FidelityConnects: Manage volatility through diversified income solutions

[00:03:25] Glen Davidson: Hello, and welcome to Fidelity Connects. I'm Glen Davidson. In today's volatile market environment where trade, fiscal and monetary policy can change on a dime many investors are looking for an actively managed diversified income solution. An income solution that is positioned for a range of outcomes, well diversified across many assets and sectors, and one that can be tactical to take advantage of new market opportunities. Joining me to reflect on the first half of the year, provide updates on positioning and unique perspectives on tariffs, and what may be next is portfolio manager, Adam Kramer. Adam co-manages the Lipper award-winning Tactical High Income Fund. Today's webcast is available with live French audio interpretation. As a reminder, please submit your questions to Adam through the Q&A box  and I'll get them here on my monitor. Welcome, Adam. Thanks for joining me today.

[00:04:14] Adam Kramer: Great to be here, Glen.

[00:04:16] Glen Davidson: So nice to see you. I wanted to start by saying, from all our discussions in the past you've got to focus on income, you've got that focus with risk minimization and you've access to an incredible amount of asset classes. That's really what tactical high income's all about, risk-adjusted returns. In fact, you've talked about it in connection with a balanced fund. Could you give our viewers today, and listeners, an overview of Tactical High Income Fund, please?

[00:04:45] Adam Kramer: Great to be back, Glen, and continuing the discussion. Thank you everybody for taking the time to be here today. The Tactical High Income Fund, we started out in 2014 so we have a number of years behind us. It's a flexible mandate to invest across the full spectrum of income-oriented asset classes. That can be anywhere from Treasury bonds on one end to dividend-paying stocks on the other and everything in the middle. That includes high yield bonds, floating rate debt, emerging market debt, investment rate corporates, it can be convertibles and preferreds. That's pretty important because when you look at all these different asset classes, they all take turns as the best and worst performing asset class in any given year and the difference can be thousands of basis points. Why is that?

[00:05:31] The market has a tendency to, rightly or wrongly, price in risks before the events occur. Our goal is to be tactical. That's sort of where the name comes in. We want to to be stepping in when things are very inexpensive when you get a premium yield, and then also give you a balanced approach. We want to be an alternative to a 40/60 fund, a 50/50 fund, a 60/40 fund. We're very tax efficient as well. We are basically just looking for where the puck is and that's what we've been doing year-to-date and over the last 11, 12 years.

[00:06:25] Glen Davidson: I've got to ask you, being tactical, which works to people's advantage, you can do that in a tax advantaged way as well. Could you explain that, please?

[00:06:36] Adam Kramer: One of the things that we were just talking about, Glen, we've known each other for a while. I'm a Canadian chartered accountant, I guess now it's called CPA. I've always thought about taxes as a key component to investing. One of things we want to do is to be able to have that flexibility, which sometimes means higher turnover, but do so in a very tax aware manner. We want to minimize our tax liability to you, and that's what we've been able to do on a regular basis. We do tax harvest and we match gains and losses appropriately to make room for these new opportunities when they come.

[00:07:11] Glen Davidson: So good to have a CPA at the helm and, yes, it is CPA now. I wanted to ask you about the first half of the year. It's been volatile. Good news is bad news, bad news is good news, it's really been quite something. When you think about the tactical nature of the fund what have you taken advantage of, what have you seen over the last six or seven months?

[00:07:32] Adam Kramer: I've been in the High Income and Alternatives Group in Boston as part of Fidelity equity research, a boutique within a larger company. I've been doing this for 25 years now, in August, actually. We're used to volatility in many different asset classes and we know that each year, like I said before, these asset classes take turns as the best and worst performing asset class pricing in bad news or good news before the events occur. We've had a very interesting start of the year where we had Liberation Day. Liberation Day for us meant opportunity. We love it when there are episodic sell-offs in the market, and there was no shortage of that in April where, in my view, I think around 70% of the COVID lows in some cases was priced in. It was very, I thought, irrational across the board, where a lot of investors were pricing in the risk of a recession, even a depression in some places, or another repeat of COVID.

