FidelityConnects: Where to find diversified income opportunities in fast and furious markets

[00:03:51] Glen Davidson: Hello, and welcome to Fidelity Connects. I'm Glen Davidson. The Federal Reserve's latest rate cut has pushed Treasury yields higher. Despite a lower policy rate the U.S. 10- and 30-year yield jumped 10 basis points following the announcement. If rates continue to lower how might this affect further fixed income? What might a good addition to your portfolio amidst the current market environment be? I'm pleased to be joined by Scott Mensi, institutional portfolio manager, for a discussion on all this and more, including how Fidelity's Tactical High Income Fund is currently positioned. Today's webcast features live audio interpretation and if you'd like to ask Scott any questions today please use the Q&A box. Welcome Scott, good to see you.

[00:04:35] Scott Mensi: Glen, thanks for having me. Great to be here.

[00:04:37] Glen Davidson: Now, you're direct from Boston today and often when I've had the pleasure of speaking with you Adam Kramer has joined you and the three of us have a good discussion around what Tactical High Income is all about. Last August Adam did a presentation through this medium about year-to-date what's happened within Tactical High Income and also the different asset classes within. It's such a fast changing environment I'm glad that we're able to speak with you today to see what's going on now because Tactical High Income Fund, if I'm not mistaken, is about capital appreciation but also income, as is in the name, and it seems that with rates going down is there still a marketplace for what Tactical High Income is all about?

[00:05:20] Scott Mensi: It wasn't very surprising to see what happened with rates the other day, last week. I think the market had been anticipating that. We're never really trying to make predictions in our portfolio. What we'd like to say is wait for the opportunities to come to us because what happens year in and year out is the market tends to rightly or wrongly price events before they happen only to adjust the following year after those events occur. What I think is unique at this time, at least where we are right now, is that while rates are going downward we're nowhere near where rate levels were back pre-COVID when we were in that [ZERP?] type period. Another 25 basis points, 50 basis points, wherever the Fed decides to do as we move forward, the relative yields are still pretty high.

[00:06:08] When I look at the yields in some of our plus sectors, bank loans, high yield, these yields are still, when we look at them, where we're able to select them, still in the 8% to 9%, 7% range. That's still a decent amount of income. Even when we start looking outside there there's unique opportunities in emerging market debt. There's some opportunities within the stock market that provide interesting, attractive yields. While rates at the short end are going down we're always finding opportunities because there's always mispricing out there in the market. I think what we can say now is that we are in a rate cutting cycle so now it's trying to determine, okay, what parts of the market are not pricing in rates moving lower or pricing in rates continually move higher and not coming down. You mentioned one, 30- year Treasuries, long Treasuries moving higher, that's another one that doesn't believe the rates are coming down so maybe there's an opportunity there.

[00:07:02] Glen Davidson: Okay, goo, that's great perspective and reason for us to continue with this webcast because there's lots to talk about. You talked on a couple of the asset classes that we'll touch on throughout. It'll be interesting today based on what Jerome Powell has to say to the marketplace. That'll be after we do this recording but lots, obviously happening. I also want to underline the fact that this portfolio is run with risk controls top of mind. Lipper Sward winner, multiple Lipper Award winner, Tactical High Income, which is really about risk-adjusted returns. Could you just touch on the risk controls that are put in front of this portfolio?

[00:07:39] Scott Mensi: We look at risk in a couple of ways, a few ways actually. One is at the top level of the portfolio. One of the things we always talk about, and if you heard Adam or I talk, or even if Adam and I are talking together, when we look at the positioning of the fund we always ask, what's the equity sensitivity, what's duration, and what's the current yield? If we've got a good matching of current yield relative to the duration and the equity risk that we're taking on the portfolio that's a good risk mitigator. What we try to say is if the stocks go up or down 10% or interest rates or credit spreads widen by 100 basis points do we have enough income to offset the negative impacts of one of those asset classes in a worst case scenario? If you can do that you can really weather the storm over a full cycle or a full year as you collect that income. That's one of the ways we do it at the top level.

