Fidelity’s Notkin Unfazed by Valuations That Alarm Icahn

Mark Notkin has managed high-yield bonds for more than a decade, and he’s beaten just about all of his peers along the way.

As money managers including Carl Icahn sound alarms that the high-yield market will collapse as interest rates rise, Notkin isn’t concerned.

“I don’t buy the idea that high-yield is in a bubble,” Notkin, manager of the top performing $11.2 billion Fidelity Capital & Income Fund, said in an interview at Fidelity’s Boston headquarters. “The numbers don’t support that at all.”

Billionaire Icahn told a New York investment conference July 15 that high-yield debt is “extremely illiquid, and extremely overpriced” and will eventually crash when interest rates rise. Notkin, 50, says he’s still comfortable with the asset class because interest rates will move up gradually as inflation is well-contained.

It’s a view shared by Jeffrey Gundlach, manager of the top-ranked $46.7 billion DoubleLine Total Return Bond Fund, who said that he likes the debt for the time being.

“I’m willing to dance the risk dance near the door” and invest in junk bonds, Gundlach said at the CNBC Institutional Investor Delivering Alpha Conference in New York Wednesday, arguing the economy isn’t strong enough to allow the Federal Reserve to raise interest rates this year.

Picking Stocks

Notkin’s skill in picking bonds, as well as stocks, has allowed his fund to outpace 99 percent of peers over three years and 98 percent over the past five years, according to data compiled by Bloomberg. Over 10 years, Notkin has topped all but one U.S. high-yield fund with at least $500 million in assets.

The manager has benefited from putting as much as 20 percent of fund assets in stocks over the past five years, as the Standard & Poor’s 500 Index has roughly doubled.

“For quite a while, we have been in an environment that has been conducive to owning stocks,” Notkin said.

While his allocation of stocks relative to high-yield bonds has proved prescient, it’s Notkin’s security selection that has driven his lead over rivals. In the 10 years ended March 31, his stock picks returned 209 percent compared with a gain of 116 percent for the S&P 500, according to Fidelity Investments.

Notkin’s picks among junk bonds have also helped the fund. His high-yield holdings returned 141 percent over the past 10 years, compared with 116 percent for the Bank of America Merrill Lynch U.S. High Yield Constrained Index.

‘Aggressive’ Fund

Notkin’s fund hasn’t always maintained its highest possible allocation to stocks. The fund was tilted more toward junk bonds during the financial crisis as spreads relative to Treasuries soared and prices plummeted.

Fidelity Capital & Income lost 32 percent in 2008. The following year, it surged 72 percent as the debt rallied, better than 99 percent of rivals.

“This fund is at the aggressive end of the high-yield spectrum,” Sarah Bush, an analyst with Chicago-based Morningstar Inc., said in a telephone interview.

Despite the down years, Notkin’s record has been impressive over the long run. The $656 million Loomis Sayles Institutional High Income Fund, run by Dan Fuss and two co-managers, is the only U.S. high-yield fund to beat Notkin over the past 10 years.

Normal Prices

Notkin says high-yield bonds are still priced normally when compared to Treasuries. The extra yield investors demand to own junk bonds versus Treasuries is 4.93 percentage points, according to Bank of America Merrill Lynch index data, compared with an average of 6.01 percentage points over the past decade. The measure was as low as 2.4 percentage points in June 2007, before the financial crisis, then surged above 20 percentage points at the height of the crisis in December 2008.

Companies have sold an unprecedented $2.36 trillion of junk bonds in the U.S. since the start of 2009 as investors sought higher-yielding assets while the Federal Reserve suppressed interest rates, data compiled by Bloomberg show.

Notkin’s usual strategy is to compare the yield on the junk bond index to the earnings yield on the S&P 500 to decide which asset class is the most attractive. The Fidelity fund has been trimming its holdings of CCC-rated bonds, the lowest level in the junk bond universe. Notkin said when his stock weightings are high, as they are now, he cuts his CCC allocation to reduce the fund’s risk profile.

On the stock side, Notkin has benefited from his holdings in semiconductor makers.

‘Booms and Busts’

There are a lot of bad businesses in that industry, he said. “There is too much competition and they are prone to booms and busts.”

Those descriptions don’t apply to Skyworks Solutions Inc., Notkin’s largest stock holding as of April 30, which produces equipment for smartphones. The firm’s sales and profits have grown rapidly, said Notkin, as phones have become increasingly sophisticated.

Skyworks shares have more than quintupled over the past five years, according to data compiled by Bloomberg. Two other semiconductor stocks in Notkin’s portfolio, NXP Semiconductors NV and Freescale Semiconductor Ltd., have climbed 37 percent and 59 percent in the past year.

TXU Profit

In 2011, Notkin scooped up bonds for about 50 cents on the dollar in TXU, a regulated utility subsidiary of Texas power producer Energy Future Holdings Corp. The bonds were cheap, said Notkin, because the parent company was in trouble and ultimately filed for bankruptcy. The utility was unaffected, he said.

TXU’s 6.55 percent bond that matures in 2034 today trades for about 96 cents.

“It has been a great investment for the fund,” said Notkin.

High-yield energy bonds lost ground in the second half of 2014 as oil prices tumbled from about $100 a barrel to less than $60 at year-end. Notkin didn’t feel as much pain as peers, because his fund typically holds less energy than the benchmark high-yield index.

“No one can predict the price of oil,” he said. “It’s guesswork. So why could you want to be overweight there?”

Notkin is a little more confident about the direction for interest rates and the high-yield market overall.

“Interest rates are not going to 4 percent anytime soon,” he said. “We ain’t going anywhere too fast.”