[00:08:51] We were able to find a lot of opportunities in high yield bonds, in loans, in equities, in convertible bonds and preferred shares. It was an opportunity for us to capture even more premium yield, capture more equity-like potential. A lot of those situations have actually worked out well. Just to give you a feel for how the year has turned out, at the beginning of the year I would not have thought that convertible bonds would be the best performing asset class in our universe, and it actually is, and the worst performing at this point in U.S. dollars is the preferreds. Investment grade's been hanging in quite well, even better than high yield. What we like to say is we don't like to make predictions, we like to wait for the opportunities to come our way, and when the opportunities come our way we have the ability to assess whether or not there's too much good or bad news priced in and we want to take advantage of that.

[00:09:46] There was a lot of irrationality, and a good example would be to take a look at just funeral homes during Liberation Day. Funeral homes, some of them are public in the U.S., some of the have bonds outstanding. Just to give you a sense of how irrational some of this selling was, funeral home bonds were selling off with tariffs. I don't know about you but with funeral homes, they're not really impacted by tariffs. In fact, with all the stress that the Liberation day created you could argue that it actually would help their businesses and therefore the prices should have gone up, but they actually went down. There was a lot of really low-hanging fruit that we took advantage of across the credit curve across all these other asset classes that I spoke to you about.

[00:10:26] Glen Davidson: Do you feel that way with preferreds as well? You were saying they were the worst asset class in the period that we've just gone through, the first half of the year. Does that create an opportunity for you or are you just continuing your analysis to see if that makes an asset class choice that you want to make?

[00:10:42] Adam Kramer: With preferreds, actually, the U.S. preferred market is mostly the largest U.S. banks and it's also REITs and utilities. It's mostly an investment grade market and if people have heard me speak over many years, it's been one of the areas that I thought was the most mispriced, most attractive for many years. A lot of it is higher duration and there's been a lot of good news priced in over there. We had a lot of fixed-to-floating prefers, we've trimmed a lot of those, but what's interesting about it is that with the U.S. banks, for example, we shifted from a U.S. preferred fixed-to-floater bank or a U.S. fixed rate preferred to the equity. We've actually been sort of moving down the capital structure because one of the things we think might not be priced in fully is the possibility for future benefits from banking deregulation in the U.S. That, obviously, would flow through to the equities.

[00:11:39] One of the areas that we added to in the last number of months, which you see in our holdings, are some of the U.S. banks in the U.S., the equites, and you'll see a decrease in the preferreds. With preferreds, we have seen some really interesting opportunities that have come to market. We've had a company called Strategy who have issued four different types of perpetual preferreds that came very inexpensive yielding 9%, 10%, 11%. This company, basically, just buys Bitcoin and the preferred relative to the amount of Bitcoin that they have on the balance sheet was covered multiple times. We felt in many cases we could be tactical over there.

[00:12:28] Glen Davidson: Interesting. Many portfolio managers tell me you are the king of convertible securities. Could you talk about how you are an absorber, if you will, of all the other asset classes. All the information comes through you from within Fidelity. Talk about the resources that you can draw upon.

[00:12:47] Adam Kramer: Thanks Glen. Convertible bonds is the secret sauce of this fund. It's a way for us to do more with less. It's a way to capture a premium yield for some growth companies that don't pay dividends because convertibles pay income, but also to have less equity sensitivity because a convertible bond is essentially a combination of a stock and a bond. You have very good downside protection because of the bond coverage but if the stock actually works you can go up with the stock.

