The August issue of our Bond Fund Intelligence newsletter features a profile of Fidelity Investments' Kim Miller, who manages the $4 billion Fidelity Conservative Income Bond Fund. The fund, which launched in 2011, is one of the largest offerings among our Conservative Ultra Short Bond Fund category and was designed to fill the space just outside of money market funds. In the Q&A, which we excerpt below, Miller tells us why he is bullish on ultra-short space. (Note: E-mail us to request a copy of the latest issue of our new Bond Fund Intelligence product and our BFI XLS spreadsheet "complement". As with our MFI, BFI is $500 a year; $1K including the XLS.)
Q: How long have you been managing short-term assets? Miller: I've been at Fidelity for 23 years. I started out as a Municipal Bond analyst then I became a Corporate Bond analyst. Beginning in 2003 I came to the taxable desk and ran both of our institutional money market funds. When I handed those off they had about $140 billion in assets. Then in 2011, I began managing the Conservative Income Bond Fund. Overall, Fidelity has been running short-term bond funds for almost 30 years. Our first short term bond fund was launched in 1986.
Q: Tell us about the launch of Conservative Income Bond Fund. Miller: After December 2008, when the Federal Reserve took interest rates to zero, a lot of Fidelity's institutional shareholders expressed interest in employing different strategies for their short-term investments that didn't need to be immediately available for operating needs. These clients didn't want to earn zero on their entire cash balance, so we started talking about differentiating their short-term investments, sometimes described as the difference between strategic cash and operational cash. By strategic cash, I mean money that they set aside for contingencies or long term capital expenditures. The question was: Is there a product that we can create beyond money markets that will provide a better yield to shareholders without introducing them to undue price volatility? By the end of 2010, we were pretty sure that the opportunity was there, and the fund was launched in in March 2011.
Q: What kind of growth has the fund seen? Miller: Conservative Income has about $4 billion in assets under management. It's been growing steadily, but has leveled off recently. From an institutional perspective, investors wanted to see a 3-year [performance] number, and the fund has been around for 4 years, so we may begin to get some traction from those types of shareholders. But [some of the] money that they would look to redeploy in this fund clearly resides in money market funds, and for the most part I think investors are inclined to wait until reform takes full effect in 2016 before they make any definitive decisions.
Q: What are the investment guidelines for the fund? Miller: The investment objective of the fund is to seek to obtain a high level of current income consistent with the preservation of capital. The fund is designed to complement traditional cash management or liquidity management strategies, not replace them, with less of an emphasis on competing in the Ultra Short category. We talk in 'WAM' terms, not in 'duration' terms, which is more familiar to traditional cash investors.
Normally, the fund maintains a [WAM] of 273 days or less. The fund's lower quality investment grade securities (BBB) exposure is capped at 5%. The fund generally does not purchase any structured product. But most importantly, from the standpoint of NAV stability, the fund normally does not invest in fixed rate securities with a maximum maturity of 2 years or floating rate securities with a maximum maturity of 3 years. That's a real governor when it comes to sourcing supply because it largely precludes the fund from participating in the primary market. So the fund sources most of its supply in the secondary market.
Q: What does the portfolio look like? Miller: It's predominately bonds -- some CDs and CP -- but it's predominantly just short term bonds. The other noteworthy thing is the fund does not buy any subordinated debt. [The fund] doesn't include many Treasury or Government securities, [but] that's more indicative of the interest rate environment.
Q: Who invests in the fund? Miller: There are two classes, and the distinction is between over $1 million and under $1 million. It's about evenly split between the two. The former is built almost entirely on high net worth individuals and the retail class is just retail investors that are looking for the slightly higher yield associated with short-term bond funds. I don't have a lot of strong institutional sponsorship yet, because they are figuring out how they're going to deal with pending changes to Rule 2a-7.
Q: How has the regulatory environment impacted the space? Do you expect to see inflows due to MMF reforms? Miller: There are a couple things going on with the institutional investors that we speak to. First of all, many of them are going to have a lot of difficulty accepting provisions for gates and fees. But I think the bigger challenge is interpreting and understanding the implications of the floating NAV. There are going to be changes in NAV, potentially more frequent than a $10 fund with only two decimals.
Q: What are the risks and rewards of rising interest rates? Miller: We learned a lot in 2004 about how funds behave when the Fed starts raising interest rates. This fund now has close to 65% in floating rate securities indexed to 3-month LIBOR, which I'm hoping starts creeping higher in anticipation of rising rates. With respect to the Fed, I think the threshold for raising rates has never been lower. First of all, FOMC members have indicated a desire to get off zero and labor market conditions certainly allow them to do that. Also, the economy is starting to show some wage inflation. FOMC members have said they only need to be reasonably confident that inflation returns to 2% in a reasonable period. (Note: This interview took place in late July, prior to recent market turmoil.)
How do you interpret what a reasonable period is? The market is thinking a reasonable period is 1 to 2 years, but I think the Fed has a longer term view -- 3 to 5 years. I have every confidence that inflation is going to get to 2% in 3 to 5 years. To me, that gives them the liberty of raising as soon as they want. Frankly, you are going to get a better indication of how the market is going to respond to a rate increase in September than you would in December, so based on the current environment, I fully expect a move in September.
Q: What are the risks to Ultra Shorts? Miller: I think a slower Fed will insulate them a little bit, but the Ultra Short category has a lot of different strategies. The fund has competitors that have up to 20% in high yield, and other competitors buy structured products, some of which are negatively convex and will not do well in a rising interest rate environment. So depending on the strategy, we could see at least for some portion of the asset class, a repeat performance of 2007. But again, I don't think we’re going to have the credit dislocation that we had in 2007.
Q: What do you see for the future of Ultra Shorts? Miller: I'm very bullish on the Ultra Short space. Ultra Shorts serve two purposes: it allows investors that are traditional fixed income investors to shorten up without leaving the asset class entirely. Also, cash right now isn't paying much, so they are not necessarily going to drop all of their fixed income assets into cash. If they are looking to hold on to their investments until other asset classes become more attractive, I think they will look at the conservative end of the Ultra Short category. After the recent changes to 2a-7 become effective, traditional cash investors will probably employ several different strategies. Some of their cash will remain in general purpose money market funds, some will go into government money market funds, and some may be invested directly in treasuries or CDs. Investors with a long time horizon may establish an SMA, but those with shorter scopes will look to conservative Ultra Short bond funds.
