Fed policy changes may create attractive market opportunities

Fed policy changes may create attractive market opportunities

Q2 2021 Putnam Ultra Short Duration Income Fund Q&A

  • U.S. Treasury yields reversed course from the first quarter as short-term rates rose and long-term yields fell.
  • With spreads historically narrow, we continue to take a more conservative approach.
  • We have shortened the duration of the fund because the Fed will likely tighten monetary policy earlier than previously expected.

How were market conditions in the second quarter?

Global financial markets advanced, driven by a broader rollout of vaccines, fiscal stimulus, the easing of mobility restrictions, and a pick-up in economic activity. Growth in the United States is being fueled by federal funding, including President Biden’s $1.9 trillion coronavirus relief package, and pent-up consumer demand. However, fixed-income securities, stocks, and other risky assets came under pressure periodically due to concerns that rising inflation and a speedy economic recovery could prompt central bankers to pare back easy monetary policies. In mid-June, the Federal Reserve signaled it expects to raise interest rates by late 2023, sooner than anticipated. The Fed’s June median dot plot now implies two rate hikes in 2023, compared with zero following the March meeting. The Fed also said officials had discussed an eventual tapering of bond-buying programs.

The prospect of higher rates in the future tends to make the fixed rates of traditional bonds less attractive. The yield on the 10-year Treasury note, which helps set borrowing costs on everything from mortgages to corporate debt, fell to 1.45% at period-end from 1.74% at the end of the first quarter. The yield on the 2-year Treasury note advanced to 0.25% from 0.17%. Outside the United States, rates moved higher as well. Within this environment, investment-grade [IG] debt gained, despite marginal spread tightening. [Spreads are the yield advantage credit-sensitive bonds offer over comparable-maturity U.S. Treasuries.] High-yield bonds gained, outpacing investment-grade corporate bonds and the broader IG fixed-income market.

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

The fund outperformed its benchmark, the ICE BofA U.S. Treasury Bill Index, during the period. The fund returned 0.20% versus 0.00% for the benchmark index for the three months ended June 30, 2021.

Corporate credit was the largest contributor to the fund’s relative performance during the quarter. Spreads tightened on the Bloomberg Barclays 1-3 Year Corporate Bond Index by approximately 10 basis points during the quarter. They are now at their tightest level since the index’s inception in 2003. Issuer selection within the financials sector, which is the largest sector allocation within the fund, was particularly strong, especially within high-quality bank issuers. To a lesser extent, the fund’s smaller allocation to the industrials sector contributed as well.

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

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

We believe the environment for risk assets remains generally supportive. Growth in the United States will be robust, particularly in the second and third quarters of 2021, fueled by the lifting of restrictions, pent-up consumer demand, and widespread vaccinations. We are also anticipating further strength in corporate earnings growth. Considering expectations for sturdier growth, we believe U.S. Treasury yields could rise further this year. That said, we think the trend toward higher rates will be gradual, as bond investors adjust their growth and inflation outlooks, leading to periods of market volatility.

Near-term inflation expectations are significantly higher than they were prior to the pandemic. While it is possible that higher-than-expected inflation could unnerve policymakers and investors, we think the Fed will view any near-term uptick in domestic inflation as transitory. We believe the Fed will maintain its accommodative policy over the short term as it seeks broader and more inclusive employment gains. At their June meeting, Fed officials reaffirmed plans to continue holding short-term interest rates near zero and continue the asset purchases for some time. While the first half of 2021 has been a challenging environment for investors on the short end of the curve, we believe the Fed’s recent actions are a first step toward unwinding the pandemic-driven liquidity, which in turn may create attractive opportunities.

What are the fund’s strategies going forward?

From a strategy perspective, the portfolio management team is continuing to take a more conservative approach, since valuations remain less attractive on the heels of historically tight spreads. In terms of rates, we continue to believe the Fed will tighten policy earlier than market expectations, and we are beginning to see this play out. Within the fund, we have been positioning the portfolio based on this view. We have been shortening the duration of the fund by selling fixed-rate corporates and swapping into floating-rate instruments, specifically investment-grade corporate bonds that have a floating-rate coupon. Typically, when we see the Fed change course, short-term rates trend higher in anticipation of an eventual rate hike. Therefore, owning securities with floating-rate coupons allows the fund to participate in a higher rate environment in the future as floating-rate coupons reset.

Within securitized sectors, we are finding opportunities in high-quality assets, including AAA-rated credit card and prime auto ABS. Although we limit the fund’s allocation to securitized sectors to approximately 10% of the portfolio, this smaller position has provided diversification benefits for the fund. We are also keeping a balance of short-maturity commercial paper [CP] for liquidity. CP yields remain low; however, issuers have started to return to the CP market, which may present opportunities going forward.

We continue to structure the portfolio with a barbell approach, emphasizing positions at separate points on the yield curve: lower-tier investment-grade securities [BBB or equivalent] maturing in one year or less and upper-tier investment-grade securities [A or AA rated] maturing in a range of 1 to 3.5 years. Despite ongoing changes in the market environment, capital preservation remains the primary objective of the fund.

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