Q4 2021 Putnam Ultra Short Duration Income Fund Q&A
- The Fed pivoted toward tighter policy by signaling a wind down of its bond-buying program and setting the stage for higher interest rates.
- Capital preservation remains the primary objective of our portfolio in a challenging yield environment.
- While the fund’s holdings of corporate credit and mortgage securities modestly detracted from returns in the recent period, higher all-in yields bolster our outlook going forward.
How were market conditions in the fourth quarter?
Global financial markets had mixed results during the quarter, buoyed by a recovering economy and ongoing fiscal and monetary stimulus. However, risks including higher inflation, rising interest rates, China’s weaker economy, and Covid-19 variants percolated through the markets. In the U.S. bond markets, yields on long-term Treasuries have been edging lower in recent weeks, while shorter-term yields have been steadily rising. Many market players are worried about more volatility ahead for the world’s largest bond market. Stocks gyrated, but the S&P 500 Index — a broad measure of U.S. stock performance — gained 11.03% during the quarter.
In mid-December, the Federal Reserve pivoted toward tighter policy with plans to end its bond-buying stimulus program in March 2022. This paves the way for higher interest rates. Most Fed officials penciled in raising interest rates, which are now set near zero, three times this year. Other global central banks are also scaling back stimulus measures. The European Central Bank has further cut its bond purchases under the Pandemic Emergency Purchase Program, which is due to end in March 2022. The rate-sensitive Bloomberg U.S. Aggregate Bond Index, a broad measure of U.S. bond performance, rose 0.01% for the period.
The U.S. Treasury bond yield curve has flattened slightly. The Fed’s hawkish pivot has pushed up rate-sensitive short-term bond yields, while the long end of the curve fell due to concerns about the economic impact of rising Covid-19 infections. The yield on the benchmark 10-year U.S. Treasury note fell to 1.52% at period-end after reaching a high of 1.74% in March 2021. The yield on the 30-year Treasury bond dropped to around 1.90%. The yield on 2-year Treasury notes advanced to 0.73% from 0.28% at the end of the third quarter. Investment-grade corporate spreads ended the quarter wider. [Spreads are the yield advantage credit-sensitive bonds offer over comparable-maturity Treasuries.]
How did the fund perform? What were the drivers of performance during the period?
The fund underperformed its benchmark, the ICE BofA U.S. Treasury Bill Index, during the period. The fund declined 0.12% on a net basis versus a gain of 0.01% for the benchmark index for the three months ended December 31, 2021. A combination of widening credit spreads and rising short-term rates drove underperformance in the fourth quarter.
Corporate credit was the largest detractor from the fund’s relative performance, as 1–3-year investment-grade corporate spreads widened from historically tight levels during the quarter. In total, 1–3 year spreads widened 10 basis points, which negatively impacted our corporate bond positions.
On the other hand, our allocations to commercial paper contributed to returns. We keep a balance of short-maturity commercial paper [CP] for liquidity. Commercial paper yields remain low; however, if rates do start to rise, we are able to reinvest the maturing paper at higher rates. Additionally, the fund’s allocation to securitized sectors, including non-agency residential mortgage-backed securities [RMBS] and asset-backed securities [ABS], marginally contributed. The team continues to focus the portfolio’s allocation in this area on highly rated securities that are senior in the capital structure, which we believe provide diversification benefits to our corporate exposure.
What is your near-term outlook for fixed-income markets?
2021 was a challenging yield environment for ultrashort managers. This was exacerbated by the amount of liquidity entering the system driven by unprecedented monetary policy actions, including the Federal Reserve’s quantitative easing program. However, yield expectations have improved meaningfully over the last few months, with investors now pricing in multiple hikes from the Fed in 2022. At the Fed’s December meeting, there was discussion of hiking the federal funds rate earlier and faster than previously anticipated. The market has begun to take note, as the yields on 2-year and 3-year Treasury notes hit their highest levels of 2021 in December and have continued to rise during the first two weeks of the new year. Additionally, short-term corporate credit spreads [as measured by the Bloomberg U.S. 1-3 Year Corporate Bond Index] have widened modestly over the last few months after reaching all-time tights at the end of the third quarter.
With the Fed reaching an inflection point and with higher rates on the horizon, we are constructive on the outlook for ultrashort bond funds, and our fund, as we can take advantage of higher interest rates. This should benefit fixed income investors without taking the same level of interest-rate risk as longer-term bond funds.
What are the fund’s strategies going forward?
We have positioned the fund to take advantage of a higher interest-rate environment. Specifically, we increased the fund’s allocation to securities with a floating-rate coupon tied to either LIBOR or SOFR [Secured Overnight Funding Rate]. These securities’ coupons reset on a daily, 1-month, or 3-month basis to reflect current short-term rates and carry a very short duration [or interest-rate sensitivity]. In a rising-rate environment, this strategy can help the fund participate in increasing yields, without experiencing the negative price effects of longer-duration fixed-rate securities.
Throughout 2021 we shortened the duration of the fund. As of December 31, 2021, the fund’s duration is 0.26 years [down 0.12 years from where it began the year]. Additionally, we continue to structure the portfolio in a manner emphasizing a combination of lower-tier investment-grade securities [BBB or equivalent] generally maturing in one year or less, and upper-tier investment-grade securities [A or AA rated] generally maturing in a range of 1 to 3.5 years.
Given the current stretched valuations on the short end of the curve, we have also been judicious in adding incremental risk to the portfolio. Capital preservation remains the primary objective of our fund. We do not try to “stretch for yield” in the strategy, even in a challenging environment for yield generation.
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