Online Extra: A Fixed-Income Fund with a Twist

Bill Eigen of Fidelity Strategic Income says a broadly diversified focus and careful risk management help his fund outperform

If you're a fixed-income investor who likes one-stop shopping, Fidelity Strategic Income might be a fund for you. The $3.2 billion fund invests in almost every type of bond -- Treasuries, corporates, junk, even emerging markets. The adroit maneuvering between these sectors has earned it a 9.6% five-year annualized return -- and an A rating on BusinessWeek's Mutual Fund Scoreboard in the multisector bond category.

BusinessWeek personal-finance writer Lewis Braham recently caught up with lead manager Bill Eigen by phone in his Boston office. Edited excerpts of their conversation follow:

Q: How does Fidelity Strategic Income (FSICX ) differ from other bond funds?


Strategic Income is unique because it is such an extremely diversified fixed-income fund. I've found that most people spend time thinking about asset allocation when it comes to designing an equity portfolio. Yet when it comes to fixed income, they mainly look to Treasuries or investment grade securities.

Fixed-income sector performance can vary widely. For example, during 2002 the Lehman Brothers Government Bond Index outperformed the Merrill Lynch U.S. High Yield Master II Index by 13.39%. However, the results changed significantly in 2003 as the Merrill Lynch index outperformed the Lehman index by 25.79%. Performance results such as these provide a compelling reason for a moderately conservative, fixed-income investor seeking greater diversification to consider the Fidelity Strategic Income Fund.

Q: Describe the fund's investment strategy.


It focuses on four fixed-income asset classes -- high-yield, U.S. government debt, emerging-markets debt, and non-U.S. developed-country investment-grade debt. High-yield and emerging-markets debt offer high current income and the potential for capital growth. U.S. government debt offers current income and liquidity, while non-U.S. investment-grade debt offers both current income and the potential for capital appreciation.

The fund's neutral asset allocation mix is 40% high-yield, 30% U.S. government debt, 15% emerging-markets debt, and 15% non-U.S. developed country investment grade debt. The fund alters the mix as relative valuations and the market environment change. However, it avoids large swings or bets.

Another important feature is that each subportfolio has its own dedicated manager who utilizes a specific process for security selection within his respective asset class. The subportfolio managers also have the added advantage of being able to leverage all of the work done by Fidelity's extensive research staff. I believe this type of investment process is important and underutilized within the fixed-income class.

Q: How do you control portfolio volatility and individual security risk?


I want to avoid having a negative absolute return over any rolling 12-month period -- the biggest fear of most bond investors. However, I also want the fund to be aggressively enough positioned to participate as much as possible in any upside moves. The fund's allocation among a wide range of fixed-income asset classes allows me to accomplish these goals.

This may be surprising to some, but the fund's weighted average credit rating is single A. Overall, the fund's assets are firmly in investment-grade territory because, in addition to our generally less aggressive high-yield allocation, the neutral allocation mix has 45% of the fund invested in AAA government-backed bonds, U.S. Treasuries, and European government-backed debt.

Additionally, the selective nature of our security selection process allows us to prudently manage our credit risk. The fund's broad diversification profile at the asset class, sector, and security level, coupled with its active tactical asset-allocation process, has helped keep volatility and overall risk levels in check.

Q: What investments or strategic shifts have helped your performance in recent years?


Security selection and timely tactical shifts among the asset classes have both added significant value. A timely overweight toward the high-yield sector during a period when high-yield far outpaced other fixed-income classes, and underweight toward U.S. government bonds when Treasuries [suffered from] interest rate concerns, added value recently. Additionally, the U.S. Government subportfolio has benefited from a late 2003 allocation in TIPS (Treasury Inflation-Protected Securities), which have outpaced Treasuries.

Q: What bond sector currently offers the best opportunity for returns?


Improving fundamentals within high-yield could bode well for investors over the next 12 to 18 months. However, as many securities within this asset class are trading at a premium, I expect any potential price gains to be limited. Most of the potential total return will come from coupon income.

Q: What's your outlook for interest rates and credit defaults in 2005? How have you positioned the portfolio for that outlook?


Risks are tilted more toward rates rising rather than falling in the upcoming months, as the economy has strengthened considerably. In particular, inflation has risen faster than most economists had forecast.

Additionally, the Fed has clearly signaled its intention to raise short-term rates in the coming quarters. Credit defaults should likely remain at their present low levels in the upcoming months as earnings are strong, liquidity is solid, Corporate America remains focused on improving the strength of its balance sheets, and demand for new corporate paper is strong, as investors continue to search for yield.

In regard to this view, within the fund I have made an allocation to TIPS and floating-rate corporate securities. These asset classes typically act as a hedge against rising rates. Additionally, the fund has a modest overweight in high yield as a result of the positive outlook for credit.

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