Earlier this month, Fidelity Investments hosted a webinar entitled, "Fidelity Conservative Income Bond Fund and the Markets," which featured Fidelity's Michael Morin, head of Fidelity Institutional Liquidity Management and CIB Portfolio Manager Julian Potenza. They discussed the latest strategies for Fidelity's offering just beyond money market funds and the overall ultra-short bond fund market. Morin explains, "We designed the fund during the first zero interest rate policy period, and we spent a lot of time and energy with our quantitative team asking ourselves, 'How would this fund perform through market cycles?' We knew we were going to start off at a zero-interest rate environment, which is where we are today, and [then] would be in a rising rate environment."
He continues, "The goal really was to design a risk-return profile just outside of prime money market funds that would be both attractive to money market investors who wanted to take on a little bit more risk with a potential higher return, as well as to attract fixed income investors who are maybe out the curve. [These investors say], 'Gee, eventually the Fed is going to tighten, and in a rising rate environment ... I should lower duration.' And this fund was designed to be one of the lowest duration bond funds in the marketplace.... What I will say is we have very tight guidelines on this portfolio, both from a credit perspective and an interest rate sensitivity perspective."
Morin tells us, "As the Fed raises rates, obviously the NAV of the fund can go down. But the majority of ... downside NAV volatility is going to be more relevant for credit spreads than it is for interest rate spreads. Part of that is because of how short the fund is. So, we have two controls on the interest rate sensitivity of the portfolio. One is the duration itself. We're right in the middle of our benchmark of 3 to 6 months. So [it's] clearly a very short duration benchmark [and has] a dollar weighted average maturity limit of less than 3/4 of a year. So [there are] very tight restrictions from an interest rate sensitivity [standpoint, and you're] only going to have so much volatility on the NAV of the fund."
He adds, "From a credit risk perspective, the final maturity is to the legal final maturity of fixed rate, two years, floating rate three years.... One of the reasons that we did that was really to eliminate structured risk, because one of the lessons from the GFC was obviously extension risk. We saw was a lot of ultra-short bond funds get caught up with securitized risk. What you thought you were holding, a one-year duration portfolio in some cases, blew all the way out to 5, 6, 7 years, and you were left holding long-term assets. So, we wanted to avoid that. Just from a credit perspective, the portfolio is 95% high quality ... A-minus or higher, and then it is allowed to have 5% lower quality. So [it's a] very high-quality portfolio, which we felt like through market cycles would limit the downside risk."
When asked, "What are you trying to accomplish now?" Potenza responds, "The fund really thrives in a rising rate environment.... I think of this as the sweet spot in the short duration space. We have flexibility; we can buy fixed-rate securities up to two years. We can buy longer floaters. We can start to take advantage of hikes as they get priced in sooner than a money market fund ... if we think we're getting compensated. At the same time, all the risk controls that you mentioned keep the funds aggregate exposure to changes in interest rates relatively modest. So, we're able to pursue yield in a way that's a little bit more opportunistic than a money fund, while still keeping an NAV volatility profile that works for strategic liquidity investors."
He says, "We have the ability to pick amongst a lot of different security types within this high-quality, vanilla-structure, investment grade universe ... ARM securities, fixed rate and floating money market securities, Treasury securities, commercial paper, repo, nontraditional repo. Working across our bond and money market trading desk and with all of our research teams across the corporate sector, we are able to navigate the different parts of the front-end market as we see value and as we look to position the fund based on our expectations for the Fed."
Potenza explains, "[Let me] give you a very quick example of how we've been doing that over the last year or so and what we're doing now. As COVID hit and we [went] into ZIRP expecting to be there for a while, 2-year fixed rate corporate bonds are what I'm trying to buy.... The Fed's going to be on hold. We want to lock in as much yield as we can. Money markets are trading super rich. The situation is technically very tough. [There's] not a lot to do in commercial paper market, [and there's] not much interest in floaters with the Fed not expected to hike."
He continues, "[As we] get into early 2021, you may remember in February, the curve started to steepen. The front end was still untouched, but the five years sold off 20-25 basis points. The 10-Year got up to like 175. At that point, we said, 'OK, the market is telling us we're getting closer to the point where the Fed cycle is going to evolve. Let's start avoiding those 2-year fixed rate securities.' What happened to the 5-year note could happen to the 2-year note soon. Let's focus on floaters, 1-year and in corporate securities and even some tier-2 money market securities. We did that for a while."
Potenza states, "Then the floating rate market got really, really tight. We were really hammering kind of tier-2 money market names, 1-year and in fixed-rate stuff. And then in the last, call it, two months, that 2-year move started to happen. So, we saw the hikes get moved into 2022 and the 2-year go up to 50 basis points. At that point, we start saying, OK, I can start to consider 2-years.... I'm not saying it's a slam dunk. I'm not saying we're going to put the whole portfolio into 2-year fixed rate securities. That's not how we manage. But I'm saying the opportunity set now at least provides enough yield and not Fed hiking priced in that there is the chance for that 2-year to outperform my benchmark."
He tells the webinar, "So on the margin, we've been doing a little bit more fixed rate securities while also trying to add appropriately priced floaters to prepare for the ultimate Fed hiking cycle. And you can see a little bit of that reflected in here. I think if you look between the middle of the year and … the end of September, ... you can still see that floaters were going up a little bit. We were avoiding two years. If you check more recently, you'll probably see our fixed rate securities start to increase as the yield environment has shifted."
Potenza adds, "But I think the big-picture comment in terms of how we've been positioning the fund is, we've been trying to be patient, do what we can to hold the line on yield and wait for more opportunities on the credit spread side.... Interest rate sensitivity is something that we spend a lot of time managing, but corporate risk is really the key driver of our returns relative to our benchmark and our risk. So, we spend a lot of time thinking about our exposure to the corporate sector, a diversified mix of very high-quality issuers across geographies, all developed markets, a lot of financial institutions given the part of the yield curve that we operate, working very closely with our research analysts."
Finally, he comments, "Another factor in an active management process is, of course, valuation. From the corporate side, corporate spreads, particularly at the front end, had been very tight. They've widened a little bit as we've seen central banks start to evolve their message.... So, when we think about our appetite for credit risk, we've been trying to hold the line toward good issuers into the fund, maintain yield, but not push our metrics of credit risk, our credit spread duration out too far.... The Fed normalization process, while offering higher rates which provide an opportunity set for the fund, also have the potential to generate some pockets of volatility in credit spreads. And we have a lot of dry powder remaining to take advantage of those opportunities should they arise."
