A Barbell Approach to Bond Funds

03/26/2018 5:00 am EST

Focus: BONDS

John Bonnanzio

Editor, Fidelity Monitor & Insight

While it is our view that inflation fears are overblown, for a variety of understandable reasons, many investors are feeling otherwise, notes John Bonnanzio, editor of Fidelity Monitor & Insight.

Regardless of who is ultimately right with respect to where inflation winds up, the continued downward pressure on bond prices has prompted us to essentially tact into that headwind — shifting our approach  to obtain yield without adding portfolio risk.

To that end, we have now “barbelled” our various models’ bond positions. That entails increasing our exposures to both very short-term bonds and to longer-term bonds with a bit more credit risk. This has been done at the expense of intermediate-term funds.

We are implementing this barbell strategy via Fidelity Conservative Income Bond (FCONX) and PIMCO VIT Low Duration (FPMCC).

Conservative Income Bond limits interest-rate risk with its extremely short duration (in many ways it is a money market substitute); Corporate Bond boosts its yield with lower-credit and more interest rate-sensitive bonds.

In barbelling our bond exposures, we’re looking to take advantage of the market’s overreaction to signs of wage inflation by moving out on the yield curve. But because longer-term bonds carry additional risk, we need to offset that by holding more ultra-short-term debt, which is less rate-sensitive.

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Conservative Income Bond is an ultra-short fund (duration is only between 2 and 3 months), and so it’s a very close cousin to money market funds. Notably, it presently yields 1.50% versus 1.32% for Money Market — Fidelity’s only prime retail money market fund.

As with most retail money market funds, it also attempts to keep its NAV steady — in this case, at around $10. (Retail money markets keep a constant NAV of $1.00 per share).

Conservative Income is up 0.3% this year; notably, when bond prices swooned in February, this portfolio of about 90% corporate bonds managed an incremental gain due to its income stream!

As for Corporate Bond, there’s no question that it takes some risks credit-wise: 60% of its assets are rated BBB and below. However, the fund’s managers are careful with risk, and Fidelity’s credit analysts are second-to-none. (Every bond Fidelity holds is subject to its own credit analysis — they do not rely solely on credit rating agencies.)

While corporates are not cheap, their recent setback now provides them with some further upside potential. Moreover, it’s our view that with the economy picking up steam, 2018 will see an uptick in credit upgrades, which will put some wind to the fund’s back. Finally, tax reform may lead to reduced issuance.

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