Even the casual observer of bond funds knows that 2018 has so far been tough on the wallet. On several occasions, the yield on the bellwether 10-year Treasury has briefly breached 3%, observes fund expert John Bonnanzio, editor of Fidelity Monitor & Insight.
However, the yield curve has been flattening because the Fed has been busy raising short-term interest rates. It’s already done so twice this year with two more hikes expected.
That would mean the Fed will have raised rates nine times since December 2015 to a top range of 2.25% to 2.50%. Against that backdrop, taxable and muni funds have struggled. Here’s how we’re playing today’s interest-rate environment.
While rising short-term interest rates obviously weigh on the value of existing short-term notes, bond funds hold securities of varying maturities. So, as older maturing bonds effectively “age out” of a fund, they’re replaced by new, higher-yielding bonds.
This is true in shorter-term bond funds, and it’s especially true in the super-short duration Fidelity Conservative Income Bond (FCONX) whose holdings are constantly replaced. Albeit ever-so slightly, this portfolio churning is what’s actually helping to keep this year’s performance (up 1.1%) in the black.
With its weighted average maturity well short of a year, Conservative Income is a kind of money market fund on steroids. Yes, it’s riskier than holding a “cash” fund because it takes more credit-risk than money funds are allowed to assume.
Notably, non-prime money markets hold very, very short-term government paper, whereas Fidelity Conservative Income is 90% invested in riskier corporate bonds, including a sizeable chunk (about a third) in foreign corporate bank loans. (The fund’s overall credit quality is “medium.”)
As to an earlier point, duration is a short 0.13 years, suggesting that a 1% rise in interest rates would clip 0.13% of the fund’s value. Viewed another way, about half the fund’s assets mature inside 30 days. That leaves Managers Rob Galusza and Julian Potenza with the opportunity to constantly replenish the fund with slightly higher-yielding bonds.
Granted, Conservative Income is no way to get rich quick. But it is a good way to secure a 2.15% yield at a time when Government Cash Reserves (FDRXX) yields an even more paltry 1.61%.
While money market funds are safer, once inflation is taken into account, your inflation-adjusted return right now is negative. While Conservative Income’s inflation-adjusted yield isn’t much better, it does help from an after-tax standpoint.
Fidelity Floating Rate High Income (FFRHX), a high-yield bond fund, is playing an increasingly important role in our model portfolio income strategies.
At a time when taxable bond funds with roughly the same interest rate risk are yielding only about 2%, it’s clear that Floating Rate’s 4.36% yield is the result of additional credit risk. In fact, it’s taking considerably more risk via its nearly 500 non-investment grade leveraged bank loans.
Naturally, companies that are highly indebted (leveraged), must pay investors a higher yield because they are riskier bets. Notably, 80% of the fund’s assets are in credits rated BB and B.
With that in mind, Floating Rate has a modest wind to its back in the form of a healthy economy and strong corporate earnings — both make the risk of default less likely right now.
It also helps that Fidelity has a deep pool of credit analysts to mitigate some of the risk that’s inherent to holding leveraged bank loans. While we generally don’t encourage investors to “reach for yield,” Floating Rate currently has its risk and potential reward in the appropriate balance.
It’s clear that Floating Rate’s 4.36% yield is the result of additional credit risk. In fact, it’s taking considerably more risk via its nearly 500 non investment-grade leveraged bank loans.
Naturally, companies that are highly indebted (leveraged), must pay investors a higher yield because they are riskier bets. Notably, 80% of the fund’s assets are in credits rated BB and B.
With that in mind, Floating Rate has a modest wind to its back in the form of a healthy economy and strong corporate earnings — both make the risk of default less likely right now. It also helps that Fidelity has a deep pool of credit analysts to mitigate some of the risk that’s inherent to holding leveraged bank loans.
While we generally don’t encourage investors to “reach for yield,” Floating Rate currently has its risk and potential reward in the appropriate balance.