[00:13:32] This is one thing that I've been working on for 25 years. As an analyst at Fidelity I sort of looked at my first tanker company which had a convertible bond back in 2002, so 23 years looking at the market. I managed the convertible bonds at Fidelity since 2008. I have a co-manager, Rick Gandhi, who works with me. I would say it's a little bit of a golden age of convertibles now because we're actually starting to see a lot of new deals, a lot of interesting deals. There's a lot of artificial intelligence and infrastructure build-outs. Around 11% of that market either has Bitcoin or is mining Bitcoin on the balance sheet. There's a lot really different flavours you can get from the convertible bond market in the U.S. that you can't find anywhere else.  I would say that of all the funds in the universe that I look at in Canada, we're probably the most involved in the convertible bond space in the tactical high-income funds.

[00:14:58] Glen Davidson: When you look at tactical high income, you're the specialist when it comes to convertibles but you've got specialists in all the other asset classes as well. They're from within Fidelity, aren't they?

[00:15:09] Adam Kramer: In our group alone, High Income Alternatives Group, we have over $100 billion in assets spanning from high yield bonds to loans to emerging market debt to direct lending to floating rate debts to real estate income, a very big group, a lot of alternatives in the group. We have 25 analysts, and these analysts, which I was part of when I first started out in 2000, cover multiple industries. We look at the entire capital structure, Glen. When we look at a company we're not just rating the bond, we're not just reading the stock, we're looking at everything. Might be a preferred stock in there, it might be a convertible bond, it might be in a loan. Our analysts are trained to look through all the documents, understand what drives the security. We're looking at 12 to 36-month fundamentals. Is the wind blowing in the right direction, are there catalysts in addition to the fundamentals, where is that sweet spot in the capital structure? Going back to the whole philosophy that I was talking go with the fund is that there's such a big difference in the valuations of so many different parts of these capital structures for companies. In many cases the convertible bond is the sweet spots.

[00:16:23] Glen Davidson: That capital structure, you're looking at it from all aspects. I think what's fascinating is when you're at the head office at 245 Summer, if you go up to the 14th floor you have access to all of the thousands of companies that come in to see Fidelity throughout the year. You're in there and fixed income, there's every different asset class type of portfolio manager and analyst are in there grilling those public companies and private companies. That's where you have that access to areas of the capital structure. Isn't that true?

[00:16:53] Adam Kramer: That's what's so great about it. Like you said, if you go onto the 14th floor we have dozens of conference rooms in there with a board like an airport with which company is in and for how long you're in. It's usually an hour meeting. What's great about is that you can go and listen to these meetings in person, or if you're away from your office or in the office you can Zoom in. There's multiple ways to capture a lot of different colour coming from the management teams. What's nice about it is that you have people like myself who are looking at the company from so many different lenses. You have an equity analyst, equity portfolio managers, high yield bond portfolio managers, loan portfolio managers, so you're able just to listen to what the company is saying and sort of assess whether or not that enhances or detracts from one's investment thesis.

[00:17:46] Glen Davidson: The current yield, Adam, on the portfolio, you mentioned about premium income, where are you at right now as far as yield on Tactical High Income?

[00:17:54] Adam Kramer: Glen, that's a great point. One of the things I could have mentioned at the beginning when we were talking about this fund is what makes it so attractive to investors over time is that we have less reversion to the mean of total return because of that turnover I was telling you about, that tax-aware turnover, where the portfolio today is different from where it was a year ago, for example. We're locking in the gains and moving on to different areas. One of the other areas, a key component of the strategy, is that we want to make sure there's a high enough level of current income to dampen the blow on a down market. We like to call it the proper matching of income to the amount of risk one is taking on. For example, a hypothetical scenario but a good proxy for how the fund is positioned on June 30th, let's call it on a pre-tax basis around 4%, 4.5%, let's call it, current yield. That's the combination of the dividends, the income from the bonds, the preferred share dividends, everything that you're collecting and paid out on a monthly basis.

