Covering all the bases

Over the past decade, fixed income markets have changed considerably. The simple fact is that there are many more different types of bonds - and, of course, issuers - than ever before which has created enormous competition in the marketplace.

There has also been a realisation that companies and institutions are raising capital in ever more sophisticated ways. Against this background, Fidelity's Ian Spreadbury is convinced that the key to successfully managing a bond fund is having the flexibility to adapt the focus of the portfolio to suit this complexity and different economic climates.

Spreadbury, who has earned an enviable reputation at the helm of the Fidelity MoneyBuilder Income and Fidelity Extra Income funds, believes the ability to flexibly asset allocate between various types of fixed income asset classes can help him deliver consistent out-performance for investors.

And it's this philosophy that's behind the launch of his new Fidelity Sterling Bond Fund which aims to achieve a relatively high income, along with the potential for capital growth, from a broad range of fixed income securities.

"The asset allocation flexibility should enable us to add more value," says Spreadbury. "I have the ability to move freely between government, investment grade and high-yield bonds dependent on my view of relative valuations. For example, when we feel that corporate bonds are expensive, we can move into government bonds. On the other hand, we can also go up to 20% in high yield names should we see fit."

This means that the portfolio manager can adjust the asset allocation across fixed income asset classes to ensure an optimal risk/reward profile.

It's certainly an innovative approach, agrees Spreadbury, but one that makes a great deal of sense when you take a look at how the global fixed income markets have been developing over recent years.

A changing market

As fixed income markets have developed, the opportunities and challenges for fund managers have increased. It has become increasingly important for managers to have access to resources to enable them to profit from the diversity of the market.

"A decade ago bond markets weren't very well developed, especially the high-yield market and some of the sub-sectors such as mortgage-backed securities," recalls Spreadbury. "They were small in the UK and practically non-existent in Europe, but this has now changed. Over the past five years there has been a general move towards fixed income by individual investors who may well have previously been more focused on equities, as well as by the institutions."

So what have been the driving forces behind this change? Well, a number of different factors have each played their part.

In Europe there has been the emergence of the single currency. A company based in Germany, for example, which previously had a rather limited potential market for its bonds, suddenly found it could easily offer them to customers across Europe.

There have also been changes to the way companies are funded, adds Spreadbury. Eight years ago the vast majority would have been reliant on their banks for finance, but the opening up of Europe has encouraged them to consider other options.

In addition, there has been increasing demand from pension funds in the UK for income producing investments.

"Investors also started to focus on income products," he points out. "All these different things came together and helped the fixed income market to develop."

The changing face of fixed income markets has presented plenty of opportunities for those running bond portfolios.

"For a manager in this sector, having more developed credit markets gives them more scope than they would have enjoyed even just a few years ago," says Spreadbury.

"They are able to look at investment grade stocks, high-yield and even European markets which can be hedged back into Sterling. However, this new diversity puts even more emphasis on a fixed income manager's research capability and the resource dedicated to this."

why launch a fixed income fund now?

When markets are very tight on yield spreads and there are fewer opportunities for price appreciation, explains Spreadbury, you need a fund which has the flexibility to look across all bond asset classes; is able to position itself for capital preservation ahead of market change and can quickly respond to changes in sentiment. The new Fidelity Sterling Bond Fund ticks all those boxes.

"Our two other UK fixed income funds have been around for a while, are very well-established and have been accepted by the marketplace," he explains. "However, we felt there was a gap in our UK fixed income product range and we needed to introduce a more mainstream fund with the flexibility to invest more broadly across the fixed income spectrum.

"In addition, many of our clients had been asking for this type of fund so it made sense."

Let's take a more detailed look at what this new product has to offer. Fidelity Sterling Bond Fund will be part of the IMA UK Corporate Bond sector and benchmarked against the Merrill Lynch Sterling Large Capitalisation Index. "It's best described as our strategic bond fund offering due to its inbuilt flexibility," says Spreadbury.

Over the long-term, the fund will be predominantly invested in investment grade bonds, while the individual bonds held will be primarily sterling-denominated or at least hedged back to sterling from other markets such as Europe and the United States. The fund is likely to be invested in around 100 holdings, providing significant diversification.

Fixed Income Pedigree

So how does the Fidelity Sterling Bond Fund compare to Spreadbury's two existing portfolios? To understand the differences, you need to appreciate their individual characteristics.

The objective of Fidelity MoneyBuilder Income Fund is to achieve an attractive level of income from a portfolio primarily focussed on UK fixed income securities - mostly bonds issued by companies rather than governments - and predominantly investment grade, in terms of credit rating.

The fund, which is AAA-rated by Standard & Poor's, is measured against the Merrill Lynch Eurosterling Index - an investment grade corporate bond index which is composed of around 900 individual bonds - although the fund can also invest in non-sterling denominated issues.

Spreadbury prefers to run MoneyBuilder Income with a high degree of diversification and, typically, will hold 200 names at any one time. Generating excess returns over the longer term through small, uncorrelated bets, is preferred to single, high risk/return bets.

"MoneyBuilder Income is primarily comprised of investment grade bonds so it would never have more than a third in gilts," points out Spreadbury. "And also has a 5% cap in terms of allocation to high-yield. Put simply, MoneyBuilder Income is our corporate bond fund offering."

A proven performer over five years, it has achieved a bid-to-bid return of 32.6%, compared to the 28.4% average for the UK Corporate Bond sector, according to data compiled by Standard & Poor's up to March 14th, 2005. This is enough to place the fund 10th out of over 50 rivals.

Fidelity Extra Income, on the other hand, aims to produce a high level of income from a diversified portfolio of mainly UK-based corporate and high-yield issues. Once again, Spreadbury likes to hold around 200 stocks. "It's our hybrid bond fund investing in a mix of investment grade and high-yield bonds," describes Spreadbury.

