Bonds rally on hopes of Fed nearing end of rate hikes

Bonds rally on hopes of Fed nearing end of rate hikes

Q1 2023 Putnam Ultra Short Duration Income Fund Q&A

  • The fund outperformed its benchmark, and its yield increased by 57 basis points to end the quarter at 4.75%.
  • We have begun buying fixed-rate securities we find attractive, given our expectation that we are nearing the end of the Fed’s hiking cycle.
  • Despite the banking turmoil experienced in March, we continue to have a high level of confidence in the creditworthiness of our banking exposure and believe the names we own can hold up well, even in a deteriorating economic environment.

How were market conditions in the first quarter?

Fixed income markets delivered their second consecutive quarter of positive performance amid considerable market volatility. After a strong start in January, markets reversed course in February. This was due to fears that the Federal Reserve might increase interest rates higher than anticipated following the release of rising inflation data and continued labor market tightness in January.

Volatility persisted into March, as markets sold off due to a few high-profile bank failures. Quick actions by global central banks to minimize systemic risk, including shoring up bank deposits, prevented contagion across the global financial system. While the turmoil stirred recession concerns, it also led to changing expectations about the future path of Fed monetary policy. Investors hoped that a continued economic slowdown might give the Fed room to ease monetary policy.

With signs that inflation was moderating but still high, the Fed announced 0.25% interest-rate increases on February 1 and March 2. Yields peaked in early March in advance of Fed Chair Jerome Powell’s testimony before Congress about the central bank’s plans for future rate hikes. The yield on the 2-year note began at 4.41% and rose to 5.05% on March 8, before closing the quarter at 4.06%. The yield on the benchmark 10-year U.S. Treasury note began the quarter at 3.88% and climbed as high as 4.08% on March 2, before ending the quarter on March 31 at 3.39%.

How did the fund perform? What were the drivers of performance during the period?

The fund outperformed its benchmark, the ICE BofA U.S. Treasury Bill Index, during the quarter. The fund returned 1.23% on a net basis versus a return of 1.12% for its benchmark for the three months ended March 31, 2023. Credit spreads widened during the quarter, and short-term yields fell dramatically in March. However, the fund’s yield increased by 57 basis points [bps] to end the quarter at 4.75%. The fund’s higher yield served as a tailwind for total return performance, as any dips in net asset value recovered more quickly due to the portfolio’s income generation. The fund’s NAV finished the quarter at $10.01, one penny higher than where it began.

Corporate credit was the largest contributor to the fund’s relative performance during the quarter, despite 1–3 year investment-grade corporate spreads widening meaningfully. After beginning the quarter at 73 bps, spreads widened out to 132 bps by March 15 amid concerns over the stability of U.S. regional and European banks. Spreads subsequently retraced following government and central bank intervention, ending the quarter 28 bps wider at 101 bps. Issuer selection within financials, which is the largest sector allocation within the fund, was strong, especially among high-quality bank issuers that represent most of the fund’s financials exposure. Many of these high-quality bank issuers held up much better in March compared with regional banks. To a lesser extent, the fund’s smaller allocation to industrials and utilities also contributed.

Our allocations to commercial paper contributed to returns as well. We keep a balance of short-maturity commercial paper for liquidity. Commercial paper yields continued to rise during the quarter. As interest rates increased, we have been able to reinvest the maturing paper at higher rates.

Lastly, the fund’s allocation to securitized sectors, including non-agency residential mortgage-backed securities and asset-backed securities, contributed to performance, albeit modestly. The portfolio management team continues to focus allocations in this area on highly rated securities that are senior in the capital structure, which provides diversification within our corporate exposure.

What is your near-term outlook for short-term fixed income markets?

We have a constructive outlook for strategies that focus on the short end of the curve, as they continue to benefit from elevated yields and the expectation that rates will remain high for the foreseeable future. The London Interbank Offered Rate [LIBOR] and Secured Overnight Financing Rate [SOFR] rose during the first quarter amid the Fed’s continued rate hiking. Regarding interest-rate expectations, there remains a relatively high level of uncertainty around the ultimate terminal federal funds rate, as the expected terminal rate adjusted downward meaningfully in March. Market expectations for future rate hikes have come down, with the thought that the recent bank turmoil may cause the Fed to pause sooner than previously expected. Our expectation is the Fed will likely hike by 25 bps one more time in May before pausing.

Where our view generally differs from the market is the timing of Fed cuts. The market is once again pricing in Fed cuts in the second half of 2023 following March’s notable banking events. Currently, the market is pricing in over a 75% chance of multiple Fed cuts by the September 2023 Fed meeting and a greater than 90% chance by the November 2023 meeting. Our view is that once the policy rate reaches 5.00%–5.25%, the Fed will likely pause for longer given the continued resilience of the U.S. consumer and tight labor market. In our opinion, Fed rate reductions in 2023 remain unlikely.

In a sustained higher-rate environment, we believe our fund, and ultrashort funds in general, will continue to capture these higher yields. Additionally, short-term corporate credit spreads [as measured by the Bloomberg U.S. 1-3 Year Corporate Bond Index] widened meaningfully during the first quarter, making valuations on the short end of the yield curve more attractive than in prior months. With interest rates likely to remain elevated, we believe investors can reap the benefits of higher income in ultrashort bond funds without taking the same level of interest-rate risk as longer-term bond fund investors.

What are the fund’s strategies going forward?

We have positioned Putnam Ultra Short Duration Income Fund to take advantage of a sustained higher interest-rate environment, as we believe Fed cuts in 2023 are unlikely. The fund continues to hold a meaningful allocation to securities with a floating-rate coupon tied to either LIBOR or SOFR. These securities’ coupons reset on a daily, 1-month, or 3-month basis to reflect current short-term rates and provide a very short duration [interest-rate sensitivity].

Given our belief that we are nearing a “pause” in the Fed’s hiking cycle, we began to marginally extend the fund’s duration during the first quarter. After beginning the quarter with a duration of 0.28 years, the fund ended the quarter with a duration of 0.35 years. We modestly extended duration by purchasing fixed-rate securities that we found attractive. Additionally, we brought down the fund’s allocation to securities with a floating-rate coupon by roughly 4.5% during the quarter.

Within investment-grade corporates, we continue to have a high level of confidence in the creditworthiness of our banking exposure despite the banking turmoil experienced in March. We believe the names we own can hold up well, even in a deteriorating economic environment. We expect balance sheets for the banking sector to remain stable, particularly within the larger “national champion” banks that dominate exposure in the fund. Most banks will continue to maintain levels of capitalization at or above long-term targets, while current asset quality profiles remain on solid footing, helping these institutions to weather this potentially more challenging period.

We continue to structure the portfolio with 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 4 years. Overall, the Ultra Short Duration Income team is actively monitoring portfolio exposures as market events evolve and continues to structure the portfolio with capital preservation and liquidity as the primary objectives. We do not try to “stretch for yield” in the strategy.

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