007 09 recession 2000 1600 1200 800 Spreads (bps) 4 400 0 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 9/30/15 0 1Current defaut rate incudes distressed exchanges. Sources: JPMorgan, High Yied Market Monitor, as of 9/30/15; Putnam Investments. Securitized debt: Staying the course with prepayment and credit risks Our prepayment strategies, which we impemented with securities such as agency interest-ony coateraized mortgage obigations (IO CMOs), did not perform as we as we hoped during the third quarter. Even though mortgage refinancing activity remained subdued over the past three months, IO CMO yied spreads are sensitive to interest-rate movements, and ower rates across the yied curve caused them to underperform. IO CMOs were aso hurt by an overa fight from risk by investors. On the pus side, various tactica trades that were designed to benefit from the difference between current mortgage rates and Treasury yieds were additive and partiay offset the negative impact of our IO CMO hodings. Notwithstanding its disappointing performance in the third quarter, we continue to find prepayment risk attractive given the prospect of higher interest rates, and we expect to continue to seek attractive opportunities in IO CMOs. Our exposures to mortgage credit, primariy through mezzanine commercia mortgage-backed securities (CMBS), aso detracted from portfoio returns, primariy due to investor risk aversion. In addition, many institutiona investors that hed high-yied bonds shorted CMBS to hedge their high-yied exposure, further hindering the performance of the sector. 4
PUTNAM INVESTMENTS putnam.com Investment-grade bonds: Fundamentas argey intact As in the second quarter, U.S. investment-grade spreads widened in the third quarter. In the more recent case, concerns about sowing growth in China potentiay affecting the U.S. economy, uncertainty about Fed monetary poicy, and the genera risk-off sentiment a worked to drive spreads wider. Nevertheess, we think corporate fundamentas remain soid. Investment-grade corporate baance sheets and profit growth may have peaked, but there does not seem to be a major deterioration in credit. Leverage within investment-grade corporates as a whoe is rising, but it is mosty increasing at higher-quaity companies and in specific sectors. Whie we think it is possibe that spreads can compress during the baance of 2015, goba economic concerns, continued pressure on oi and commodity prices, geopoitica headines, and/or voatie and rising U.S. Treasury rates may drive spreads wider. 800 600 Figure 4. Current spreads reative to historica norms n Average excess yied over Treasuries (OAS, 1/1/98 12/31/07) n Current excess yied over Treasuries (OAS as of 9/30/15) 573 We continue to find severa compeing investment opportunities in out-of-benchmark sectors, with the exception of emergingmarket debt, which we beieve may remain under pressure. 698 750 760 400 450 425 418 200 34 47 56 31 130 169 108 123 89 123 130 129 210 150 180 0 Agencies Agency MBS Investment-grade corporates CMBS High yied Non-agency RMBS CMBS Mezzanine Agency IO Emergingmarket debt Sources: Barcays, Boomberg, Putnam, as of 9/30/15. Data are provided for informationa use ony. Past performance is no guarantee of future resuts. A spreads are in basis points and measure optionadjusted yied spread reative to comparabe maturity U.S. Treasuries with the exception of non-agency RMBS and mezzanine CMBS, which are oss-adjusted spreads to swaps cacuated using Putnam s projected assumptions on defauts and severities, and agency IO, which is cacuated using assumptions derived from Putnam s proprietary prepayment mode. Agencies are represented by Barcays U.S. Agency Index. Agency MBS are represented by Barcays U.S. Mortgage Backed Securities Index. Investment-grade corporates are represented by Barcays U.S. Corporate Index. High yied is represented by JPMorgan Deveoped High Yied Index. CMBS is represented by both Agency and Non-Agency CMBS that are eigibe for incusion in the Barcays U.S. Aggregate Bond 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 Barcays EM Hard Currency Aggregate Index. Non-agency RMBS is estimated using average market eve of a sampe of beow-investment-grade securities backed by various types of non-agency mortgage coatera (excuding prime securities). Mezzanine CMBS is estimated from an average spread among baskets of Putnam-monitored new issue and seasoned mezzanine securities, as we as a synthetic (CMBX) index. Agency IO is estimated from a basket of Putnam-monitored interest-ony (IO) and inverse IO securities. Option-adjusted spread (OAS) measures the yied over duration equivaent Treasuries for securities with different embedded options. 5
