Strategy advances amid risk-on shift in markets

Strategy advances amid risk-on shift in markets

Q1 2024 Putnam Ultra Short Duration Income Fund Q&A

How were market conditions in the first quarter?

The U.S. economy continued to grow at a strong pace with a resilient job market and stable consumer spending. Gross domestic product increased by 3.4% in the fourth quarter of 2023, exceeding market expectations. Data released in the first quarter (Q1) of 2024 saw non-farm payrolls growing by a monthly average of 265,000, higher than the 2023 monthly average of 251,000. The unemployment rate ticked up to 3.9% at the end of February, and year-over-year (Y/Y) average hourly earnings remained around 4.3%. Increases in headline and core Consumer Price Index (CPI) data moderated with the Y/Y change in headline CPI down to 3.2%, while core CPI reached 3.8%. This drop of only 0.1% signaled that inflation remains sticky.

The U.S. Federal Reserve maintained its data-dependent path in Q1, choosing to keep its policy rate unchanged at both its January and March meeting. Early in the year, the market was expecting the Fed to begin the process of reducing its federal funds rate up to five times in 2024, beginning as early as March. The information from the Fed’s January meeting was somewhat more hawkish than expected, as Fed Chair Jerome Powell pushed back on the potential for near-term rate cuts but assessed that monetary policy was sufficiently restrictive to reach the goal of taming inflation. At its March meeting, the Fed again maintained the fed funds target range for its policy rate at 5.25%–5.50%. The policy rate is likely at its peak, and the Fed expects to begin easing “at some point” this year provided inflation is moving sustainably toward 2.0%.

Over the period, U.S. Treasury yields moved significantly higher across maturities, led by intermediate rates, while the Treasury yield curve remained inverted. One-month T-bill yields decreased by five basis points (bps), while three-month T-bill yields moved two bps lower. Yields moved higher by 37 bps to 4.62% on the two-year Treasury note and also gained 37 bps to 4.21% on the five-year note. By the end of the quarter, the yield on the benchmark 10-year note increased by 32 bps to 4.20%, and the yield on the 30-year bond rose 31 bps to 4.34%.

Fixed income sectors experienced spread tightening in Q1 2024 with a strong risk-on shift in market sentiment. However, total returns were mixed due to the move higher in interest rates. The Bloomberg U.S. Aggregate Bond Index, which is composed largely of U.S. Treasuries, highly rated corporate bonds, and mortgage-backed securities, returned –0.78%. On the short end of the curve, the Bloomberg U.S. Corporate 1-3 Year Index returned 0.79%.

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

The fund outperformed its benchmark for the three months ended March 31, 2024. The fund returned 1.32% on a net basis versus a return of 1.27% for the benchmark index. The fund’s NAV finished the quarter unchanged at $10.10.

Corporate credit was the largest contributor to the fund’s relative performance during the three-month period. The fund benefited from tighter short-term corporate credit spreads. [Spreads are the yield advantage bonds carrying credit risk offer over comparable-maturity U.S. Treasuries. Bond prices rise as yield spreads tighten and decline as spreads widen.] Issuer selection in the banking sector, the largest sector allocation within the fund, was the top contributor to performance.

The fund’s allocations to commercial paper contributed to returns as well. We keep a balance of short-maturity commercial paper for liquidity purposes and as a source of returns.

Lastly, the fund’s allocation in securitized sectors, including non-agency residential mortgage-backed securities and asset-backed securities, augmented performance. The portfolio management team continues to focus allocations in this area on highly rated securities that are senior in the capital structure. We believe these holdings help broaden diversification within our corporate exposure.

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

We continue to believe future monetary policy decisions will be influenced by incoming economic data. With that said, our view is the “last mile” of disinflation will be harder to achieve, and rate cuts will not take place until the second half of 2024. Currently, the market is pricing fewer than three rate cuts in 2024, a drastic difference from the beginning of the year when the market was pricing in over six rate cuts. Said another way, the market has converged more in-line with our view.

Within investment-grade corporate credit, healthy market technicals and supportive macroeconomic data have kept spread volatility low, and increasingly pervasive expectations for a Fed pivot in 2024 have driven valuations to their year-to-date tights. While dovish central bank commentary has reduced the probability of a near-term recession, challenges in commercial real estate and regional banks remain. Additionally, lower-end consumer stress has increased with the depletion of pandemic-era savings and cuts to government stimulus programs. With that backdrop, we continue to seek out and find pockets of idiosyncratic opportunity but remain cautious on overall valuations.

As it relates to the banking sector specifically, we expect overall credit fundamentals to remain stable, particularly within the larger systemically important banks, which dominate the exposure in the fund. We believe most banks will continue to maintain strong levels of capitalization. Current asset quality profiles are also on solid footing, in our view, helping these institutions to weather a potentially more challenging environment.

How have you positioned the fund to reflect that outlook?

We have positioned Putnam Ultra Short Duration Income Fund to take advantage of the current higher interest-rate environment. The fund holds a balanced allocation across fixed-rate securities and securities with a floating-rate coupon tied to the Secured Overnight Financing Rate. Additionally, given our belief that we are at the end of the Fed’s hiking cycle, the fund’s duration’s posture remains at approximately 0.5 years; nearly twice as long as it stood a year ago.

From a credit quality standpoint, the portfolio is structured 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], generally maturing in a range of one to four years. Within investment-grade corporates, we continue to focus on companies with improving or stable credit trajectories.

Overall, the Ultra Short Duration Income team is actively monitoring portfolio exposures as market events evolve. We continue to structure the portfolio with capital preservation and liquidity as the primary objectives and will dynamically position more conservatively or moderately as we anticipate different risk environments. We believe our disciplined portfolio construction is key to reducing volatility and providing consistent liquidity.

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