[00:18:58] What would proper matching be? Well, 4.5%, how would that 4.5% help if the underlying stocks in the portfolio were to go down 10%, and how would that 4.5% help if the underlying bonds in the portfolios were to widen by the first 100 basis points? To get to that proper matching with the 4.50% current yield, and this is what I'm constantly trying to work on all the time, make sure we have that proper matching, you'd probably want to have around a 45% to 47% equity sensitivity. In other words, if the stocks were to go down that first 10% you're covered by the income. Then you also want to make sure you have the proper matching. Let's call it 3 1/2, 4-year duration on the bond portfolio, which would be a little less than half of what the investment grade bond market is in the U.S., and that sort of protects you for that first 100 basis point move in bonds. That's one of the things, I always have to make sure that we have that high enough level of current income in the fund, and that really has helped us in down markets.

[00:20:19] Glen Davidson: When you think of the high yield allocation within the portfolio right now, is that more of a yield opportunity? Is there a capital gain opportunity? Both? Where are we at with high yield?

[00:20:30] Adam Kramer: High yield really sold off during Liberation Day and we tactically added quite a bit to that fund. We had in many cases some bonds that were pricing in, like I said, two-thirds to 70% of where we were in COVID, I thought. It's still an overweight. I like high yield relative to investment grade, for sure, because when you think about high yield, even at a very tight spread of Treasury plus 300 which is sort of where it is today, and that's tight historically on the absolute, you're really only talking about a 3-year duration When you look at the current yield of high yield, call it 6%, 7% versus the 3-year duration you're talking about the ratio of two to one. That's pretty good, actually, going back to that proper matching. Even if I just did a market portfolio I still think that's much more attractive than investment grade corporates at this point which are yielding maybe 4 or 5% for a 6 or 7-year duration. You can understand you don't get that much, and they're also trading at very tight spread so you're not getting that downside protection if the economy were to weaken, if they were to weaken, spreads are going to widen both investment rate and high yield so where do you get that best bang for the buck? I think it's in high yield. We have brought down high yield somewhat. [indecipherable] part of the portfolio is probably around 20%, a mixture of high yield, preferreds and loans, but I still like our portfolio and we're still able to find those 70% versus 3-year duration.

[00:22:20] Now, what I think is even more attractive than high yield is still the floating rate debt market. Floating rate debt are senior in the capital structure so they're senior to high-yield bonds. There's actually collateral to them so they're secured by some of the assets of the company, and they actually float off [indecipherable]. What's interesting is everybody's worried about rates eventually coming down, which they probably could, but that market's already pricing in much more than what people would expect in the market. The market's maybe expecting 60 basis points of cuts. The loan market's trading much higher than ... I've had higher premium yield in that than the high yield market so it's sort of like you're pricing in the rate cuts already. We do still like the loans, and you'll see in our top 10 holdings we still have a company called Bass Pro Shop, Cabela's, which you have in Toronto and Canada. It's a private company. It's paying out SOFR plus 400 or so. I can't remember the number but it's closer to 8,.9%. What's nice about these loans is that there's no duration so you're really just taking on the credit risk of the company and what happens with interest rates going forward.

[00:23:29] Glen Davidson: With the complexity of some of these structures that you're able to deal with you must have an army of lawyers that are assisting and looking at covenants and so on and helping with the research that you and your team have to do.

[00:23:41] Adam Kramer: First of all our analysts are all trained to look through the covenants, that's part of the key parts of being an analyst in our group. We do credit research and when you put your credit hat on you're going through the indentures and you're looking at the covenance and you're modelling out the company and trying to see if there's any covenant breaches or how much room they have to pay out a dividend. These are the type of things that really matter. We also have a very big distressed division in our group. We have a distressed fund in our group which is managed by Harley Lenk. We have our legal team that works alongside distress and also our analysts. We have some very seasoned analysts where we're quite involved in special situations and those are all opportunities for this fund as well. I mean, we've had a few high yield bonds and loans that have been very good performers that have come out of special situations. We have a whole team that's dedicated to these type of events.

[00:24:44] Glen Davidson: Let's talk about Treasuries as a way of balancing out risk within the portfolio. You've talked very glowingly about the 30-year in the past, comments on the 30 and also just Treasuries as a whole.

