Joanna Bewick and Chris Sharpe are portfolio managers in the global asset allocation group at Fidelity Management & Research, the investment adviser for Fidelity's family of mutual funds. As co-managers of Fidelity Strategic Income, they recently answered our questions on using the "barbell" approach to beat volatility, how high-yield securities have the potential to perform well in a slow-recovering economy, how strategic income is managed for total return, and the differing outlooks for sovereign developed markets versus developing-markets bonds at this time.
1. You have talked about using the "barbell" approach to manage risk. Can you elaborate on how you have specifically used this strategy to beat volatility?
In calling the fund "barbelled," we mean that the fund combines the very highest-credit-quality sovereign debt holdings and lower-quality high-yield and emerging-markets debt. In terms of asset-allocation strategy, in a deteriorating credit-quality environment, we would likely lean toward the higher-quality portions of the portfolio in order to protect the downside. Likewise, in an improving credit-quality environment, we would likely lean toward the higher-beta, lower-quality portions of the portfolio as they offer the greatest return potential in an improving investment environment. The global financial crisis of 2007-09 offers an excellent example of how we used this strategy to the shareholders' advantage.
In 2007, we noted a deteriorating credit environment led by sudden and severe losses in then newly issued subprime mortgages. In an effort to protect the downside, as of the summer of 2007, the weighting of investment-grade holdings was as high as it had ever been in the history of the fund. In retrospect, 2007 was just the beginning of the credit crisis, and as market conditions further deteriorated in 2008 and early 2009, we continued to add to the investment-grade positions of US Treasuries, G-7 nations excluding US sovereign debt, and cash. Ultimately, we reached our peak investment-grade holdings in September 2008 when the fund was 15% overweight in investment-grade holdings (for example, the neutral allocation to investment-grade holdings is 45%, but the fund was positioned with a 60% weighting).
As credit conditions slowly thawed in 2009, we pursued opportunities in high-yield and emerging-markets debt and shrank the overweight to investment grade thus moving the fund back toward its neutral allocations. In quantitative terms, versus the neutral allocation, these asset-allocation moves reduced volatility (standard deviation) by about 80 basis points per year for the three years ended June 30, 2010. For a fund that posted a three-year standard deviation of approximately 9.5%, an 80-basis-point reduction in volatility is meaningful. This example is illustrative of how we use asset allocation to protect the downside and reduce volatility.
2. Given all of the uncertainties about the strength of the economic recovery, do you think the fund is at a disadvantage with its high composition of 40% in high-yield securities? What are you doing to mitigate the portfolio's sensitivity to a slowing economy?
While the economy is experiencing an uneven recovery, it is growing nonetheless. Our best-case scenario is that the economy will continue its recovery albeit at a slow pace and that risk assets can post positive returns, though we expect a lower-than-average return environment. In such a slow but steadily improving environment, high yield has the potential to perform relatively well. Issuers in this space will likely experience steadily improving operations, and default rates will likely continue to decline. Moreover, the coupon of high-yield debt offers an attractive fixed payment that offsets price volatility. Finally, with little risk of inflation overheating, interest rates are likely to remain tame which is a positive for all fixed-income instruments--including high yield--given that bond prices are inversely related to the general level of interest rates.
If the economy and the markets turn negative, then the higher beta nature of the high-yield allocation is offset by a 30% neutral allocation to Treasuries and a 15% allocation to other G-7 sovereign debt. These sovereign debt positions offer a safe haven in times of volatility. Note that the fund's performance history dates back to 1994. During the life of the fund, there have been two recessions and numerous bear markets, and yet the fund's long-term performance remains attractive on both a gross- and risk-adjusted basis. The structure of this fund has proved its resilience during a variety of market ups and downs.
While higher-beta asset classes like high yield have the potential to underperform in a recessionary environment, such assets also have the potential to outperform as markets recover. As it is difficult to accurately call inflection points in markets, it is important to own a fund like Strategic Income for the long-term in order to reap the rewards of the full economic cycle.
