High-yield bonds came under selling pressure in 2015 as investors reacted to looming Federal Reserve rate hikes and weak oil prices. Shale oil producers borrowed heavily over the past six years, fueling expansion with ultra-low interest rates under the Fed’s quantitative easing policies. Investors grew concerned about energy exposure, and selling pressure spread across the high-yield space, leading to losses in the illiquid portions of the bond market. Fund managers have adapted to changing conditions, finding value in sectors carried lower by the indiscriminate selling seen over the past few months.
The three-star Morningstar rated Fidelity High Income Fund (SPHIX) seeks high income and capital growth. In addition to small preferred-stock exposure and convertible securities, the fund invests in a range of lower quality, income-producing debt securities. It may also invest in non-income-producing financial instruments, such as defaulted securities and common stocks. The fund typically focuses on securities issued by both domestic and foreign companies facing a troubled or uncertain financial future.
Investment Strategy
Under the direction of lead manager Fred Hoff since 2000, SPHIX has followed a strategy of investing in high-yield, non-investment-grade bonds issued by companies that have generally strong balance sheets and that offer the best values within their capital structure. Using fundamental credit analysis, he strives to identify attractive risk/reward characteristics with the assistance of Fidelity’s global research and high-income teams. The goal is to find highly leveraged companies that can provide consistent risk-adjusted returns over a full credit cycle. As a result, he takes a long-term investment outlook with a keen eye on where the market sits within the current credit cycle.
With over 15 years of experience, Hoff has transformed SPHIX into a moderate-risk offering compared with benchmark Bank of America Merrill Lynch U.S. High-Yield Master II Constrained Index. Hoff focuses on B-rated debt issued by companies that are poised to improve credit profiles within the next few years. Unlike his more aggressive competitors, Hoff does not hold large stakes in common stock, preferring bank loans and cash for remaining assets. He keeps these holdings as low as possible, with the belief that security selection is key to overall performance. Hoff will take risks only when he feels they are warranted.
Portfolio Composition and Holdings
Founded in 1990, the fund has slightly less than $4.0 billion in assets under management (AUM). At the end of January 2016, SPHIX had an 86 percent exposure to corporate bonds as well as an 8 percent investment in bank debt and 5 percent in cash and cash equivalents. The fund also has a small exposure to convertible bonds, convertible preferred stocks and equities. Bonds from domestic issuers account for slightly more than 78 percent of holdings. Foreign securities total slightly less than 22 percent of the portfolio. Foreign exposure is derived primarily from Canada, the UK and developed Europe. The fund is diversified; top-10 holdings account for 11 percent of assets. These include bonds issued by CHS/CMTY Healthcare, Tenet Healthcare, Altice and Post Holdings followed by two separate issues from Laureate Education, Citigroup, Hockey MGR, Tronox Financial and the C&S Group.
The fund’s portfolio is overweight healthcare, banks and thrifts, food and beverage, and services categories. It is underweight energy, diversified financial services and cable TV as well as technology and home building. The portfolio is overweight B- and below B-rated securities and underweight BB-rated issues compared with the category average. The fund has an average weighted maturity of 6.0 years, with an effective duration of 3.69 years. SPHIX has an average credit quality of B and an average weighted coupon of 6.49 percent.
Historical Performance and Risk
Hoff showed remarkable acumen steering SPHIX through the hardest-hit areas of the 2008 credit crisis and its aftermath. It was one of only a handful of funds to beat the category averages in 2008 and 2009. Recent performance has been muted by a concentration in B-rated securities. As the market swings from risk-aversion to risk-taking, the mid-level quality tier has underperformed. The fund has recently produced negative low single-digit returns and has modestly lagged the benchmark index. In general, the fund has bolstered its long-term performance by maintaining limited exposure overall to struggling coal and energy names. The fund’s performance was helped by holdings in the steel industry along with picks in the financial sector, including Barclays and Altice Financial.
SPHIX has delivered 1-, 3- and 5-year total returns of -5.40 percent, 0.82 percent and 4.01 percent, respectively, as of February 2, 2016. These compare with the benchmark returns over the same periods of -4.61 percent, 1.65 percent and 4.84 percent. SPHIX has a 30-day SEC yield of 7.91 percent. The fund has an average Morningstar risk rating. Its 3-year beta and standard deviations are 1.01 and 5.50, which compare with the category averages of 0.58 and 2.96.
Fees, Expenses and Distributions
The fund boasts a 0.72 percent expense ratio, compared with the no-load high-yield category average of 0.86 percent. SPHIX has an initial investment minimum of $2,500 for taxable and nontaxable accounts. There is no subsequent investment minimum. The fund has a 1 percent redemption fee for shares held 90 days or less.
Outlook
At the end of 2015, the high-yield market faced severe headwinds from several quarters. These included a slowdown in China, increasing macroeconomic and geopolitical risks, plunging energy prices that raised the risk of defaults, and a slowdown in emerging market economies. Many of these scenarios have now been priced into the market. This has created a situation where valuations have once again become attractive. SPHIX remains overweight single-B-rated issues as a hedge against volatility.
A turnaround in overseas economies or a rebound in the oil and gas space could produce a strong rally for high-yield bonds. SPHIX is appropriate for individuals looking for above-average current income and the potential for long-term capital appreciation who can also withstand the additional risk and volatility of the high-yield market. We currently recommend SPHIX as a Strong Buy with a rank of 89.