Below, we reprint the lead article from our October BFI, "Fidelity Muni Conservative Income's Doug McGinley." It says: This month, BFI profiles Fidelity Conservative Income Municipal Bond Fund's Doug McGinley. He discusses the ultra-short municipal space and Fidelity's shortest tax-exempt bond fund offering, which celebrates its 3rd anniversary this month. McGinley also talks about his investment strategies and the recent jump in tax-exempt yields. Our interview follows. (Contact us if you'd like to see the latest Bond Fund Intelligence. Also, thanks to those who visited with us at the recent AFP Annual Conference. We hope you had a great show and a nice visit to Orlando!)
BFI: Tell us about your history. McGinley: We've had a short [muni] product offering for nearly 30 years now, and obviously Fidelity has been in the muni fund business for decades. The Conservative Income Municipal Bond Fund is a more recent fund launch; it will be 3 years old this month. In terms of my background, I joined Fidelity coming out of Harvard Business School and started off as a credit analyst in 1994, so I've been with the company for 22 years.... I've been on the money market side for the past 10 years, then [moved] back into the bond world with our launch.
BFI: Did you see a gap in the market? McGinley: Yes.... We've had a short muni bond fund (Fidelity Limited Term Municipal Bond Fund) for the past 30 years that would have a duration on average of between 2 to 5 years. And we've had money market product offerings for quite a while. Our question was: Is there something in between that there's demand for [which] we're not meeting? We took a look at ... the market and assessed how much money flowed into ultra-short types of muni bond products.... Also [we asked], if we did launch something and if it was growing, would there be enough security supply to meet that type of customer demand? We spent some time reviewing that, and after considerable examination came to the conclusion, 'Yes, there is customer demand for it.' This followed the launch of our taxable Conservative Income Bond Fund, which was in 2011. We had great success with that product launch.
BFI: What's your biggest challenge? McGinley: When we first launched the fund, it was in a lower rate environment.... That has been a challenge for this product category. The fund has seen consistent growth [which] has accelerated as time has gone on. Short term rates have gone up since we launched, so that has enabled the fund to provide a higher yield.... When this product is examined in [an ultra-short bond] context, the category is so broad that this really fits on one end of the spectrum, being very short [with] limited credit exposure.... I think the 'Conservative' name in the fund name is trying to indicate to people what the goal of this fund is.
BFI: What can and can't you buy? McGinley: The fund purchases securities that are designed for money market funds, in terms of the variable rate demand bonds and tender option bonds.... There are times when those securities have been issued without actually meeting the money market requirements ... or maybe they were issued and held in a money market fund at one time but then were downgraded, taking them just outside of money market eligibility. So the fund has been able to accumulate and buy a lot of these 1-day and 7-day instruments that provide great liquidity, which is wonderful to have in a short-term, ultra-short type of fund. These securities also give the fund a great anchor in terms of average maturity and interest rate risk. In the past, the fund has typically had anywhere from a quarter to half of its assets invested in these ... and the fund was able to pick up some decent yields on those types of holdings.
This fund, may normally invest in securities out to 4 years in maturity, but the average maturity for the fund is normally below 1 year. Owning a lot of these dailies and weeklies allows the fund to buy bonds out 3 or even 4 years if we think they represent good value and still keep that average maturity down below one year. The fund does have many diversification rules as well that are similar to money market funds and other bond funds in terms of sector and issuer diversification.
BFI: Is there a lot of issuance? McGinley: Municipal securities are definitely issued inside of 4 years. The fund does buy deals in the primary market when new deals are coming and participates in those. But I would say we've probably had even more success buying in the secondary market and purchasing securities that may have been longer than 4 years when they were issued but have now rolled down.... [T]here has been enough supply in both the primary and the secondary market. And another thing, there's a fair amount of issuance that comes in the one year space in the form of cash flow notes.
Again money market funds will buy a lot of that type of paper. But to the extent that the issuer does not meet [the] very high standards for money market funds, then ultra-short bond funds can step in, typically at higher yields, and purchase those. It's great that Fidelity's analysts that are looking at deals as they're coming. The analysts may conclude: 'I cannot give this the minimal credit risk designation necessary for money market funds, but now let me take my work over to the ultra-short and short bond funds and see if they have an interest in this credit.'
There are thousands of issuers out there, and they typically have many different securities with different maturities and different coupons. It is a very wide spectrum in terms of the number of offerings in the municipal space. One of the great strengths of Fidelity is our strong research staff, especially on the tax-exempt or municipal side. We have analysts looking across all these different sectors, following many different credits. It gives us the opportunity to look at more investment options that way. We have a money market trading desk and a municipal bond trading desk sitting just a few feet from one another. There's great synergy in understanding what's going on in each marketplace, how they impact one another and what we're seeing in terms of the offerings.
BFI: Who are the big issuers? McGinley: There is a lot of issuance out of the big states such as California, Texas, Illinois, and Florida. [But] that's not necessarily how the Conservative Income Municipal Bond Fund [looks]. In the past, the fund has not purchased many securities issued in California ... because its securities generally trade a lot richer and do not meet the yield hurdles that we may be looking for in the fund. That's not to say there aren't specific issuers out there that we find attractive and purchase for the fund.... Historically, the two states to which the fund has had the most exposure to in terms of everything issued within the state are Illinois and Texas. But that's across a wide variety of different issuers and different sectors.
BFI: What about the spike in SIFMA? McGinley: I think it's really a reflection of what has happened with shareholder flows as a result of pending money market regulation changes. We have seen money move out of municipal money market funds during the calendar year. And if you go back a full year ago, we really [were] in a market environment where demand by 2a-7 funds appeared to exceed eligible supply out there. So that kept rates very low.... But as the months rolled by [and as] we continued to see money leaving muni money market funds, we've almost experienced a flip of [these] technicals now where supply is exceeding the demand.... The re-marketing agents are pricing these securities at higher yields to find other buyers.
BFI: What about bank regulations? McGinley: Any regulatory impact on banks can impact the marketplace, because the banks do play a big role by providing letters or credit or liquidity facilities for a lot of the daily and weekly securities in the money market space.... Certainly, to the extent that regulations change and impact bank behavior, that can change the pricing charged by the banks and the availability of credit enhancement to the municipal issuers which can change the types of supply or the amount of supply that we see in the money market or short muni bond space.
BFI: Who are the investors in the fund? McGinley: We've seen the institutional class for this fund grow faster than the retail share class. But it does appear that the great majority of assets are coming more from individual investors than big institutional investors. That may change over time as the fund establishes a three year track record and if it crosses the $1 billion threshold.
BFI: How tough has the zero yield environment been? McGinley: It probably makes it more challenging for munis to look attractive on an after-tax basis in an extremely low rate environment. Having said that, with the rise in SIFMA and short term muni rates, as of the first week of October, the Conservative Income Municipal Bond Fund is now offering over 80% of the yield of the taxable version, Fidelity Conservative Income Bond Fund.... Our Conservative Income Municipal Bond Fund looks very attractive at this time.
BFI: Any comments on the future? McGinley: Current yields are catching investors' eyes.... Hopefully they're also looking at what's in the portfolio, and see that the fund has conservative positioning [credit-wise]. The fund is not taking much interest rate risk, because we are trying to limit the shareholder's downside exposure.... Looking back, we felt that there was investor demand between a money market fund and a short term bond fund, and I think that conclusion was correct. We've seen flows to support that conclusion. With money market funds going through transitions right now, investors may be taking a fresh look at how they want their short term money invested.... I would think that the future demand for ultra-short bond funds will continue to support having these funds offered in the marketplace, and that we'll continue to see inflows over the longer run.