[00:24:56] Adam Kramer: Going back to the description of the fund, I mentioned that we want to be an alternative to a balanced fund, an alternative to that 40/60, 50/50, 60/40 fund. We don't have a benchmark but I do manage it against the benchmark with a very wide risk budget. Our benchmark would be 50% of the Barclays Aggregate Index, which is the investment grade bond market in the U.S., that's a 3-year duration, give or take, and 50% of the S&P 500. This is a very tough benchmark to beat and, proudly, we've actually been beating it on a gross of fee basis and, depending on the period, net of fee as well.

[00:25:35] Now, one of the things I mentioned before, that means that relative to 50% equity sensitivity, which would be 50% of the S&P 500, we've only been overweight equities once in the history of the fund, and that was 2021 after COVID. We're probably around 45 to 47%, I said before. The other side of the benchmark is, what is the investment grade duration of 50% of that market, and that's around 3.1 years. Like I was mentioning, if I'm finding more opportunities in other asset classes outside of investment grade corporates, if there are better risk-rewards elsewhere, our playbook is we want to build out the entire duration of 50% of the investment grade bond market with the least amount of cash as possible.

[00:26:28] That's why we have had the 30-year Treasury, the U.S. 30-year Treasury, the most discounted ones, from 2015, 51, which you'll see the top 10 holdings, are trading in the 40s and 50 cents on the dollar, but they're yielding the same as the regular Treasuries, 30-year Treasuries or 20-year Treasuries that are issued. It's just discounted because it's a little coupon. That has actually tracked 50% of the market quite well. Then we can deploy that extra cash to all these other opportunities. This is a testament to my co-manager on this fund, Ford O'Neill, who manages that total bond fund. We are also working together on the strategic funds in the U.S. asset allocation fund. He's a very seasoned investment analyst, and that's a toolbox tool that we've been using for quite some time.

[00:27:18] The 30-year had a lot of chances to get above 5%. It really just couldn't get above there, even during the worst of times when market was pricing in stagflation. I think that it's hard to tell exactly which way things are going to go but my base case, or our base case, is that we might have a little bit of economic weakening but we're going to also have some inflation too, so it's a wash. Most likely we could get cuts from the Fed but it's probably not a bad tool to have for gaining that exposure while we take advantage of some of the other opportunities across the curve.

[00:28:00] Glen Davidson: Another tool that you have is the entire world. We could go on about different economies but let me zone in on emerging markets. That's an area that you've explored with the portfolio as well.

[00:28:11] Adam Kramer: Emerging markets is an area that's in our group. I'm an asset allocator in the other funds, Strategic Income Fund in the United States. Emerging markets are one of the asset classes where we invest in. We're speaking with our experts in the Fidelity High Income and Alternatives Group, our sub-portfolio managers in those other funds so we know what their best ideas are. That's what's great about this process is that I'm speaking to so many people within Fidelity, whether it be analysts or sub-portfolio managers, and sometimes we'll get the best ideas in this fund. For many years we had Petróleos Mexicanos which was trading at a very big discount to the Mexican sovereign, and if you take a look at what's been happening with Petróleos Mexicanos over the last number of years, it's actually worked out quite well. There were hundreds of basis points of spread tightening there on durations in 7 to 10%. That used to be a best idea and then we've been moving on to other ideas. One of the areas that you'll see in our top holdings is Brazil local currency, sov local currency. We like to invest in this fund in U.S. dollars. We only want to take on non-U.S. dollar exposure when there are episodic opportunities, but with the Brazil currency sovereign as sovereigns right now, which are short dated, you have 15% policy rates in Brazil, you have 5% inflation so the real yields are 10%. That is quite a bit. What we're waiting for now is just to see what happens with the election. It's going to be driven a little bit by the currency in Brazil but in the meantime you're collecting a high double-digit yield. There's a lot of cushion for error, as we like to say, depending on what events and scenarios happen.

