3. Do you manage more for income or for total return? And if income is a focus, how do you balance generating a decent yield in a very low-interest-rate environment with the need to protect investor capital?
Strategic Income is managed for total return. That is, we aim to offer income but also capital appreciation. The danger of managing for yield is that "yieldy" securities are such because the market is demanding a risk premium, implying that the security has the potential for losses. Thus, higher yield can mean higher risk. When buying fixed income, investors and managers should look beyond yield.
Our total-return focus means that we are focused on both yield and price. Remember that bonds mature at par. The upside potential of bonds is capped. Therefore, as an offset to capped upside potential and an asymmetric return distribution, it is critically important that fixed-income managers protect the downside. At Fidelity, we aim to protect the downside by leveraging our global research platform to select the issuers and individual issues that we believe represent value, offer upside potential, and have minimal chance of default. This active-management approach is especially effective in the fixed-income markets because the bond market is so vast and frequently inefficient. In the case of Strategic Income, our bottom-up, fundamental research process that identifies mispriced securities has produced superior results that offer both income and price appreciation to our shareholders.
4. You rely on individual sector specialists to pick securities for the various parts of the
portfolio--for example, Mark Notkin handles high yield. Given the complexities and uncertainties in the direction of the market, what process do you use when working with your subportfolio managers to properly position the fund?
We cannot overstate the importance of the individual sector specialists, or subportfolio managers as we call them. Many of the managers behind the individual asset classes within Strategic Income also manage industry-leading stand-alone funds. Indeed, the security selection talent of our subportfolio managers is the primary driver of the fund's returns. The subportfolio managers are conducting the fundamental research that allows for careful security selection that outperforms each of their individual benchmarks. The subportfolio managers are the experts in each of their asset classes and have full autonomy to run their subportfolios. The two of us have the risk-management responsibility of rolling up or aggregating exposures and positioning the fund to offset any unintended concentrated positions among the managers.
Working with our subportfolio managers is a process of constant dialogue. Their conviction levels and the color and filter that they provide on their markets are invaluable inputs to the asset-allocation process. However, they are specialists, and so we need to add an overarching comparative view. In typical Fidelity fashion, we will build a top-down view by using bottom-up inputs. We believe that Fidelity has unmatched access and insights into the companies in which we invest. Some of the largest market movers in the world come to our offices here in Boston, and we have the opportunity to sit down with them face to face and get their take on the economy. From these meetings we can build a mosaic that gives us timely information on consumer trends and on business-activity levels, such as pricing and cost structures, revenues, and earnings. In this way, bottom-up research conducted by our subportfolio managers and their analysts helps create our top-down view.
5. Are you inclined to emphasize sovereign developed-markets or developing-markets bonds at this juncture?
Currently, the fund is positioned with an underweight to G-7 sovereign debt and a neutral allocation to emerging-markets debt. We are overweight in high yield.
With regard to the sovereign debt portion of the portfolio, our underweight is a function of historically low yields accompanied by historically high sovereign credit concerns. We simply do not believe that investors are being properly compensated for the risks of chronic deficits and high debt burdens in the sovereign world. With regard to U.S. Treasuries, their performance has been robust in 2010 as they are the world's preferred safe harbor, and the dollar remains the reserve currency.
However, at this point we feel they are pushing the lower limit of yields. There is still a wall of supply coming for Treasuries, and the U.S. government has yet to offer a credible plan for dealing with its debt burden and structural deficit. While the United States is not producing blockbuster gross domestic product growth, there is the risk of similarly slow (or even slower) growth in the rest of the G-7 with only Canada bucking the trend. Although some of the pressure from the European debt crisis appears to be abating, the developed-world sovereign debt crisis is a problem we'll likely have to contend with for years to come. We expect this to be a headwind for the performance of developed-world assets and currencies.
In contrast, emerging-markets debt countries have experienced rating migrations that have been the exact opposite of the downgrades we've seen more recently in their developed-markets counterparts. During the past 15 years, many of the bond-issuing countries represented in the JPMorgan Emerging Markets Bond Index Global have been upgraded to investment-grade status. This market is very different today than it was in the past. Many of these countries have stronger credit profiles and sturdy surpluses in their current account balances, and they are exporting a tremendous amount of goods to the rest of world, growing very quickly as a result. While this asset class looks relatively healthy, there's been a tremendous flow of assets into this market segment, along with strong bids for those assets which may have stretched valuations. These two offsetting factors have led us to a neutral positioning in the emerging-markets debt asset class.
Overall, however, the markets remain in flux and uncertain. The markets--and therefore our views on them--are constantly evolving. As such, we believe the diversification offered by Strategic Income remains a good strategy for all seasons.
Liana Madura is an assistant site editor with Morningstar.com, a sister site of Morningstar.co.uk.
