Tuesday October 18, 2011
by Jim Lowell, editor Fidelity Investor
I'm recommending Fidelity High Income (SPHIX) to capitalize on a currently unloved and, I think, undervalued portion of the bond market.
Junk bond funds tend to be more economically sensitive than interest rate sensitive; you’d want to own them as an economy is recovering.
Investors have been selling out of junk based on fears of potential outcomes rather than on known fundamentals. Over the past six months, for instance, almost $3.3 billion has flowed out of High Income.
So, what are we buying with this fund? High yield bonds, or junk bonds are fixed-income securities rated BB or below.
The term “junk” is apt; these bonds are issued by companies where default is a very real risk. Some of these companies are, in- deed, junky and always have been.
Others are good companies that, for one reason or another, have taken on enough debt that rating agencies and investors think they could miss an interest payment, or several, and could possibly be unable to pay off their bonds at maturity.
On average 5% of the bonds in the junk, or non-investment grade, market default each year. At times defaults have spiked to 10% to 15%, but it’s rare.
One difference between high-yield bonds and other bonds is that, in the high-yield market, prices are often more attuned to the state of the economy than simply to interest rates.
If the economy is heading for trouble, junk bonds typically lose value because the potential for defaults. In a strong junk bond market, though that often also translates into lower yields.
As in the stock market, there are higher quality junk bonds and lower quality junk bonds. Fred Hoff, who runs the fund, builds a “higher quality, high yield” portfolio by focusing on bonds where he has greater confidence in the issuer’s ability to repay debt. He studiously avoids investing in the riskier segments of the market.
Default rates are very low, corporations have improved balance sheets, and we continue to be in a slow growth, not no growth environment.
Anything is possible, but today, High Income offers an attractive yield at a spread over risk-free assets that have historically signaled higher relative returns down the road.
For the current climate where growth is being discounted to the point of no return, I think High Income will help elevate our portfolios.
Learn more about this financial newsletter at Jim Lowell's The Fidelity Investor.