Long-term U.S. Treasury bonds suffered one of their worst years ever in 2022. The decline in the price of a 10-year Treasury bond was the worst since 1788, according to one bank’s research. Back then, the newly formed United States was saddled with high inflation stemming from funding the Revolutionary War. This time, the losses were mainly a consequence of an unsustainably high bond price caused by the Federal Reserve’s zero-percent interest rate policy.
Interest rate risk is a function of time and cash flow. The less cash flow, the higher the interest rate risk. The longer the time until maturity (return of principal), the higher the interest rate risk. Long-term, zero-coupon bonds have the highest interest rate risk, while high-yield, short-term bonds have the lowest. Bond funds are measured by their duration, calculated by factoring in both the cash flow and time until maturity. The longer the duration of a fund, the higher the interest rate risk.
Bond prices move up when yields fall, and they move down when yields rise. When the Federal Reserve pinned short-term rates at zero (again) in 2020, many bonds rallied strongly. Eventually, inflation was out of control and the central bank raised rates. Previously, the Fed hiked rates slowly because there was little consumer price inflation from 2011 to 2020. This time, the Federal Reserve waited far too long before hiking and had to rapidly raise rates back to “normal” levels. Bond prices tumbled in response.
U.S. government bonds have only interest rate risk. Corporate bonds and riskier foreign countries have interest rate risk and credit risk. Last year saw a rise in credit risk, which peaked in June. Since then, it has been in a general downtrend. As long as the economy is growing, credit risk will remain low.
Entering 2023, long-term interest rates are on the decline. Consumer prices remain elevated and will continue rising, but the pace has slowed considerably. How much it slows will determine Federal Reserve policy. From July to December, the Consumer Price Index rose about 1 percent. If it continued at that pace for another six months, the Fed could declare victory. The Cleveland Fed thinks inflation will be in the range of about 4 percent, annualized, in the first quarter. If this scenario plays out, the Federal Reserve will hold interest rates higher for longer and may hike them even more.
If the Federal Reserve keeps rates high and economic growth is strong, investors in floating-rate and high-yield corporate securities will see better performance than long-term government bond holders will. Fidelity Strategic Income (FADMX) is a great option, with its experienced multimanager team covering all manner of fixed-income segments and keeping an eye on higher-yielding securities.
Fidelity Strategic Income has 11 managers. The lead managers are Ford O’Neil and Adam Kramer, who have 10 and six years with this fund, respectively. O’Neil has more than 30 years of experience with Fidelity and has managed Total Bond (FBNDX) for nearly 20 years. Kramer has been with Fidelity for 22 years. The other managers all specialize in various credit sectors, including foreign bonds. Lead managers set the fund’s allocation in each credit class, and the other managers focus on security selection.
FADMX yields 5.74 percent. It has an expense ratio of 0.66 percent. There is no investment minimum. The fund has earned a four-star and a Silver rating from Morningstar.
The fund’s default allocation is as follows: junk bonds 40 percent, investment grade 30 percent, emerging markets 15 percent, developed markets 10 percent and floating rate 5 percent. Roughly speaking, the fund’s base allocation has 60 percent of assets in what would normally be higher-risk, higher-yielding debt and the remaining 40 percent in investment-grade bonds or sovereign debt.
FADMX currently has 41 percent of assets in junk bonds; of those, 34 percent are corporate bonds. There is nearly 3 percent in equity, rights and warrants; 2 percent in cash; and 2 percent in bank loans.
Floating-rate debt is currently underweight, at approximately 8 percent of assets. U.S. government debt is nearly 30 percent; of that, 27 percent is government bonds and 3 percent securitized debt.
Developed market debt is 5 percent, split almost evenly between sovereign and corporate debt. Emerging market debt is nearly 16 percent of assets, with 11 percent in sovereign debt, 4 percent in corporate bonds and the rest in floating rate and cash.
Geographic exposure is heavily weighted in the U.S., with 81 percent of assets. Canada, Germany, Mexico, the United Kingdom and Israel each have more than 1 percent of assets and combine for about 7 percent.
As for credit quality, U.S. government bonds are 29 percent, AAA through A is 6 percent, BBB is 18 percent, BB is 18 percent and B is 23 percent. Nearly 4 percent is CCC and below, while 12 percent has no rating. Almost 100 percent of the fund—to be precise, 99.87 percent—is in U.S. dollar-denominated debt as of December 31.
The weighted average maturity of bonds is 15.60 years, but the duration is only 4.45 years, thanks to the high yield on many of the bonds. For every percentage point decline or increase in interest rates, we’d expect FADMX to rise or fall about 4.45 percent, respectively.
FADMX has a beta of 0.98 and a standard deviation of 8.59, making it more highly correlated with the Bloomberg Aggregate Bond Index but slightly less volatile, despite having much more credit risk than the average multisector bond fund.
FADMX fell 11.13 percent last year. The five-year U.S. Treasury bond rose from 1.2 percent to 4.0 percent on the year. Given the fund’s duration of 4.45, we’d expect the fund would lose about 12.46 percent; thus, it performed about as expected with respect to the decline in price.
FADMX has a 3-year annualized return of 0.66 percent. This compares with negative 0.35 percent for the category and negative 1.97 percent for the index. It has been a volatile period for bonds, but FADMX has bested the competition.
Dividends are paid monthly. They have fluctuated between 3.6 cents per month and 2.1 cents over the past three years. Dividends trended up with yields in 2022, but investors can’t be sure that rates will stay high. Retired investors looking for spendable income should budget on the low side of that range. On the bright side, that low included the 2020-2021 period, when the Fed slashed the fed funds rate to zero. Capital gains were 20 cents in 2021 and 15 cents in 2020.
FADMX offers investors a diversified portfolio backed by Fidelity’s deep manager and analyst pool. Including all the subsector managers who also manage other funds at Fidelity, there are 11 managers providing guidance for this portfolio. While many areas of the market have become dominated by passive investing, credit analysis provides a critical edge for bond investors. Buying the bonds with the largest market share, for example, might mean buying bonds of companies with the largest debt. Most of the time, it doesn’t matter, because the bond markets function smoothly. In March 2020 though, FADMX outperformed iShares iBoxx High Yield Corporate Bond (HYG) by 7 percentage points. In short, high-yield bonds are one of the asset classes where active management provides the greatest value.
As for interest rates and credit risk, the current environment favors higher-than-expected interest rates, falling-but-still-elevated inflation and better-than-expected economic growth (assuming most of the market was buying into all the recession chatter the past two months). This is a good environment for high-yield bonds because long-term bond yields should fall with disinflation, but the fund’s higher-yielding short-term debt will benefit from the Fed keeping short-term rates elevated. Even if longer-term rates go higher this year, there’s no evidence to suggest rates will rise nearly as much as they did last year. This will limit the downside from interest rate risk. Stable economic growth will keep a lid on credit risk.
Finally, after a brutal 2022, some investors have cut back on bond allocations. However, in the wake of such a negative year, the outlook for a diversified portfolio of bonds has improved. Short-term bonds, for example, went from a near 0 percent yield to 4 percent now. Many investors aim for a long-term total portfolio return in the range of 6 to 8 percent. The rise in interest rates has greatly aided investors in reaching their targets with less risk and lower volatility than equities come with.
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