Hawkish Fed benefits short-term investors

Hawkish Fed benefits short-term investors

Q3 2022 Putnam Ultra Short Duration Income Fund Q&A

  • The fund outperformed its benchmark, and its yield increased by 133 basis points to end the quarter at 2.82%.
  • A combination of tightening credit spreads and rising short-term yields contributed to the fund’s relative outperformance.
  • We remain focused on deploying capital into securities that we believe are appropriately priced for further Fed rate hikes.

How were market conditions in the third quarter?

Fixed income markets rallied into August on expectations that inflation had peaked after reaching a four-decade high of 9.1% in June 2022. Inflation remained a concern, but investors appeared heartened that a strong labor market and a relatively healthy consumer might give the Federal Reserve room to curtail inflation without provoking a serious recession. At their July meeting, Fed policymakers announced a 0.75% hike in their benchmark interest rates, which was widely expected.

The Consumer Price Index declined to 8.5% in July, but inflation was still running well above the Fed’s target inflation rate of 2%. At the Fed’s annual symposium in Jackson Hole, Wyoming, in August, Fed Chair Jerome Powell affirmed that any expectation of easing monetary policy was premature.

Bond prices fell and yields rose for the balance of the quarter as the markets priced in more aggressive monetary policy. Investors feared the Fed would announce another three-quarter-point increase in September, or even raise a full percentage point, to demonstrate its resolve in tackling inflation. At that meeting, the Fed approved a 0.75% increase, bringing its target interest rate to a range of 3.00% to 3.25%. In its commentary, the Fed affirmed that ongoing interest-rate increases were appropriate and forecasted its target rate range to be 4.25%–4.50% by the end of 2022. It also lowered the U.S. growth forecast for 2022, 2023, and 2024.

The U.S. Treasury market underwent a substantial adjustment due to the Fed’s actions and market expectations. At times, yields on some shorter-term Treasuries rose above those of longer-term bonds. As a result, the yield curve remained inverted for much of the quarter, which in past economic cycles has been an indicator for recession. The sharp interest-rate increases over such a short period favored investors on the shorter end of the maturity spectrum. [Shorter-term interest rates tend to be more responsive to changes in the Fed’s benchmark rate than longer-term rates.]

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 0.56% on a net basis versus a return of 0.42% for the benchmark index for the three months ended September 30, 2022. A combination of tightening credit spreads and rising short-term yields contributed to the fund’s relative outperformance in the third quarter. The fund’s yield increased by 133 basis points [bps] to end the quarter at 2.82%, reflecting the fund’s ability to capture higher rates on the short end of the yield curve.

Corporate credit was the largest contributor to the fund’s relative performance, as 1–3 year investment-grade corporate spreads tightened marginally during the quarter. Although 1–3 year spreads only ended the quarter 5 bps tighter than where they began, spreads narrowed meaningfully during the first half of the quarter. After beginning the quarter at 93 bps, spreads narrowed to 69 bps by August 16 before widening out in September to end the third quarter at 88 bps. Issuer selection within financials, which is the largest sector allocation within the fund, was strong, especially among high-quality bank issuers. To a lesser extent, the fund’s smaller allocation to industrials contributed as well.

Our allocations to commercial paper contributed to returns as well. We keep a balance of short-maturity commercial paper for liquidity. Commercial paper yields have continued to rise in 2022. As interest rates increased, we have been able to reinvest the maturing paper at higher rates.

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

The outlook for ultrashort fund returns 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 rose sharply in the third quarter. The London Interbank Offered Rate [LIBOR] and Secured Overnight Financing Rate [SOFR] also rose meaningfully in 2022 amid the Fed’s aggressive rate hiking. Looking at forward rates [market expectations for yields in the future], the market is currently expecting 3-month LIBOR to end the year around 4.70%, and SOFR to end the year around 4.25%. In this 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] remain wide relative to the all-time tightest levels reached at the end of the third quarter in 2021. This has made valuations more attractive on the short end of the curve, in our view.

With higher rates on the horizon, we are constructive in our outlook for our ultrashort bond fund. With an ultrashort bond strategy, we believe investors can reap the benefits of higher income 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 higher interest-rate environment. The fund holds 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]. In a rising-rate environment such as we have experienced in 2022 to date, we believe this strategy can help the fund capture higher yields without experiencing the negative price effects of longer-duration fixed-rate securities.

Given the improving valuations on the short end of the yield curve, we remain judicious in adding incremental risk to the portfolio. We believe credit spread volatility will likely remain elevated in the near term as the market digests tighter financial conditions. Accordingly, we remain focused on deploying capital into securities that we believe are appropriately priced for further Fed interest-rate hikes.

Since the start of 2022, we have kept the fund’s duration fairly consistent. As of September 30, 2022, the fund had a meaningfully shorter duration posture [0.25 years as of 9/30] than that of its Morningstar Ultrashort category average [0.64 years as of 9/30]. 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 3.5 years. Capital preservation remains the primary objective of our fund; we do not try to “stretch for yield” in the strategy.

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