Q1 2022 Putnam Ultra Short Duration Income Fund Q&A
- The Fed’s very hawkish turn has set the stage for interest rates to rise to the highest levels since 2008.
- The outlook for ultrashort managers continues to improve, as realized yields and future yield expectations have improved meaningfully over the last few months.
- We remain confident in fund positioning and continue to have a constructive view moving forward.
How were market conditions in the first quarter?
It was a challenging quarter for global financial markets, including fixed income securities. The poor performance of bond markets was caused by a myriad of factors, including rising inflation, the Federal Reserve’s increasingly hawkish rhetoric, and the war in Ukraine. In mid-March, the Fed lifted the federal funds rate to a range of between 0.25% and 0.50%. The Bloomberg U.S. Aggregate Bond Index — made up largely of U.S. Treasuries, highly rated corporate bonds, and mortgage-backed securities — returned –5.93%. The S&P 500 Index, a broad measure of U.S. stock performance, returned –4.6%.
Fed policymakers also penciled in six more rate increases by year-end, reduced their U.S. growth estimates for the year, and raised inflation expectations. The Fed’s latest dot plot, or median projections, show the policy rate rising to around 2.75% by the end of 2023, which would be the highest level since 2008. Yields on some shorter-term Treasuries, such as the 2-year note, have edged above those of longer-term bonds like the 10-year note, creating a flat or inverted yield curve. The yield on the benchmark 10-year U.S. Treasury note rose from 1.63% on January 3 to 2.32% on March 31.
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 returned –0.30% on a net basis versus a return of –0.03% for the benchmark index for the three months ended March 31, 2022. A combination of widening credit spreads and rising short-term rates drove relative underperformance in the first quarter.
Corporate credit was the largest detractor from the fund’s relative performance, as 1–3 year investment-grade corporate spreads widened meaningfully from historically tight levels. After ending 2021 at +42 basis points, 1–3 year spreads widened out to +89 basis points by mid-March, before retracing part of that move to end the period at +59 basis points, negatively impacting our corporate bond positions. Additionally, the fund’s allocation to securitized sectors, including non-agency residential mortgage-backed securities [RMBS] and asset-backed securities [ABS], detracted, albeit marginally. 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.
On the other hand, our allocations to commercial paper contributed to returns. We keep a balance of short-maturity commercial paper for liquidity. Commercial paper yields have risen to begin the year; as rates have increased, we have been able to reinvest the maturing paper at higher rates. Avoidance of Treasuries contributed to relative returns as well, in an environment where Treasuries sold off and the curve flattened.
What is your near-term outlook for fixed-income markets?
Ultrashort managers faced a challenging yield environment in 2021. This was exacerbated by the amount of liquidity entering the system driven by unprecedented monetary policy actions, including the Fed’s quantitative easing program. However, the outlook for ultrashort managers continues to improve, as realized yields and future yield expectations have improved meaningfully over the last few months. The yields on 2-year and 3-year Treasury notes have risen sharply during the first three months of the year. Additionally, short-term corporate credit spreads [as measured by the Bloomberg U.S. 1-3 Year Corporate Bond Index] have widened over the last few months after reaching all-time tights at the end of the third quarter in 2021.
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 in particular, 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 remain confident in fund positioning and continue to have a constructive view moving 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 Financing Rate], now roughly 60% of the portfolio as of quarter-end. 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. Additionally, as yields rise, income generation can act as a larger buffer to NAV movements on a total-return basis.
Throughout 2021, we shortened the duration of the fund and have kept the fund’s duration relatively static to begin 2022. As of March 31, 2022, the fund’s duration is 0.25 years [down 0.13 years from where it began 2021 and roughly equal to the previous quarter-end]. We also continue to structure the portfolio in a manner emphasizing a combination of lower-tier investment-grade securities [BBB or equivalent], generally maturing in 1 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 improving valuations on the short end of the curve, we have been able to add some incremental risk to the portfolio but have been judicious in doing so. Capital preservation remains the primary objective of our fund; we do not try to “stretch for yield” in the strategy.
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