This month, Bond Fund Intelligence interviews Fidelity Investments Portfolio Manager Julian Potenza, who along with Rob Galusza, runs Fidelity Conservative Income Bond Fund. Fidelity "CIB" as it's referred to, is one of the pioneers in the "Conservative" Ultra-Short Bond Fund space, and recently passed the $10 billion milestone. We discuss the fund's strategies, its success, and a number of issues in the shortest segment of the ultra-short term bond fund market. (Note: This profile is reprinted from the Sept. issue of our Bond Fund Intelligence publication. Contact us if you'd like to see the full issue, or if you'd like to see our BFI XLS performance spreadsheet, our BFI Indexes and averages, or our most recent Bond Fund Portfolio Holdings data set, which was published yesterday.)

BFI: Tell us about your history. Potenza: Fidelity has a very long history managing fixed income assets across the entire yield curve. Obviously, that includes our money market business, with which you're very familiar. We also have a long track record managing short-term bond funds.... For example, Fidelity Short Term Bond Fund, another fund that I co-manage, has been around since the mid-1980s.... The Conservative Income Bond Fund was launched in 2011.

I have been involved with Fidelity's fixed income investment efforts since about 2007. I joined as a 'financials' analyst, and cut my teeth covering banks.... Then in 2012, I moved into our macro research team, focusing on the U.S. economy and the Fed. I've been with both our bond and money market investment teams for about 10 years [and] joined the Conservative Income Bond Fund management team a little under a year ago in October of 2017.

BFI: What drove the launch of CIB? Potenza: The fund was launched in the midst of the zero-interest rate environment.... Our philosophy has always been to offer a range of products across the duration and risk spectrum.... It's also always been clear that there is a portion of clients' liquidity portfolios, where they have a little bit longer time horizon and a little bit more of a risk appetite.

The product design reflected some of the lessons learned managing money through the financial crisis.... The idea is that the fund seeks to generate a high level of current income consistent with the preservation of capital. If you look at the type of investments that we put in the fund, it sits on the more conservative end of the ultrashort bond category.

I think one of the lessons of the crisis was that overly complex or overly risky securities have the potential to cause unpleasant surprises. So, we wanted to design a product that really generated most of its returns by investing in simple, plain vanilla investment grade corporate credit products. As you know it is a bond fund. But it's a fund that's benchmarked to a 3- to 6-month Treasury bill index, meaning the duration is quite short, which is designed to limit the amount of interest rate risk that investors in the fund are exposed to.... I feel like that approach really resonates with clients.

BFI: The fund just broke $10 billion, right? Potenza: Yes, the fund hit $10 billion in assets under management in July.... That was an important milestone and clearly a vote of confidence from fund shareholders that the portfolio we have carefully assembled is really helping them with their investment challenges. Part of that story is the fund's strong performance history along with limited NAV volatility, which is really the objective that we’ve been shooting for.

I also think that really this has been a great time in the cycle for the fund. It's a fund that generates yield primarily by taking risk in the credit markets as opposed to interest rate risk. A lot of the credit exposure is in financials, given the nature of issuance in that part of the yield curve. When you think about an environment where the Fed is gradually raising short term interest rates against the backdrop of a global financial system that's really quite healthy, that's been an attractive combination for many of our investors.

You now have the potential to earn yields that are safely above inflation without taking on outsized duration or credit risk. I think that's one of the reasons that we've seen such strong interest in CIB this year. Conservative Income Bond Fund has been in a sweet spot from a yield curve perspective in terms of the balance between risk and return.

BFI: What are your big challenges? Potenza: Supply is always a focus, and we're always working hard to make sure that we have access to the widest opportunity of investments for our clients. The fund has been pretty heavily invested in floating rate corporate bonds in the last couple years. Demand for floaters has been pretty elevated. So, we are always on the lookout to make sure that we have ample opportunities to get invested.... Being part of an organization like Fidelity ... we have the ability to source opportunities from across both our bond and money market trading desks, which gives us a wider set of traders and analysts looking for ideas.

We always want to make sure that we're attracting the right type of investors for the fund. The fund is designed for the strategic cash component of a client's liquidity portfolio -- for example, someone with a 6-month plus time horizon. We've seen greater and greater interest in the product as yields have moved higher as the Fed has tightened.

BFI: What about its composition? Potenza: The fund tends to be a combination of short term bonds and money market instruments. In this interest rate environment, the bonds are mostly corporate floaters. The money market credit instruments are primarily CP and CDs, and we also hold a modest amount of Treasury securities.... The fund tends to be, [roughly] 75% in short term corporate floating rate bonds, and about 25% in money market securities.... We tend to have meaningful exposure to financials, but generally not as concentrated as you would expect to see in a money fund.

As far as investment strategies, we manage interest rate risk in the fund, although, consistent with Fidelity's broader approach to fixed income active management, we take a relatively cautious approach. We don't take huge duration swings relative to the benchmark, and we put a pretty high emphasis on limiting NAV volatility. Our benchmark has a duration of about a third of the year, and we've generally been running a little bit short relative to the index.

It is worth noting that the fund does have a bit more interest rate risk appetite than a money market fund. We have the ability to buy fixed rate securities out to about 2 years final maturity and floating rate securities out to three years. We carefully select securities working with our traders and analysts, making sure every idea that we put in the fund is a good combination of risk and return. It's also the ability to opportunistically shift across the different parts of our opportunity set, depending upon relative value conditions.

BFI: Are there other 'Conservative' funds? Potenza: Our Muni Conservative Income Bond Fund offers a similar approach as the taxable Conservative Income Bond Fund, but it is intended for investors that are also are concerned with tax-advantaged income.... We think of our "Conservative" branded products as part of a broader lineup of ... 'Liquidity Management Solutions' offered by Fidelity. [W]e also manage a number of institutional separate accounts for both corporate cash management and family office clients. Some of these tend to have a little bit more risk appetite than the conservative-branded funds, but they utilize a lot of the same investment strategies and underlying investment markets.

BFI: Tell us about the investors. Potenza: This product has really been resonating with a pretty broad segment of investors. We have a healthy allocation of retail shareholders. We also have seen interest from a variety of different types of institutional investors, as well as advisors and other types of intermediaries. Generally speaking, interest has been really across the board.... While our typical client is a cash investor looking to move out the yield curve a bit, one of the things that we're finding now is we're seeing interest come from the other direction, as well, meaning people that are looking to shorten their bond portfolio.

BFI: What about the Fed and economy? Potenza: It's a little bit cliché, but the phrase 'Goldilocks environment' comes to mind ... because we have growth that clearly has inflected upwards, but inflationary pressures are only building modestly.... The Fed is suggesting probably 2 more interest rate hikes this year along with several more next year.... Markets are pricing this year pretty well. In 2019, you only have about one and a half hikes priced in currently, and that might be a little bit shallow. The fund has tried to maintain a duration slightly short relative to its benchmark. In my view, that type of a positioning tends to work well in a rising interest rate environment.

BFI: How do you feel about the future? Potenza: I feel very good about the way that the product has been growing and about our ability to continue to get the fund invested on the behalf of our shareholders. Cyclically, the wind has seemed to be at the fund's back. But I also think more structurally, a fund like this that offers incremental pick-up over money funds without getting involved in overly complex securities or taking on inappropriate credit risk, is likely to have a pretty lasting appeal for many investors throughout the cycle.

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