Q4 2015 Fixed-Income Outook Figure 5. Excess returns reative to U.S. Treasuries High-yied and emerging-market debt strugged in the third quarter as investors retreated from risk assets. 0% -1% -2% -3% -4% -5% -6% -7% -8% High yied Emerging-market debt (EMD) U.S. investmentgrade credit CMBS MBS Source: Barcays, as of 9/30/15. Past performance is not indicative of future resuts. High yied and bank oans: Maintaining a constructive view High-yied bonds strugged during the quarter amid a broad retreat from risk assets, fueed by concerns about the pace of growth in China and esewhere around the gobe. Uncertainty about the strength of demand from the word s second-argest economy and biggest importer of raw materias deepened a se-off in commodities. The uncertainty was compounded in September when the Federa Reserve opted not to raise its target for short-term interest rates, citing concerns about the potentia impact of internationa deveopments on U.S. economic growth. New issuance of high-yied bonds deceerated consideraby during the quarter as heightened market voatiity exacerbated what is normay a sow summer season. Issuers that brought bonds to market were forced to make concessions, such as paying a higher coupon, which spurred a repricing of existing bonds in certain sectors, such as chemicas and heath care. Severa unexpected deveopments in the automotive, teecommunications, heath-care, and chemicas sectors aso gave investors pause. For exampe, Moody s downgraded the credit rating of bonds issued by wireess communications provider Sprint Nexte, which weighed on performance in the teecom sector. 6
PUTNAM INVESTMENTS putnam.com High-yied defauts sti beow historica norms The 12-month high-yied defaut rate rose modesty in September to 2.3% but is sti meaningfuy beow historica norms. It s important to note that this increase was driven by defauts in commodity-reated sectors such as energy and metas/mining, which accounted for roughy 80% of defaut voume year to date through September 2015. Despite the impact of these sectors, we think the defaut rate coud remain muted. With interest rates at ow eves, we beieve high-yied issuers shoud continue to benefit from ow debt-servicing costs, which coud keep the defaut rate beow the ong-term historica average for some time. In the high-yied market, we beieve most issuers excuding those in more commodity-sensitive industries are in reasonaby good shape from a fundamenta credit perspective. Marketpace iquidity has been constrained but not overy so, aowing us to accompish our trading objectives. With vauations more attractive foowing recent market turbuence, and an abundance of new high-yied issuance on the horizon, we continue to have a constructive outook for the asset cass overa. Figure 6. Muni credit spreads have narrowed from historica wides, but remain attractive Municipa bond spreads by quaity rating Credit spreads widened in Q3 but remained fairy tight, with owerquaity bonds modesty outperforming higher-quaity issues. 500 AA A BBB 400 300 200 100 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 9/30/15 Source: Putnam, as of 9/30/15. Credit ratings are as determined by Putnam. 7
Q4 2015 Fixed-Income Outook Bank oans outperform high yied Bank oans hed up better than high-yied bonds amid the various macro gyrations hampering the markets, and generated significanty stronger reative performance for the quarter. Bank oans better performance was party due to the fact that oan indexes had consideraby ess exposure to energy-reated sectors during a period when the price of oi and other commodities decined. Within the bank-oan index, simiar to high-yied bonds, oans in the highest-quaity credit tiers posted the best reative returns, whie the owest-quaity oans sod off sharpy, and more-defensive industry groups were the top reative performers. Emerging markets: Pressures continue to mount Outside the United States, we think emerging markets are ikey to remain under pressure for some time. As the biggest buyer of commodities from many EM countries, China s economic sowdown is having a major impact on many other deveoping economies, such as Brazi, South Africa, and Maaysia. Capita has been fowing out of EM countries seeking better investment opportunities, primariy in the United States. This capita outfow is forcing some EM nations to devaue their currencies or dip into their foreign-currency reserves to defend their exchange rates. Athough capita outfows have moderated somewhat more recenty, the authorities across EM are strugging with weak commodity prices, stressed financia asset markets, faing exchange rates, and weakening economies. In some, this unhappy economic configuration is interacting with difficut poitica circumstances. In our view, some