[00:30:01] That's one of the things that I like to focus on with this fund, we want to position ourselves for multiple scenarios. Can we win in multiple scenarios? We don't want to make predictions, we want to wait for the opportunities to come our way, but when they do come our way are we getting paid enough on the yield and on the valuation where we can just sit and wait for things to play out. The case with Brazil, there won't be an election until October 26th, I believe it is, we won't find out who the opposition will be until maybe Q1 of next year, but a lot of that bad news is priced into the currency. I think it was similar to the Canadian dollar thesis where we saw in November there was a lot of bad news priced into the Canadian dollar as well. We were able to take advantage of that dislocation by buying some Canadian stocks in November of last year which actually played out quite well for this fund.

[00:30:57] Glen Davidson: Financial advisors and investors have appreciated something that you just said, which is your positioning for multiple outcomes. That is fascinating and we could go on and on about it, and maybe I'll word the question this way because we only have a couple of minutes left, what are you keeping an eye on for the second half of this year?

[00:31:16] Adam Kramer: I'm keeping an eye on a number of things. I mean, I think the key thing now is going to be tariffs in the U.S., obviously was not as bad as the market thought and so there are a lot of stocks that still have a lot of bad news priced in, so really keeping an eye on making sure that we capture as much upside as we can on names that are mispriced. It doesn't have to be equities, it's elsewhere as well. We want to keep an eye on where inflation is because we are going to have tariffs, we know it's going to be somewhere between 10 and 15%, how much of that will actually get passed on to the consumer, how much will be eaten up by the company. What is the impact of tariffs on the lower end consumer? Is there an offset in the economy to higher tariffs? Base case for me would be that there's more of a wash at this point so then if that's the case and the economy is in a good area, what does the Federal Reserve do at this point? How many cuts are there?

[00:32:19] Where is deregulation? I was talking about this with my co-manager, Ford O'Neil, before. We think we're in maybe the first inning of deregulations in the US. We frontline loaded a lot of the bad news with tariffs and now we have a lot of benefits that can come with deregulation in the U.S. What type of impact will that have? How are companies thinking about that? Then making sure we're cognizant of where valuations are, that's very important. At this point we're still in a period of time where we have a high enough level of income to the amount of duration that's out there so it's very hard to outrun this high yield. This still has to play out, and that's why I think that being invested in these type of multi-asset and tactical high income funds is a good decision. What I always like to say also, Glen, it's always the right time to own this fund. These asset classes are always taking turns and we're moving with the time. We're offering you the same risk profile throughout the full cycle, whether it be recession, early cycle, mid- cycle, late cycle.

[00:33:27] Glen Davidson: Adam, I hope we're able to reconvene in a few months and find out where we're at and what you've been doing. Wonderful to see you. Adam Kramer, Tactical High Income Fund. Thank you very much for your time.

[00:33:37] Adam Kramer: Thanks, Glen. Great discussion.

[00:33:39] Glen Davidson: And thank you for joining us on Fidelity Connects today. We have a new episode of the Fidelity Fund feature with Adam and the Tactical High Income Fund in both Mandarin and Cantonese with traditional and simplified Chinese subtitles. Be sure to reach out to your sales representative for a copy. Check that out and many more of our latest investor-friendly Chinese language offerings.

[00:33:58] Wednesday, John Bradley, Director of Emerging Technologies, and Vishal Chopra, Equity Research Associate, will look into the fast-moving world of technology. What trends are making noise in 2025 and what areas are investable. Tomorrow's show will be presented in English with live French interpretation.

[00:34:14] On Thursday, Fidelity's Denise Chisholm, Director of Quantitative Market Strategy, will be here to discuss the impact of the latest Fed's decision to hold interest rates, plus she shares which sectors are best positioned in today's market environment.

[00:34:27] On Friday we'll check in with portfolio manager, Aneta Wynimko. She gives us an update on global consumer trends and where she's seeing opportunities in this space. Thanks very much for watching. I'm Glen Davidson. Take care.