Policy keeps short-term rates low

Putnam Investments, 04/21/21


Q1 2021 Putnam Ultra Short Duration Income Fund Q&A

  • Longer-term Treasury yields rose significantly in the first quarter, while moves on the short end were less pronounced.
  • With spreads historically narrow, we continue to take a more conservative approach.
  • We have started to marginally shorten the duration of the fund, as we believe the risk of a rate move to the upside has increased.

How were market conditions in the first quarter?

Global financial markets ended the period mixed. Key equity market indices edged higher, driven by progress on Covid-19 vaccinations, loose monetary policy and signs of economic recovery. U.S. fiscal stimulus, including President Biden’s $1.9 trillion pandemic aid package, has served as a tailwind to the economy. The S&P 500 Index, a broad measure of stocks, rose 6.17% during the period. Fixed-income assets ended the period with mixed results. The rate-sensitive Bloomberg Barclays U.S. Aggregate Bond Index fell 3.37% for the three-month period. The ICE BofA 1–3 Year U.S. Corporate Index rose 0.02%.

Investors’ expectations for a strong economic rebound and a pick-up in inflation have driven yields on all but very short-term government debt higher. Markets appear somewhat worried the Federal Reserve may raise short-term interest rates, though the Fed has stated otherwise. This has resulted in a sharp increase in U.S. government-bond yields during the quarter. The yield on the benchmark 10-year Treasury note surged as high as 1.78% in March, before falling to 1.74% at quarter-end. That rate was below 1% for much of 2020. The yield on the 2-year note ended the period at around 0.16%.

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

The fund performed roughly in-line with its benchmark, the ICE BofA U.S. Treasury Bill Index, during the period. The fund returned 0.02% net of fees versus a gain of 0.03% for the benchmark index for the 3 months ended March 31, 2021.

Corporate credit was a contributor to the fund’s relative performance during the quarter. Issuer selection within the financials sector, which is the largest sector allocation within the fund, was particularly strong, especially within high-quality bank issuers. With that said, 1–3 year investment-grade corporate spreads began to widen out from historically tight levels towards the latter half of the quarter, which offset relative returns to an extent.

The fund’s allocation to securitized sectors, including non-agency residential mortgage-backed securities (RMBS) and asset-backed securities (ABS), contributed to performance. The team continues to focus the portfolio’s allocation in this area to highly rated securities that are senior in the capital structure, which provides diversification benefits to our corporate exposure.

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

The medium-term economic outlook for 2021 is improving, buoyed by the rollout of mass vaccinations and additional federal government aid. The upward trend in vaccinations is expected to slow the pace of new infections and increase mobility by the third quarter of this year. However, we believe the Covid-19 pandemic will continue to weigh on economic activity over the near term. Concerns surround new variants that might cause spikes in infections and overshadow gains made by vaccinations.

Furthermore, 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. Fed officials in March highlighted an improved outlook for U.S. growth but signaled they expect to maintain ultralow interest rates through 2023. While short-term bond yield movements will likely be less pronounced, we believe long-term bond yields, including Treasury debt, will trend slightly higher.

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 valuations remain less attractive after several months of spread tightening. We have marginally shortened the duration of the fund, as we believe the risk of a rate move to the upside has increased with the recent vaccine rollout and a greatly improved macro outlook for 2021. This is being accomplished by selling fixed-rate corporates that have rallied and are currently trading with tight spreads. To this point, 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 continues to recover 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 for the fund. We are also keeping a balance of short-maturity commercial paper for liquidity. CP yields remain low; however, issuers have started to return to the CP market, which may present opportunities going forward.

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 1 to 3.5 years. Despite ongoing changes in the market environment, capital preservation remains the primary objective of the fund.