[00:08:30] We also have a number of risk teams that are looking at this portfolio on a day-to-day basis to make sure ... we always say we want to wiggle around a traditional balance fund benchmark, a 50/50 split of the S&P 500 and the U.S. Agg Bond Index. We want to make sure that over a full cycle we wiggle around that profile so we have limits in place in terms of how far we can deviate from a beta perspective, tracking error perspective that help us deliver that 50/50 balance and experience. The last thing I would say from a risk perspective is that the underlying names themselves, we've got hundreds of analysts that are looking at these stocks, bonds, loans, whatever we're investing in this portfolio. It's their research that helps us gain conviction and put them into the portfolio.

[00:09:17] It's really three layers of risk management, the underlying positions with the analyst team and the portfolio management team as we talk with them and try to understand what's going on with the companies themselves, what the portfolio looks like at kind of that beta level and tracking error level, how does it look relative to that 50/50 index, and then how do we have that, do we have that proper matching of income relative to the duration and equity sensitivity in the portfolio? Those three things put together have provided a pretty good risk control network that we have that has delivered pretty good risk-adjusted returns over the life of the strategy.

[00:09:52] Glen Davidson: No kidding, that's great perspective. You really do have an army of people that you can draw on, not only for regular monitoring of what's happening within the portfolio but for analysis of all the different securities that you can put within Tactical High Income as well. Could you talk briefly just about the army of people that you have at your disposal?

[00:10:11] Scott Mensi: I mentioned a couple of those asset classes, you mentioned convertibles, high yield bank loans, preferreds, CLOs, emerging market debt. Now, these asset classes, when you look at the history of kind of the markets they tend to be the top performing asset class relative to S&P 500 stocks or investment grade bonds more than 50% of the time over the last 20 years. That's telling you there's opportunities there. The only way you can really understand these credit asset classes is having a team of analysts just focused on these asset classes. Within the high income and alternatives group, which Adam and I are part of, we've got a dedicated team of 25 analysts just looking at these issuers and these securities. It's important because credit work takes a lot of time. You need to understand the company, you need to understand the management teams and you also need to understand the indenture.

[00:10:59] For example, back in 2022 when everything was selling off because of duration, preferreds included, we had our analysts come to us and say, hey, the market is selling these preferreds because they think they're long duration because they have long maturities but in a couple of years they're going to start to float and that's in the indenture. So if you have those folks that are looking through the indenture it's easier for us, we feel like, to catch some of those anomalies. That's just in the high income and alternatives group. Then we have folks in our investment grade division, we have folks in the equity group. You aggregate it up it's over 100 plus folks that are looking at these assets for us, helping select the best ideas from their little pockets and niches of the market to put this portfolio together brick by brick.

[00:11:45] Glen Davidson: Excellent. Let's talk from a macro perspective before we get into some of the individual asset classes. I read recently that cardboard box production has gone down which is a sign that Amazon's not sending as much stuff and so on. That's a sign that the consumer is softening. Do you agree?

[00:12:02] Scott Mensi: We were certainly seeing that, particularly in the low end consumers and starting to seep into middle end consumers. But really, when you look at what drives consumption in the United States it's that top end, the top 20% of consumers really drive spending in the United States and they seem to be doing it pretty well. We see that in a number of not just retail type businesses but also in leisure areas where the high end hotels and resorts are seeing prices increase while maybe some of the mid and lower tier areas of the market are decreasing. It feels like there's some softening happening in the economy from a consumption perspective.

[00:12:43] I was talking with an analyst of ours that covers business services type companies. These are companies that maybe are providing temporary work for certain industries. He said one of the things he looks at on a regular basis to get a sense of where the employment rate is and where the economy is, is looking at the ratio of people within kind of the prime age work years, let's call it 18 to 50. What is the work ratio, meaning how much of them are employed relative to how many of them are in the market? That's at pretty high levels. It hasn't really come down. While we're seeing some softening on the spending side the job market still looks pretty good. Ultimately, spending really starts to slow down when people start to lose their jobs. As of right now it's something to watch but I don't think it's a huge concern for us at the moment.

[00:13:34] Glen Davidson: Okay, so unemployment's not a concern at this stage. What about inflation, thoughts on inflation.

[00:13:42] Scott Mensi: Adam and I were talking about this a couple of weeks ago, or two weeks ago when we were up in Western Ontario. We just haven't seen it yet. We're starting to see signs of it in some services areas of the market. We haven't really seen it on the goods side. That's something that, obviously, the Fed is on the lookout for, we're on the lookout for it with the companies as well. What we've heard is a lot of the inflation has been absorbed through cost cutting on the company side. A lot of it hasn't been passed through yet to the end consumer. We'll see if that starts to happen.

