- Different types of bonds may have disparate performance during varying market environments.
- A multi-sector bond fund can provide the potential for income and wealth preservation despite market ups and downs.
Building a bond portfolio that can deliver steady income while seeking to preserve principal during varying kinds of markets is no mean feat. The bond universe is a vast and complex place including everything from US Treasurys to corporate and emerging market bonds. Like master craftsmen building a sturdy boat, managers of multi-sector funds rely on years of skill and experience to build vessels that can navigate the market's unpredictable seas.
About the expert
That's what the team that manages the Fidelity Strategic Income Fund (FADMX) has been doing for 25 years. It's a go-anywhere bond fund that seeks to achieve a balance between income and wealth preservation (as opposed to just reaching for the highest yield without concern for risks). Known as a multi-sector bond strategy, this approach seeks to configure the right mix of bonds for different phases of the business cycle. The goal: to help investors smooth some of the ups and downs of their portfolios while generating reliable income over the course of a full market cycle.
Of course, not all multi-fund strategies are managed in the same way. So it's important to understand how any fund you invest in is operated. Here, co-manager Ford O’Neil explains what has worked over the years.
When the fund launched in 1994, 10-year US Treasury notes were yielding 7.81% and globalization was just starting. Now, 10-year Treasurys yield less than they once did, and China and emerging markets have been driving global growth. How have you managed to find income for investors through all the changes while also preserving capital?
O'Neil: A lot of investment strategies tend to be very tactical, moving abruptly in and out of a variety of investments. We manage the fund so that we don't need to make those kinds of abrupt shifts in direction and that helps investors to feel more comfortable staying invested throughout the ups and downs of the market cycle. If you look at our history with this portfolio, we’ve mostly stuck with the original 4 asset classes of US government, high yield, emerging market, and foreign developed market bonds. We’ve also maintained a pretty consistent balance between the "risk-on" and "risk-off" assets in the portfolio.
What is the "risk-on/risk-off" philosophy and how do you use it?
O'Neil: We seek to provide investors with some upside potential while preserving wealth. We believe that the return of capital is just as important as the return on capital. We think market conditions come in 2 varieties, "risk-on" and "risk-off." By that we mean some investments will perform better when the market is rewarding those who invest in riskier assets such as high-yield bonds, emerging markets, and leveraged loans. Other investments will preserve capital or may appreciate in value when the market is not rewarding risk-takers. Government securities, both US and non-US, tend to outperform in risk-off environments. If in general we think the prospects for economic growth are weak, we tend to favor government securities. Having a mix of assets in the portfolio helps to maintain a balance between risk and reward. Sometimes, the risk-on assets may deliver reward. At other times, the risk-off assets may lower exposure to risk.
What is your approach during those times when risk-taking is being rewarded by the market?
O'Neil: We believe high-yield bonds are attractive because they offer generous yields and we expect their overall rate of default to be low absent a recession. We also put emerging market bonds in the risk-on category. Over time we've found this approach has provided a better balance between risk and reward than either Treasurys or high yield alone would have (See chart. For the most current standard performance, please visit the Fidelity Strategic Income Fund summary page).
A multi-sector approach also means you need to know a lot about a variety of bonds, rather than just focusing on a single category. How do you do that?
O'Neil: We have a team of specialists. Adam Kramer and I are the co-lead portfolio managers. Mark Notkin manages high yield, Eric Mollenhauer runs the leveraged loans. Jonathan Kelly manages EM and Franco Castagliuolo and Sean Corcoran run the US government sleeve while Fidelity International manages developed markets. We meet formally every quarter to hear what the other folks' views of the market are and we also meet informally far more frequently. Adam and I pick securities all day long so we have strong views on sectors because we're interacting in those markets on a daily basis. I think that helps in regard to the interaction among the managers.
History never repeats, but it can rhyme. How did your multi-asset strategy work during the global financial crisis?
O'Neil: It was significantly underweight high yield, relative to our composite benchmark in 2009. The fund added high yield in 2009 which had an extraordinary bounce back that year and in 2010 as well.
Does your current positioning reflect the belief that the global economy is in the late phase of the economic cycle, when financial markets typically turn more volatile?
O'Neil: I would argue that we are late cycle. But the late cycle can last a long time with interest rates where they are today. The Federal Reserve remains very dovish in their current outlook for monetary policy. The vast majority of late cycles didn't die of old age but were often killed by the Fed. But the Fed is doing everything they can to make sure that they're not the culprit this time around. Now there can be exogenous events like trade shocks that escalate the late cycle into recession, but those are virtually impossible to predict.
How would a multi-sector strategy like this one ride out a recession?
O'Neil: When it looks like we might be heading to recession, government bonds are assets that can be very helpful to have in our portfolio. More than likely, they're going up in value when everything else, including stocks, high yield, and convertible bonds, is going down in value. The government bonds are like our insurance. The other assets in the portfolio are risk-on assets that we want for the other 5 of those 6 years on average when risk-taking is being rewarded. When you put risk-on and risk-off assets together in a portfolio, it can help to smooth out your returns, because usually when one is going down in value, the other is going up in value.
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