"We've recently pivoted away from strategies designed to absorb market shock and toward those designed to opportunistically add well-priced risk to the portfolio," says Franco Castagliuolo, portfolio manager of Fidelity® Government Income Fund (FGOVX).
Castagliuolo says that he and co-portfolio manager, Sean Corcoran, had become increasingly bearish about the US and global economies by the end of 2019, due to what they saw as a maturing business cycle. Because of this, they believed financial markets were increasingly vulnerable to exogenous shocks.
Accordingly, the team put in place a series of "shock absorbers." They purchased derivatives called swaptions that benefit from increased interest-rate volatility. At the same time, they shied away from investing in Treasury Inflation-Protected Securities (TIPS), which they felt would underperform in a slowing, deflationary environment.
They also refrained from underweighting duration (interest-rate sensitivity), given their contrarian view that rates would need to remain at ultra-low levels to support high levels of consumer, business, and government debt.
Mainly, they stuck to government-backed agency securities, based on their analysis that suggested credit spreads could widen and result in the underperformance of bonds with credit risk. "While we didn't—and couldn't—foresee the coronavirus pandemic, we had anticipated some turmoil, and the shock absorbers helped us amid the selloff in the first quarter of 2020," he says.
More recently, against the backdrop of the Federal Reserve's recent dramatic and massive moves to steady the financial markets and stimulate the economy, the team started to sense value among some of the more distressed areas of the government bond market.
As the market initially declined, they aggressively added to the fund's exposure to government agency-backed mortgage securities—at ever-better prices and ever-higher yields relative to comparable-duration US Treasuries. Furthermore, they opportunistically added TIPS to the portfolio at what they deemed as very attractive valuations.
"Inflation protection seems very cheap, and we think unprecedented stimulus could make inflation possible," Castagliuolo says.
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Franco Castagliuolo is portfolio manager of Fidelity® Government Income Fund.
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