[00:14:32] Some of the big areas of inflation like housing, it's a big ship when you compare it to how much of the percentage it makes of CPI but it's a slow moving big ship, meaning that once it starts to go in one direction it takes a long time to adjust. That's still coming down, and I'm talking about owner's equivalent rent in the inflation component within the U.S. That's roughly a third of what makes up that calculation. That is still pushing lower. Maybe we see some other things come up a little bit higher but right now we're not thinking that we're going to get some massive spike in inflation over the next, let's call it, six months or so.

[00:15:09] Glen Davidson: Scott, you mentioned being in Ontario a few weeks ago, Northern Ontario I think you mentioned and Southwestern Ontario and, in fact, you're coming up tomorrow to see some advisors on the east side of the province. You've travelled with Adam across the country a lot spreading the word about Tactical High Income and answering a lot of questions from advisors. What kind of questions do you think, if you kind of aggregate them what do you get most commonly? Have we already discussed them or are there some that really pop up a lot relative to Tactical High Income Fund?

[00:15:39] Scott Mensi: That's a great question. Ultimately, all these questions come out whether it's what do you think about inflation, what do you think about where the economy is going, how are you picking securities within all of these asset classes? It's really it boils down to how they see ... this fund, as I said earlier, has delivered really great returns for investors over the life of the strategy. Folks hear us talk and they really want to understand how can you do this with all these different asset classes and all of these different areas of the market you can invest in? The thing I tell them, without the infrastructure built underneath us at Fidelity, none of this would be possible.

[00:16:18] The way we've set up this strategy, it's really a compliment to some of the other strategies that Adam and even Ford O'Neil, the co-manager, and Ramona Persaud are part of as well, all of the discussions we have at Fidelity whether it's our REIT analysts, our inflation analysts, our high yield team, all of them are repeating and they're all providing inputs to a number of these strategies. With the infrastructure that we've set up we're able to do this on a day-in and day-out basis in a very duplicative manner. That's really the secret sauce. We talk about convertibles tongue-in-cheek but this secret sauce is the resources underneath us. That is what allows us to do it.

[00:16:55] If we weren't at Fidelity trying to get the best ideas within the preferred securities market would be really hard. If we weren't at Fidelty it would be hard to get our best read ideas. A lot of shops out there focus on one area of the market or the other area, we really cover that full spectrum of income oriented asset classes. If you just look at the portfolio management team we've got everything covered, Ford with investment grade bonds and emerging market debt, Adam and myself with high yield bonds and loans, Adam, obviously, has his expertise in convertibles and preferreds, Ramona on the equity side. That, I think, is the question we get asked the most is how can you do this? It really boils down to the research and the infrastructure that's behind it what we're doing on a day-in and day-out basis.

[00:17:42] Glen Davidson: Let's talk a little bit more about those resources of the people that you work with. Ford O'Neil, as an example, who's been with Fidelity forever, he runs the investment grade fixed income side of it. We've just had a question come in, actually, from one of our viewers, because the 10-year seems so correlated to equities right now does it make sense to go longer-dated bonds? What would Ford say about that?

[00:18:05] Scott Mensi: When we look at our investment grade positioning whether that's Treasuries or in IG corporates we really lean on Ford's expertise there. I think from our perspective, when we look at that part of the portfolio what we've done historically is when spreads get really, really tight in the IG corporate market, which they are today, the most expensive going back to, I think, the late '80s if you go back that far and into parts of the '90s, when you look at the amount of spread relative to the duration it's really, really tight. When we get to those tight levels and with a strategy like this what we tend to do is try to use the least amount of capital to get our investment grade duration.

[00:18:45] When we look at this portfolio we want to have ... a 50/50 balanced fund has a duration of around three years, 50% of the investment grade bond market. When we get to these tight spreads what we try to do is find the area that we can use the least amount of capital to get that investment grade duration. We, in fact, have long-dated Treasuries. That's where the bulk of our Treasury position has been in over the last, basically, since, I'll call it, late 2024, maybe mid-2024, the most discounted long-dated Treasuries because it's the easiest and most efficient way for us to get exposure to get that investment grade duration.

