Bond yields rise amid risk-off sentiment

Q2 2022 Putnam Ultra Short Duration Income Fund Q&A

  • Bonds with shorter-term maturities fared better than longer-maturity bonds given their lower sensitivity to interest rates.
  • The fund's yield increased by 88 basis points to end the quarter at 1.49%, reflecting the fund's ability to capture higher rates on the short end of the yield curve.
  • The outlook for ultrashort fixed income continues to improve, as realized yields and future yield expectations have improved meaningfully over the last few months.

How were market conditions in the second quarter?

The three-month period proved to be a difficult quarter for fixed income assets. Bond prices fell and yields rose in response to record-setting inflation. The Consumer Price Index increased 9.2% and 8.6%, respectively, in April and May 2022 — levels not seen in four decades. Rising commodity prices, component and supply chain issues, food shortages, and Covid-19 lockdowns in China intensified inflationary pressures. Geopolitical tensions weighed on investor sentiment as well. Investors sold high-risk assets and sought refuge in cash and short-term investments. Shorter-maturity bonds, such as those held by the fund, fared better than longer-maturity bonds given their lower sensitivity to interest rates.

To address the persistently high inflation, the Federal Reserve raised its benchmark short-term rate by half a percentage point in May 2022, the largest increase since 2000. Fed officials also outlined a plan to reduce the central bank's massive bond holdings to aid their efforts in taming inflation. In June 2022, the Fed responded with a 0.75% percentage-point increase, the third rate hike this year. Many Fed observers had expected a half-point increase. The degree of the rate hike, along with announcements from other key central banks, led to worries about how central banks might cool inflation without tipping economies into recession.

The Bloomberg U.S. Aggregate Bond Index, which is composed largely of U.S. Treasuries, highly rated corporate bonds, and mortgage-backed securities, returned –4.69%. The S&P 500 Index, a broad measure of U.S. stock performance, returned –16.10%. Yields on some shorter-term Treasuries, such as the 2-year note, have edged above those of longer-term bonds like the 10-year note, creating a flat or inverted yield curve. The yield on the benchmark 10-year U.S. Treasury note rose from 2.32% on March 31 to 2.98% on June 30. The yield on the 2-year note rose to as high as 3.10% on June 28 before settling at 2.92% at quarter-end.

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

The fund underperformed its benchmark, the ICE BofA U.S. Treasury Bill Index, during the period. The fund returned –0.16% on a net basis versus a return of 0.07% for the benchmark index for the three months ended June 30, 2022. A combination of widening credit spreads and rising short-term rates was the main cause of relative underperformance. That said, the fund's yield increased by 88 basis points [bps] to end the quarter at 1.49%, reflecting the fund's ability to capture higher rates on the short end of the yield curve.

Corporate credit was the largest detractor from the fund's relative performance, as 1–3 year investment-grade corporate spreads widened meaningfully during the quarter. Following a brief period of tightening to begin the quarter, 1–3 year spreads widened by 34 basis points to end the quarter at 93 bps. While corporate credit was a detractor, we fared considerably better than the 1–3 year corporate index, which returned –1.02% during the period. This is reflective of our more conservative posture and capital preservation bias, which benefited us during the quarter.

Additionally, the fund's allocation to securitized sectors, including non-agency residential mortgage-backed securities [RMBS] and asset-backed securities [ABS], detracted, albeit marginally. The team continues to focus the portfolio's allocation in this area on highly rated securities that are senior in the capital structure, which we believe provide diversification benefits to our corporate exposure.

On the other hand, our allocations to commercial paper contributed to returns. We keep a balance of short-maturity commercial paper for liquidity. Commercial paper yields continued to rise as interest rates rose during the second quarter, so we have been able to reinvest the maturing paper at higher rates.

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

The outlook for ultrashort fixed income continues to improve, as realized yields and future yield expectations improved meaningfully over the last few months. The yields on 2-year and 3-year Treasury notes have risen sharply in the first half 2022. Interest rates on the shortest end of the yield curve, including the London Interbank Offered Rate [LIBOR] and Secured Overnight Financing Rate [SOFR], also rose sharply in the first half of 2022 with the Fed's aggressive rate hikes. Looking at forward rates [market expectations for yields in the future], currently the market is expecting 3-month LIBOR to end the year around 3.75% and SOFR to end the year around 3.30%. In this environment, we believe our fund, and ultrashort funds in general, will continue to capture these higher yields. Additionally, short-term corporate credit spreads [as measured by the Bloomberg U.S. 1-3 Year Corporate Bond Index] have widened in 2022 after reaching their all-time tightest levels at the end of the third quarter of 2021. This has made valuations more attractive on the short end of the curve, in our view.

The market is currently pricing in over 150 bps of additional Fed hikes through September, and just under 200 bps for the remainder of 2022. If the projected rate hikes do materialize, we believe the fund's yield should continue to be positively affected given the fund's current portfolio structure.

What are the fund's strategies going forward?

We continue to have a constructive view looking ahead and have positioned the fund to take advantage of a rising interest-rate environment. Specifically, we increased the fund's allocation to securities with a floating-rate coupon tied to LIBOR or SOFR, which accounted for about 64% of the portfolio's assets at quarter-end. These securities' coupons reset on a daily, 1-month, or 3-month basis to reflect current short-term rates and carry a very short duration [interest-rate sensitivity]. As of June 30, 2022, the fund's duration was 0.22 years, down 0.04 years from the previous quarter-end. In a rising-rate environment, this strategy can help the fund capture higher yields without experiencing the negative price effects of longer-duration fixed-rate securities. Additionally, as yields rise, the income generation can act as a larger buffer to net asset value movements on a total-return basis.

We have moved into a "credit pickers" market, in our view, with diverging outcomes and idiosyncratic opportunities across investment-grade credit. We have structured the portfolio with an emphasis on 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 1 to 3.5 years.

Given the improving valuations on the short end of the curve, we have been able to add some incremental risk to the portfolio but have been judicious in doing so. Capital preservation remains the primary objective of our fund; we do not try to "stretch for yield" in our strategy.