Bond markets divided on pace of recovery

Putnam Investments, 01/22/21


Q4 2020 Putnam Ultra Short Duration Income Fund Q&A

  • The U.S. Treasury yield curve trended higher and slightly steepened during the fourth quarter.
  • Investment-grade corporate bonds and high-quality securitized assets aided portfolio results.
  • We are finding value in floating-rate securities over fixed-rate assets, especially those issued by high-quality banks.

How were market conditions in the fourth quarter?

Global financial markets ended the period on a strong note, fueled by the development of COVID-19 vaccines, signs of economic recovery, and a new U.S. stimulus package. Both equities and fixed-income assets rebounded, continuing the market’s run from the downturn earlier in the year. The S&P 500 Index, a broad measure of stocks, rose 12.15% during the period. The rate-sensitive Bloomberg Barclays U.S. Aggregate Bond Index advanced 0.67% during the quarter. The ICE BofA 1–3 Year U.S. Corporate Index rose 0.74%.

In late December, U.S. lawmakers approved a $900 billion coronavirus relief package that would send direct payments to many Americans, provide aid to businesses, and fund distribution of the COVID-19 vaccines, among other measures. Meanwhile, the Federal Reserve has kept short-term interest rates near zero since March. It also announced an extension of several lending programs that are supportive of the short end of the curve. At the same time, it decided to let the primary and secondary corporate credit facilities expire at year-end.

The U.S. Treasury yield curve moved higher and steepened somewhat during the period. The 10-year Treasury yield rose quarter over quarter, ending the period at 0.93%, while the yield on the 2-year note ended unchanged at around 0.13%. Elsewhere, high-yield and investment-grade corporate bonds, along with emerging-market debt, outperformed Treasuries during the period. Mortgage credit also enjoyed relative outperformance, albeit more modestly.

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 0.13% net of fees versus a gain of 0.03% for the benchmark index for the three months ended December 31, 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]. Therefore, 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 during the remainder of 2020, albeit at a slower pace in the second half of the year. 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 23 basis points (bps) during the fourth quarter and resides at +35 bps as of year-end. Spreads have retraced more than 100% of the widening in March and are now at post-financial crisis tights. 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 second half of the year, which proved beneficial.

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

The progress on the development of vaccines has reduced the chances of slower economic growth in 2021. However, rising infection rates and shutdowns could lead to weaker-than-expected economic activity in the coming months. In November, several drug makers released positive news about vaccines, including those with efficacy in excess of 90%. In December, the U.S. Food and Drug Administration approved both Pfizer-BioNTech and Moderna’s vaccines. The financial markets are now pinning hope on widespread vaccinations by the middle of 2021.

We believe credit markets, supported by the Fed’s promise to maintain quantitative easing, will continue to recover. The central bank is committed to aiding the economy by keeping borrowing costs low, pinning short-term interest rates near zero, and buying billions of dollars of bonds. We think bond yields, including Treasury debt, will remain low across the curve for an extended period, but will remain in positive territory.

Direct spending by Congress and the White House will help boost economic growth and consumer spending in the United States. The second coronavirus relief package will provide a fresh infusion of aid to households and small businesses, and for the distribution of vaccines.

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 we believe valuations are less attractive after several months of spread tightening. We are confident about the fund’s positioning as we head into 2021. The fund is targeting a duration around 0.30 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.

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 and additional incremental yield for the fund. Additionally, we are keeping a balance of short-maturity commercial paper for liquidity. Market liquidity is strong on the front end, but it was a challenging environment to put new money to work in the fourth quarter. CP yields are trading through historical averages, driven by lower supply as many companies issued longer-term debt in replace of commercial paper during the year. With that said, we have begun to see issuers return to the CP market, which may present opportunities going forward.

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 one year or less and in upper-tier investment-grade securities [A or AA rated] maturing in a range of one and 3.5 years. Despite ongoing changes in the market environment, capital preservation remains the primary objective of the fund.