- The short end of the yield curve has experienced substantive change over the past 10 years.
- Ultrashort bond funds have produced attractive risk-return profiles for investors seeking safe havens.
- We continue to believe ultrashort strategies are a viable option in diverse market conditions.
The short end of the yield curve has evolved over the past decade due primarily to new regulations and changes in monetary policy. At the same time, ultrashort bond portfolios have become a strategic allocation for many investors. We discuss these changes in greater detail in our new white paper.
A changing marketplace
The ultrashort bond category gained traction among investors following the global financial crisis (GFC) in 2008–2009. Amendments to SEC Rule 2a-7 included modifying the liquidity, maturity, and quality constraints on ultrashort funds. These significant regulatory changes, combined with evolving supply/demand dynamics, created an opportunity for asset managers with deep knowledge of the short-term markets, including Putnam.
Subsequent regulatory changes, such as the SEC passing a second round of money market reforms that were implemented in October 2016, also had an impact. Investors shifted assets out of prime money market funds due to potential liquidity fees and redemption gates. Spreads on commercial paper (CP) and certificates of deposit (CDs) widened as a result of lower demand from prime money market funds. Ultrashort funds and other market participants took advantage of this relative value opportunity and increased exposure to these short-term credit instruments at more attractive yields.
Monetary policy influences
The monetary policy landscape has also influenced the short end of the yield curve. Over the past 10 years, the Federal Reserve’s policy rate (federal funds rate) has gyrated. The yields on ultrashort strategies followed the same ups and downs as short-term interest rates and tested the ways ultrashort funds manage interest-rate risk.
Credit environment challenges
Lastly, ultrashort bond fund managers have experienced various credit environments over the last decade. The greatest test for the ultrashort space occurred in March 2020 with the emergence of the Covid-19 pandemic and the accompanying liquidity-driven stress across markets. While this affected most fixed income sectors, it was particularly pronounced on the short end of the curve. The ultrashort universe was not immune to volatility during the onset of the pandemic. However, many ultrashort strategies experienced a substantial or full recovery in their net asset values (NAVs) following the Fed’s intervention and the subsequent quick tightening of credit spreads. The NAV recovery was a testament to the conservative nature of the asset class.
Movements in short-term corporate bond spreads and Treasury yields
Sources: Bloomberg, Putnam, as of October 31, 2021. Corporate bonds are represented by the Bloomberg U.S. 1-3 Year Corporate Bond Index.
Attractive risk-return profiles
We believe the ultrashort category has provided an attractive risk-return track record for investors over the past 10 years. Ultrashort strategies produced excess returns to money market funds and short-dated government securities, with only modest additional risk.
Our strategy with Putnam Ultra Short Duration Income Fund has, in our view, offered investors the capital preservation and liquidity profile that we intended, while capitalizing on broader income opportunities. The fund has consistently implemented risk controls, including a weekly stress test of the NAV to identify potential sources of volatility.
At the onset of the Covid-19 market crisis in March 2020, the fund experienced a significantly lower drawdown than similar funds rated by Morningstar. We believe this is a testament to our team’s more conservative philosophy, short-end portfolio construction skill, and experience in managing through previous crisis periods.
The current environment for ultrashort managers
As we enter the final weeks of 2021, the yield environment for ultrashort managers remains challenging. Also, short-term corporate credit spreads are lower than historical averages.
However, we believe the Fed is reaching a policy inflection point. The Fed is now tapering monthly bond purchases. The recent shifts in the dot plot imply the Fed will likely begin hiking rates multiple times in 2022. The market has begun to take note, as the yields on 2-year and 3-year U.S. Treasury notes recently hit their highest levels of 2021.
Finding opportunities today
We are positioning our strategy for a higher interest-rate environment. Specifically, we increased the 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 provide a very short duration (or interest-rate sensitivity). In a rising-rate environment, we believe this strategy can participate in increasing yields, without experiencing the negative price effects of longer-duration fixed-rate securities.
We remain steadfast in our belief that an ultrashort allocation for investors is viable in all market environments. An allocation to an ultrashort bond fund provides investors the means to generate attractive income versus other conservative fixed income options. It also helps investors shorten the duration of their fixed income allocation and reduce the risk (or standard deviation) of their overall investment portfolio. Looking ahead, given our views on changing policy and the potential for higher short-term rates, this may be an opportune time to take a closer look at an ultrashort allocation.
Learn more about our current views in Ultrashort bond funds and short-term markets: The last decade and charting the road ahead and the 10-year track record of Putnam Ultra Short Duration Income Fund (PSDYX).
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