Floating Rate: Fidelity's Sweet Spot in High Yield

10/10/2019 5:00 am EST


John Bonnanzio

Editor, Fidelity Monitor & Insight

The key to performance at Fidelity Floating Rate (FFRHX) is that the interest rates paid on its high-yield bank loans are not fixed, but rather float with the benchmark to which a particular note is linked (such as the Fed Funds rate or LIBOR), explains John Bonnanzio, editor of Fidelity Insight & Monitor.

So while many bond funds saw their returns suffer in 2018 amid rising rates, Floating Rate offered some relief because its interest payments were continuously reset higher.

This year, of course, interest rates have fallen, sending most conventional bond prices higher. But the super-short-term bank notes held in this fund were reset lower.

While this diminished the fund’s yield and ultimately weighed on its total return (dividends plus capital appreciation), the fund’s co-managers are conservative in that they maintain a below benchmark weighting in lower-rated (CCC) leveraged loans.

That, coupled with excellent high yield credit analysis has provided strong risk-adjusted returns for the fund’s shareholders. Relatively speaking, last year Floating Rate High Income was a superstar! While high-yield bonds fell about 2%, and the funds’ high-yield peers retreated from -2.4% to -7.8%, Floating Rate eked out a gain of 0.1%!

So far this year, the fund is faring significantly better — at least in absolute terms. Up 7.0%, a generally healthy appetite for risk assets combined with investors’ desire for higher yields have made Floating Rate a laggard versus its riskier peers.

So why not trade Floating Rate for that or another high-yield fund? The answer comes down to risk. Keeping in mind that all bond funds expose investors to varying degrees of credit- and interest-rate risk, Floating Rate is the most conservative on both counts — especially interest-rate-risk.

And, relatively speaking, there’s not exorbitant credit risk there, either. Granted, high-quality investment-grade bonds are non-existent. (which is what you’d expect from a high-yield fund).

Still, almost 90% of Floating Rate’s assets are rated BB and B (which is not much different from its cohorts) and just 6% are rated CCC and below. Of course, that credit risk is what drives its current yield of 5.21%.

None of this is meant to suggest that Floating Rate is magically risk resistant. It’s not. Indeed, when investors have been worried that the economy is slowing and that credit quality might deteriorate as a result, this fund suffered.

In fact, the asset class has experienced outflows during the first half of 2019 (though this has been somewhat countered by reduced supply). Falling interest rates have also weighed on its yield and ultimately its returns (see box).

Floating Rate is our only Buy-rated high-yield fund (the rest are rated one notch below). With the U.S. economy healthy, loan defaults remain low: just over 1% versus a long-term average of roughly 3%.

Within this investment landscape the fund provides the best balance between downside risk and potential reward. Bottom line: It’s still a good fit for our income-oriented model portfolios.

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