[00:19:21] Additionally, if there is something bad that happens in the market, and it hasn't acted like this recently, but I would say we haven't had the real shock of the economy slowing and folks really getting scared. We've seen it in bits and pieces but I think when the economy slows and things start to really go bad money flocks to the 30-year Treasury. We are using that as kind of an insurance policy within the portfolio, get the investment great duration and if we really see something bad happen in the market that's unexpected we expect, we would think that money would flow back to the 30-year Treasury. If rates start to move down, the economy starts to slow a little bit, which was what we're seeing, the long Treasury should benefit from there. Today there's about 17% of the portfolio is in those long-dated treasuries and that's giving us kind of an equal weight to investment great duration.

[00:20:17] Glen Davidson: Great, thank you for that. Ramona Persaud runs the dividend equity component of the portfolio, what would she say right now from a global perspective because Tactical High Income is not specific to the United States. You can go anywhere. What is her mix looking like from an equity standpoint?

[00:20:36] Scott Mensi: When you look at this portfolio over time it's historically been 90+%, 92, 93% U.S. dollar denominated. The benchmark that we use for this portfolio is that S&P 500 U.S. Agg Bond Index so it's a U.S. based benchmark. More recently, we have been moving out into non-U.S. stocks. Prior to the situation in April we had some some stocks in Canada, we've had stocks in parts of Europe, a couple in Asia as well. There's still, again, opportunities out there in the market. I would say right now one of the things that we've been doing in the portfolio, we feel like within the stock part of the portfolio the valuations in large-caps are certainly not super attractive so we have been going down the whole spectrum and looking for areas where we think there is a recession priced in.

[00:21:32] Many of these mid and small-cap discretionary type names, you look at the stock prices and you look where they were during the pandemic period, some of them are almost at that same level. That tells us there's a lot of bad news priced in those parts of the market. Obviously, in the equity part of the portfolio, we've had it for years and we can talk about it, Adam loves them and so do I, that's the tanker stocks within the market. The tanker stocks have been a great source of income for the portfolio and they've also been a great geopolitical hedge. When we see things happening out there in the market as it relates to ... whether it's the Middle East or anything involved in sanctions or OPEC increasing production, these things tend to perform really well. A lot of different ways to win right now in the equity market outside of just kind of the Mag Seven and those big mega-cap tech stocks out there.

[00:22:34] Glen Davidson: That's from an equity standpoint so let's get into some of the other asset classes. You mentioned earlier in this discussion the secret sauce. Many times we've talked about convertible securities being the secret sauce of this portfolio. Adam Kramer is the king of convertibles, he may even own a convertible car, I'm not sure. Could you talk more about convertibles, what they're all about and why they make such a big difference for the portfolio?

[00:23:00] Scott Mensi: Convertible bonds are just like a bond, they're issued by a company, they usually pay some level of income. The unique aspect of it is that the investor can convert that bond into stock at any point in time. Because they can be converted into equity there's a sensitivity to the equity performance of that company. If the equity starts to move higher you start to participate with the equity. As you get beyond what they call the strike price on the convertible bond, the price where it can be converted, when you get above that price it starts to participate more and more and more with the upside of the stock.

[00:24:01] When we think about this portfolio, we first started putting it together a little over a decade ago, we kind of joked around that this is convertible bond 2.0, meaning it takes the best of the characteristics of convertible bonds, meaning the income component, let's call it that 50% equity sensitivity, although we've been a little bit lower than that over the life of the fund, and taking that profile and instead of just investing in convertibles we can invest across the full spectrum of income-oriented asset classes. It's a really unique asset class. It's one that I think folks are really underexposed to. There are always really unique themes that are showing up in the convertible bond market which makes it an exciting place to invest.

[00:25:07] Glen Davidson: Great, thank you for that overview. Let's go into high yield and, in particular, the spread over corporates right now.

[00:25:15] Scott Mensi: High yield spreads now are below 300. Again, high yield bonds are bonds issued by companies that have credit ratings below triple-B, so double-B, single-B and triple-C rated companies. The rating is dependent on the amount of leverage, the financial stability of those companies. Right now the spread is around 273, I think it was yesterday 278, somewhere around there. The long term average is around 500. We're well below the long term average. A lot of people say, well, that means high yield bonds are expensive. When you think about what we can do in this portfolio, right, this is a best ideas portfolio. We aren't investing in sleeves. What we can do, and what we've been doing, over the life of this strategy is looking at our high yield bond analysts and saying, hey, what are your best ideas? Can we get those in the portfolio rather than owning the most expensive names that might be big parts of the index that a traditional high yield bond fund might have to own?

