Ultra-short-duration strategy rises as Fed considers rate cuts

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Q4 2023 Putnam Ultra Short Duration Income Fund Q&A

Overall, the U.S. economy is showing signs of resilience with a strong consumer and job market coupled with declining inflation. U.S. gross domestic product growth in the third quarter of 2023 (Q3) was a substantial 4.9%. Job creation continued at a moderate pace with an average increase of 204,000 jobs per month. The unemployment rate stood at 3.7% by the end of November. Wage growth continued roughly at the 4.0% per annum rate during the period. Year-over-year (y/y) changes in the core Consumer Price Index (CPI) have been relatively stable over the past several months at 4.0%.

At its November meeting, the U.S. Federal Reserve (Fed) left its policy rate unchanged. The post-meeting statement said “tighter financial” conditions existed when compared to its September meeting. This potentially signaled that the rise in long-term yields had left the Fed with less to do in terms of raising rates. Indeed, in the minutes release of the meeting, participants set the tone that the bar for additional rate hikes is quite high with risks now more “two-sided,” but all participants noted “that it would be appropriate for policy to remain at a restrictive stance for some time.” In a speech in late November, Chair Jerome Powell commented that although current monetary policy is restrictive, it will take time to assess the full impact of the Fed’s tightening.

As widely expected, the Fed kept its policy rate unchanged at its December meeting. The Summary of Economic Projections (SEP) included minor changes to expectations of GDP, unemployment, and inflation, but the major adjustment was to the projections for future fed funds rates. When compared to the September SEP, the year-end 2024 median fed funds rate was reduced by 0.5 percentage points (pp) to 4.6%. This is 0.75% (three rate cuts) lower than current levels. Further rate cuts were penciled in for 2025 before with the projected long-run average penciled in at 2.5%.

Over the period, the U.S. Treasury market experienced significant volatility. Inflation fears drove rates higher during the first half of the quarter. However, after a dovish tilt by the Fed, rates were pushed significantly lower. The Treasury yield curve remained inverted. One-month T-bill yields rose by five basis points (bps), while three-month T-bill yields dropped 11 bps. Yields decreased 79 bps to 4.25% on the two-year Treasury note and 76 bps to 3.85% on the five-year Treasury note.

Fixed income spread sectors posted strong excess returns for the quarter as a risk-on shift in market sentiment started in late October and drove spreads tighter through the end of the year. Falling Treasury yields supported strong absolute returns. The Bloomberg U.S. Aggregate Bond Index, which is composed largely of U.S. Treasuries, highly rated corporate bonds, and mortgage-backed securities, returned 6.82%. On the short-end of the curve, the Bloomberg U.S. Corporate 1-3 Year Index returned 3.10%, driven by lower yields and tighter spreads.

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

The fund outperformed its benchmark for the three months ended December 31, 2023 with a return of 1.82% on a net basis versus a return of 1.40% for the benchmark index. The fund’s NAV finished the quarter at $10.10, five pennies higher than at the start of the quarter.

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 allocation in the brokerage and automotive sectors was also a notable contributor.

Allocations to commercial paper contributed to returns as well. We keep a balance of short-maturity commercial paper for liquidity purposes. As interest rates increased, commercial paper yields rose. This allowed us to reinvest the maturing paper at higher interest rates.

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?

In December, many central banks opened the door to rate cuts earlier than expected as the inflation outlook softened. This helped to spur a global bond rally, led by the Fed’s communications and the direction of U.S. rates. The market has priced in a number of rate cuts in 2024, beginning as early as March, while the Fed has signaled three 25-bp rate cuts in 2024. In the near term, Fed rate-cut expectations may be challenged with stronger data prints; however, rates are likely to trend downward as the Fed is planning to cut rates this year and reduce the pace of quantitative tightening (QT).

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, stress on consumers with lower incomes has increased with the depletion of pandemic-era savings and the cuts to government stimulus programs. With that backdrop, we continue to seek out and find pockets of idiosyncratic opportunity, but we 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 fund’s exposure. 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 posture remains at approximately 0.5 years; nearly double where 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 rated], 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 and strong downside protection.

Overall, the Ultra Short Duration Income Fund 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.