countries are much better paced than others: Poand, for exampe, ooks steady, and Mexico appears to us to be we positioned. But Brazi, Indonesia, and South Africa have to contend with far more difficut conditions. We beieve that the seing off of EM assets is not normay enough to change market sentiment; what is needed is economic reform that gives investors a pausibe beief in a better tomorrow. Municipa bonds: Mixed technicas and positive returns Whie equity markets experienced considerabe voatiity, posting negative returns for the third quarter, the municipa bond asset cass saw positive gains. Tax-free bonds, as measured by the Barcays Municipa Bond Index, ed taxabe fixed-income markets, outperforming the Barcays U.S. Aggregate Bond Index and the BofA Merri Lynch 3-Month Treasury Bi Index for the quarter. Technicas or the market s suppy and demand dynamics were fairy we baanced. The suppy of municipa bond issuance has been reativey heavy, amost 34% higher in the first nine months of 2015 than for the same period in 2014. The buk of new issuance has been earmarked for refinancing activity as municipa issuers took advantage of the ow-interest-rate environment to repace their oder, higher-coupon bonds with ower-cost debt. So the suppy side is sti heathy but was met with decent demand. Municipa bond fows were modesty negative in the third quarter. However, we beieve this deveopment was more a resut of broader market factors than fundamentas within the municipa bond market. Credit spreads (the difference in yied between higher- and ower-quaity municipa bonds) remained tight during the period, contributing to sighty better returns for ower-quaity investments than for higher-quaity investments for the quarter. With the 2016 campaign season in fu swing and the presidentia candidates better defining their poicy agendas, we are hearing chatter about individua and corporate tax reform and the eimination of some oophoes and tax deductions. We woud caution municipa bond investors from overreacting to discussions about changes to the tax code unti after the 2016 eection, when we wi know better if reform becomes a bona fide priority. As we have seen in previous instances, headines about isoated municipa credits can ead to investor overreaction and temporary price disocation. Such price action often resuts in investment opportunities for Putnam s Tax Exempt team. 8
PUTNAM INVESTMENTS putnam.com Currency: Though ess ascendant, the doar sti hods advantages Within active currency strategies, our U.S. doar position is a more modest overweight. The piars for U.S. doar strength are based upon reative growth outperformance and the subsequent impications for attractiveness of U.S. assets and reative monetary poicy. The U.S. growth story has stabiized at more moderate eves, but on a reative basis it is not the standout eader as other major economies have seen improvement as we. The United States is regaining equity market eadership, and it remains an attractive destination for fixed-income capita with the Bank of Japan (BoJ) and the European Centra Bank (ECB) activey purchasing oca government debt. Whie maintaining this ong-term view on the doar, we note that the euro has some short-term advantages. Growth in the eurozone has stabiized at modest eves. The ECB poicy remains easy. The current situation in Greece remains fuid and provides a great dea of voatiity for the singe currency. A more benign outcome (which is our base case) in which Greece agrees to additiona austerity measures and receives a new financia assistance program from creditors, shoud see the singe currency move higher in the short run. A Greek exit woud ikey cause quite a bit of financia market voatiity and woud require the ECB to ensure the monetary poicy transmission channe remains functiona through even more extensive purchases of sovereign debt (on top of its current QE program). This woud ikey cause the singe currency to drop sharpy. Whie sti at a disadvantage versus the doar, the British pound stering benefits in the near term from U.K. growth eves remaining soid. Athough infation eves and expectations have come down consideraby, they appear to have reached a trough. Additionay, the abor market data is showing signs of wage pressure, and the hawks on the Bank of Engand Monetary Poicy Committee coud start to voice the need for rate hikes in coming meetings. Regarding the Japanese yen, we sti favor a modest short. BoJ Governor Kuroda continues to highight that the BoJ does not have any intention to ease the poicy near term given the current economic and price conditions, expaining that the decine in core CPI infation is temporary and coud be reversed in ine with oi price deveopments. Most importanty, Kuroda stresses that the BoJ wi not hesitate to adjust the poicy if fundamenta price trends change and if the eary achievement of the infation target is found to be difficut. This very easy poicy (and expectations that more wi be needed) couped with the Fed possiby ifting rates sooner than the market expects shoud continue to keep pressure on the yen. 9