While the high-quality corporate bond element provides a degree of stability, the principal role of the lower quality portion is to boost the yield.

"The Extra Income Fund is much more focused on the high-yield end of the market and benefits from the low correlation between the two main asset classes," explains Spreadbury. "We maintain the high-yield weighting between 30% and 50% of the fund."

This S&P AA-rated fund also has a solid history of delivering out-performance. The three years to March 14th, 2005, have witnessed a bid-to-bid return of 32.4%, compared to the 29.7% average for the UK Other Bond sector, according to S&P data.

A flexible approach

While similar out-performance will be expected from Fidelity Sterling Bond, the fund will follow a rather different path which will combine the most attractive elements of the existing portfolios and blend them to create a fund with an effective, flexible approach.

That's not to say the overall investment aims will be any different. The guiding theme, adds Spreadbury, is to look to add value for the minimum level of risk and this will remain the same regardless of which fund is under the microscope.

The higher exposure to different sources of return is not expected to result in higher absolute risk levels because of the favourable correlation between fixed income asset classes and the utilisation of various risk management proprietary tools.

"It's very much a risk controlled process and we go to great pains in order to add value in the most efficient way possible," he explains. "There are many different ways in which a manager can add value in a fixed income portfolio."

In Spreadbury's case these include focusing on strategies in which Fidelity has the proven ability to achieve an advantage through the research carried out by professionals in the investment house such as the credit research and quant teams.

"We also aim to have a number of different strategies on the go at once, a multi-strategy approach if you like," he adds. "Historically we have demonstrated our ability to achieve success in this way and taken the emphasis away from areas where it's been more difficult, such as making substantial directional and currency bets."

As far as the Sterling Bond Fund is concerned, Spreadbury will maintain this multi-strategy approach although asset allocation will contribute significantly to expected returns.

"This means shifting the mix of investment grade bonds, government bonds and high-yield bonds, as well as asset classes such as inflation-linked bonds, convertibles and emerging market bonds to where we see most value," says Spreadbury.

The asset allocation process reflects Fidelity's team approach and sees Spreadbury's experience combined with inputs from credit research, quantitative research and the trading desk.

The quality and size of the team that supports him, therefore, will be crucial to the overall success of the product and Spreadbury is keen to emphasise the benefits of having the support of global expertise at his finger tips.

It's easy to see his point. The company boasts some 79 research professionals and 34 portfolio managers within fixed income globally, while in the UK alone there is a team of 22 people who are totally dedicated to fixed income management. It's an impressive line-up by any measure.

"Our fixed income process is very much a team-driven affair, with input from what we consider to be the key disciplines of credit, quant and trading, as well as from the portfolio managers that put everything together," he explains.

All the input from the different disciplines will help in the construction of valuation models which, when combined with supply and demand factors and other historic data, enables the manager to make an informed judgement.

An interesting market

As well as the fundamental qualities of individual names, Spreadbury points out that the economic and market backgrounds are also important factors to be taken into consideration.

The technical issues in particular, he adds, make very interesting reading. "Investors have been going further down the credit spectrum to achieve a higher yield," he explains. "At the same time, supply has been relatively muted since last year because companies have had strong cash flows and didn't need the money. When these two factors are combined it creates a relatively strong pick-up."

There are, however, negative issues to be taken into account.

Valuations are beginning to look rather expensive - particularly as far as high-yield names are concerned - even though the fundamentals remain in pretty good shape.

"Shareholders are also putting companies under more pressure to deliver value back to them in the form of buybacks and special dividends," points out Spreadbury. "There's also an expectation that default rates will start to rise."

So how has Spreadbury responded to these issues? "You could argue that now is the time in the cycle where you want to be a bit more cautiously positioned in corporate bonds," he says. "In my view these markets are looking a bit on the expensive side. Having been very substantially overweight corporates in 2003, and for a large chunk of last year, we have brought our funds back to neutral over the last six months."

Understandably, ensuring the new portfolio has a mix of names is also high up Spreadbury's investment agenda. "I think it's particularly important when fixed income is at relatively expensive levels to be diversified in order to dilute the risk," he says.

"There will initially be 100 holdings in the new fund but that number will probably rise as it grows in size."

How the market behaves in the first year of Fidelity Sterling Bond's life will directly affect the construction of the portfolio. What themes, therefore, is he expecting to see over the next few months?

"Given the forecasts for economic growth and inflation, government bonds appear fairly valued, even though you may get some volatility in connection with shorter term supply and demand issues, while the outlook for corporate bonds is neutral," explains Spreadbury.

"We will continue to have exposure to high yield, but it will be a case of hand-picking the most attractive opportunities."

Experience Counts

Spreadbury is very well qualified to judge, having established himself as one of Fidelity's most respected portfolio managers since he joined the company 10 years ago.

As well as having managed Fidelity MoneyBuilder Income since September 1995 and Fidelity Extra Income since February 1999, he also looks after a number of off-shore mandates for the investment house.

In light of the current economic backdrop and outlook for the coming year, therefore, where does Spreadbury anticipate his new Sterling Bond Fund will be positioned in order to capture upside for Fidelity clients?

"The new fund is more likely to be defensive at first," he says. "On the negative side, the credit cycle looks like it's turning and valuations look expensive, while the positives are the strong demand and relatively limited supply."

Either way, the flexible nature of the fund means that he'll be able to alter the bias of the portfolio when either markets or environments change. It's a prospect that he relishes.

"I will have far more scope to express our views within this fund than I would if I had to have most of the fund concentrated in one area," he says. "This portfolio will be actively managed in order to provide investors with the best possible return on their investments. Flexibility will be the name of the game."