Fed programs continue to support short-term fixed income

Putnam Investments, 10/20/20


Q3 2020 Putnam Ultra Short Duration Income Fund Q&A

  • U.S. Treasury yields hover near lows amid pandemic and legislative impasse on a new stimulus package.
  • Investment-grade corporate bonds and high-quality securitized assets have aided portfolio performance.
  • We believe short-term securities will remain an attractive safe-haven investment as we head into the fourth quarter.

How were market conditions in the third quarter?

Global financial markets ended the period on a strong note. The rally was fueled by ongoing stimulus policies, signs of economic revival, and progress toward a COVID-19 vaccine. All three major U.S. stock indexes turned in a second consecutive quarter of gains, continuing the equity market’s historic run from the downturn earlier in the year. The market’s resilience also benefited bondholders. The rate-sensitive Bloomberg Barclays U.S. Aggregate Bond Index advanced 0.62% during the quarter. The ICE BofA 1–3 Year U.S. Corporate Index rose 0.74%.

In August, the Fed announced a new monetary policy framework that will essentially abandon its longtime strategy of preemptively lifting rates to head off higher inflation. The Fed’s shift in how it sets rates indicates the central bank will tolerate “lower for longer” policy easing. Central banks across Europe, Asia, and other regions also rolled out COVID-19 stimulus measures. Still, investors remain concerned about low global growth, spikes in COVID-19 cases, and the November U.S. presidential elections.

The Fed continues to make it clear that interest rates will remain low for a while; thus, Treasury yields were range bound during the quarter, with the 10-year Treasury ending almost unchanged quarter over quarter at 0.68%. Meanwhile, the yield on the 2-year note ended the quarter around 0.13%. The market for high-yield and investment-grade corporate bonds continued to recover as spreads, or the risk premiums investors demand to hold these securities over U.S. Treasuries, narrowed during the period.

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 rose 0.35% versus a gain of 0.04% for the benchmark index for the three months ended September 30, 2020.

Corporate credit was the main contributor to the fund’s performance over the three-month period. The fund is primarily invested in investment-grade corporate bonds and commercial paper [CP], so corporate spread movements tend to have the largest impact on the fund’s performance. Following a period of extreme widening in March, corporate credit spreads tightened dramatically in the second quarter and continued to tighten in the third quarter, albeit at a slower pace. This served as the main catalyst for the fund’s outperformance relative to its benchmark. The Bloomberg Barclays 1–3 Year Index OAS versus Treasuries tightened by 15 basis points (bps) during the third quarter and resides at +58 bps as of end September; spreads have retraced approximately 95% since March. Issuer selection within the financials sector, which is the largest sector allocation within the fund, was particularly strong, especially within high-quality bank issuers.

In addition, the fund’s allocation to securitized sectors like non-agency residential mortgage-backed securities (RMBS) and asset-backed securities (ABS) contributed to performance. The team increased the portfolio’s allocation to AAA-rated credit card and prime auto ABS during the quarter, which proved beneficial. We limit our allocation to securitized sectors to a maximum of 10% of the portfolio, but this smaller allocation within the fund proved to be beneficial.

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

The U.S. economy continues its slow recovery from the sharp decline in the second quarter. The development of a vaccine or vaccines for COVID-19 could help provide a boost to economic growth and consumer spending. That said, we believe the risk of renewed widespread lockdowns is low. Politics will take center stage over the next few months, including the legislative gridlock on a new stimulus package. Democrats and Republicans have been at an impasse over the next virus relief bill since talks broke off in early August. In addition, the U.S. presidential election campaigns will kick into full gear over the next few weeks. That has the potential to create asset market volatility.

Despite uncertainty surrounding the elections and the virus, Putnam’s fixed income team has a positive outlook on the fixed-income markets. We believe the Fed continues to understand the importance of the funding markets to the broader fixed-income landscape. Usage of the Fed’s facilities, including the money market liquidity facility, the commercial paper funding facility, and the corporate credit facilities, has been relatively low thus far. However, these facilities will continue to serve as an important backstop for the financial markets in the event of future market stress. Fed officials expect to leave rates near zero for years — through at least 2023 — as they try to coax the economy back to full strength after the pandemic-induced recession. We think bond yields, including Treasury debt, will remain low across the curve for an extended period but will remain in positive territory.

What are the fund’s strategies going forward?

From a strategy perspective, the portfolio management team is taking a more conservative approach this time, as spreads have tightened significantly over the past five months on the heels of Fed intervention. We are confident about the fund’s positioning as we head into the fourth quarter. The fund is targeting a duration of 0.30–0.35 years, approximately a tenth of a year longer than where it began the past fiscal year. We are finding value in floating-rate instruments over fixed-rate securities, particularly those issued by high-quality banks. Floating-rate securities also can participate in higher rates in the future as the economy recovers from the COVID-19 pandemic. Also, we are finding opportunities in high-quality securitized assets, including AAA-rated credit card and prime auto ABS. Additionally, we are keeping a balance of short-maturity commercial paper for liquidity, although we have been less active deploying new money there. Market liquidity is strong on the front end, but it’s a challenging environment to put new money to work at current low yields.

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