Q4 2015 Fixed-Income Outook This materia is provided for imited purposes. It is not intended as an offer or soicitation for the purchase or sae of any financia instrument, or any Putnam product or strategy. References to specific securities, asset casses, and financia markets are for iustrative purposes ony and are not intended to be, and shoud not be interpreted as, recommendations or investment advice. The opinions expressed in this artice represent the current, good-faith views of the author(s) at the time of pubication. The views are provided for informationa purposes ony and are subject to change. This materia does not take into account any investor s particuar investment objectives, strategies, tax status, or investment horizon. The views and strategies described herein may not be suitabe for a investors. Investors shoud consut a financia advisor for advice suited to their individua financia needs. Putnam Investments cannot guarantee the accuracy or competeness of any statements or data contained in the artice. Predictions, opinions, and other information contained in this artice are subject to change. Any forward-ooking statements speak ony as of the date they are made, and Putnam assumes no duty to update them. Forward-ooking statements are subject to numerous assumptions, risks, and uncertainties. Actua resuts coud differ materiay from those anticipated. Past performance is not a guarantee of future resuts. As with any investment, there is a potentia for profit as we as the possibiity of oss. The information provided reates to Putnam Investments and its affiiates, which incude 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 affiiate, The Putnam Advisory Company, LLC. 10
PUTNAM INVESTMENTS putnam.com Putnam s veteran fixed-income team offers a depth and breadth of insight and an independent view of risk. Successfu investing in today s markets requires a broad-based approach, the fexibiity to expoit a range of sectors and investment opportunities, and a keen understanding of the compex goba interreationships that drive the markets. That is why Putnam has more than 70 fixedincome professionas focusing on deivering comprehensive coverage of every aspect of the fixed-income markets, based not ony on sector, but aso on the broad sources of risk and opportunities most ikey to drive returns. D. Wiiam Kohi Co-Head of Fixed Income Goba Strategies Investing since 1988 Joined Putnam in 1994 Michae V. Sam Co-Head of Fixed Income Liquid Markets and Securitized Products Investing since 1989 Joined Putnam in 1997 Pau D. Scanon, CFA Co-Head of Fixed Income Goba Credit Investing since 1986 Joined Putnam in 1999 11
Market update putnam.com/markets Research putnam.com/perspectives putnam.com/white-papers Find us Consider these risks before investing: Internationa investing invoves certain risks, such as currency fuctuations, economic instabiity, and poitica deveopments. Additiona risks may be associated with emerging-market securities, incuding iiquidity and voatiity. Lower-rated bonds may offer higher yieds in return for more risk. Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk. Derivatives aso invove the risk, in the case of many over-the-counter instruments, of the potentia inabiity to terminate or se derivatives positions and the potentia faiure of the other party to the instrument to meet its obigations. Bond investments are subject to interest-rate risk, which means the prices of the funds bond investments are ikey to fa if interest rates rise. Bond investments aso are subject to credit risk, which is the risk that the issuer of the bond may defaut on payment of interest or principa. Interest-rate risk is generay greater for onger-term bonds, and credit risk is generay greater for beow-investment-grade bonds, which may be considered specuative. Unike bonds, funds that invest in bonds have ongoing fees and expenses. You can ose money by investing in a mutua fund. If you are a U.S. retai investor, pease request a prospectus, or a summary prospectus if avaiabe, from your financia representative or by caing Putnam at 1-800-225-1581. The prospectus incudes investment objectives, risks, fees, expenses, and other information that you shoud read and consider carefuy before investing. In the United States, mutua funds are distributed by Putnam Retai Management. PUTNAM INVESTMENTS putnam.com CM0200 297182 10/15