Easing inflation sparks bond rally

---

Q4 2022 Putnam Ultra Short Duration Income Fund Q&A

• The fund outperformed its benchmark, and its yield increased by 136 basis points to end the quarter at 4.18%.
• We are beginning to buy fixed-rate securities that we find attractive, given our expectation that we are nearing the end of the Fed’s hiking cycle.
• We believe credit spread volatility will likely remain elevated in early 2023 as the market continues to digest tighter financial conditions and a relatively high level of uncertainty around the ultimate terminal federal funds rate.

How were market conditions in the fourth quarter?

Fixed income markets turned in their first positive quarter of performance for calendar 2022 due to signs that stubbornly high inflation was easing. Investors were relieved to see that the annual inflation rate, as measured by the Consumer Price Index [CPI], fell steadily during the quarter. The CPI, which stood at 8.2% in September 2022, fell to 6.5% in December 2022.

The Federal Reserve announced its fourth consecutive 0.75% interest-rate increase in November 2022. With data suggesting its aggressive monetary policy was having some effect, the Fed announced a 0.50% interest-rate increase in December 2022. While the increase was less than the previous four rate hikes, Fed Chair Jerome Powell signaled the fight against inflation was not over, stating “it will take substantially more evidence to give confidence that inflation is on a sustained downward path.” Minutes from the central bank’s policy meeting in December revealed that Fed officials agreed it would be appropriate to slow the pace of its aggressive rate hikes to minimize the risks to economic growth. As 2022 closed, the Fed had raised its benchmark rate seven times during the year, from a range of 0.00%–0.25% to 4.25%–4.50%.

Yields peaked in early November just before the announcement of the October inflation data on November 10. Thereafter, a rally ensued for many sectors as fixed income markets priced in less aggressive monetary policy. At times, yields on some short-term U.S. Treasuries rose above those of longer-term bonds, like the 10-year note. As a result, the yield curve remained inverted for much of the quarter. In past economic cycles, this has been an indicator for recession. The yield on the 2-year note began at 4.22% and rose to 4.72% on October 20, before closing the quarter at 4.41%. The yield on the benchmark 10-year U.S. Treasury note began the quarter at 3.83%, climbed as high as 4.25% on October 24, before ending the quarter on December 30 at 3.88%.

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

The fund outperformed its benchmark, the ICE BofA U.S. Treasury Bill Index, during the quarter. The fund returned 0.98% on a net basis versus a return of 0.86% for the benchmark index for the three months ended December 31, 2022. A combination of tightening credit spreads and rising short-term yields contributed to the fund’s relative outperformance in the fourth quarter. The fund’s yield increased by 136 basis points [bps] to end the quarter at 4.18%, reflecting the fund’s ability to capture higher rates on the short end of the yield curve.

Corporate credit was the largest contributor to the fund’s relative performance, as 1–3 year investment-grade corporate spreads tightened during the quarter. After beginning the quarter at 88 bps, spreads narrowed 15 bps to end the quarter at 73 bps as the investment-grade corporate bond market, along with other risk assets, rebounded meaningfully in October and November. Issuer selection within financials, which is the largest sector allocation within the fund, was strong, especially among high-quality bank issuers. To a lesser extent, the fund’s smaller allocation to industrials also contributed.

Our allocations to commercial paper contributed to returns as well. We keep a balance of short-maturity commercial paper for liquidity. Commercial paper yields continued to rise through year-end. As interest rates increased, we have been able to reinvest the maturing paper at higher rates.

Lastly, the fund’s allocation to securitized sectors, including non-agency residential mortgage-backed securities and asset-backed securities, contributed to performance, albeit modestly. The portfolio management team continues to focus allocations in this area to highly rated securities that are senior in the capital structure, which provides diversification within our corporate exposure.

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

We have a constructive outlook for strategies that focus on the short end of the curve, as they currently benefit from elevated yields and the expectation that rates will remain higher for the foreseeable future. The yields on 2-year and 3-year Treasury notes remained elevated in the fourth quarter, ending the quarter near where they began. The London Interbank Offered Rate [LIBOR] and Secured Overnight Financing Rate [SOFR] continued to rise amid the Fed’s aggressive rate hiking. The Fed’s official dot plot released in December 2022, which policymakers use to signal their outlook for the path of interest rates, showed 17 of 19 committee members targeting rates above 5% in 2023. It also showed an expected terminal federal funds rate of 5.1%. Our expectation is the Fed will hike a few more times in early 2023, likely in 25-bp increments.

Where our view generally differs from the market is the timing of Fed cuts. Currently, the market is starting to price in Fed cuts in the second half of 2023. Our economist’s view is the Fed will likely pause for longer, as we believe the U.S. economy is unlikely to enter a recession before 2024, given the resilience of the consumer and the tight labor market. In a sustained higher-rate environment, we believe our fund, and ultrashort bond funds in general, will continue to capture these higher yields. Additionally, although short-term corporate credit spreads [as measured by the Bloomberg U.S. 1-3 Year Corporate Bond Index] tightened during the fourth quarter, they remain wide relative to the all-time tightest levels reached at the end of the third quarter in 2021.

With rates likely to remain elevated, we believe investors can reap the benefits of higher income in ultrashort bond funds without taking the same level of interest-rate risk as longer-term bond fund investors.

What are the fund’s strategies going forward?

We have positioned Putnam Ultra Short Duration Income Fund to take advantage of a higher interest-rate environment. The fund holds a meaningful allocation to securities with a floating-rate coupon tied to either LIBOR or SOFR. These securities’ coupons reset on a daily, 1-month, or 3-month basis to reflect current short-term rates and provide a very short duration [interest-rate sensitivity]. In a rising-rate environment such as we experienced in 2022, we believe our current strategy can help the fund capture higher yields without experiencing the negative price effects of longer-duration fixed-rate securities.

Within investment-grade corporates, we continue to have a constructive view on the financial sector, particularly U.S. banks. Fundamentals in the banking sector remain solid in our view, while valuations are relatively attractive as heavy supply from the financial sector throughout the year has kept spreads elevated versus similarly rated industrial issuers. We believe credit spread volatility will likely remain elevated in early 2023 as the market continues to digest tighter financial conditions and a relatively high level of uncertainty around the ultimate terminal federal funds rate. Accordingly, we remain focused on deploying capital into securities we believe are appropriately priced for further Fed interest-rate hikes.

Since the start of 2022, we have kept the fund’s duration fairly consistent. As of December 31, 2022, the fund had a meaningfully shorter duration posture [0.28 years] than that of its Morningstar Ultrashort category average [0.62 years]. However, we are beginning to buy fixed-rate securities that we find attractive, given our expectation that we are nearing the end of the Fed’s hiking cycle.

We continue to structure the portfolio 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 1 to 3.5 years. Capital preservation remains the primary objective of our fund. We do not try to “stretch for yield” in the strategy.