[00:26:15] Within our portfolio today, even though yields are now in the 7% range we can put a piece of the portfolio together, it's about 7% today that yields around 8.5% and only has a two-year duration. You've got a low duration, if we're doing our credit work right we should feel good about getting our money back. An 8.50% yield versus a two- year duration, that's a really good matching of income. Basically, what it's saying is that credit spreads could go up, basically, 400 basis points and you'd still be making money on the yield. I think there's going to be a lot worse things happening in the market than getting your 1% from high yield bonds.

[00:27:03] Glen Davidson: We should get into collateralized loan obligations, CLOs, loans. Talk about those and how they factor into the portfolio, Scott.

[00:27:12] Scott Mensi: Leveraged loans, they used to be the little sister of high yield bonds just from a market cap perspective but that market has grown to the point now where they're actually bigger from a par value perspective. Bank loans and high yield are brother and sister. It's a lot of the same companies but bank loans are a little bit different in that they float, so they don't have any duration, and they're also senior in the capital structure. When you think about a company when they issue securities to finance themselves bank loans are first, then bonds, then convertibles, then preferred, then equity. If the worst case scenario happens and a company defaults the bank loan should do the best because they're most senior and they're secured by the company's assets. That's the real interesting aspect of bank loans, that they're secured and that they float. We've invested, again, we can find today 9% yields for very little duration in companies that we feel really comfortable with, and we can certainly talk about those. That's what bank loans are, just a loan obligation, very similar to a mortgage, that's collateralized.

[00:28:21] Now, collateralized loan obligations, CLOs, this is somewhat an alternative asset class to some folks but it's becoming more mainstream. The way I think of a CLO is to make an analogy to what a bank is. A bank takes money in and then it lends it out. That money that you give in deposits, that has to get some sort of rate. We receive a savings rate from the bank and then they lend that money out to other individuals and they get a higher interest that they're getting paid from those individuals that they are paying out to the deposit holders. A CLO  works very similarly, a CEO buys loans, those loans give us a certain amount of spread and then they lend out money to finance those purchases to many different types of investors. The cost of all of that debt that they use to finance those purchases is less than the spread on the loans. That's how the CLOs make money.

[00:29:21] CLOs are the biggest buyer of loans. The bank loan market is 75% collateralized loan obligations. That's important because within the bank loan market that means there's 70% of the holders that need to own loans all the time regardless of what's happening. If there's a recession, if we're in mid-cycle, if the economy's booming, CLOs need to own loans. So there's this natural buyer for bank loans regardless of the economic environment which has resulted in the bank loans having a better downside track record than some of these other asset classes like high yield and convertibles. It's a little unique but, hopefully, that makes sense.

[00:29:58] Glen Davidson: Unique and an army of lawyers, I'm sure, that are a resource for you when looking at covenants and so on. Just because we have a few minutes left we should talk about AI, such a popular thing to discuss these days, some themes around AI and how you're looking at that from Tactical High Income's perspective.

[00:30:19] Scott Mensi: There's a couple ways that we've been thinking about AI. I think the first one has been in the utilities. We saw this happen in Texas where we saw many of the independent power producers in Texas go through this revaluation by the market as we saw demand for electricity increasing across the world and in North America as a result of the hyperscalers, the need for electricity. What happened to a company called Vistra, which we've owned in the portfolio, we saw that company trade at a very wide wide premium to the market and then as the AI theme is kind of developed they now trade much tighter to the market as a result of that. That's one way, the power production, we're starting to do that as well and part of the reason we've invested in some of the Alberta utilities, particularly Capital Power and Transalta, that's an area where we do see slack in the power production in North America. We'll see if we get some sort of deal up there in the near future but as of right now, when we look around North America there are power plants that are already in place that have been mothballed, there's the assets that need to generate the power so the natural gas that is already there and it's cheap, that's a natural area where we think that we could see potentially some deals happen where data centres start getting built in that part of Canada.

[00:31:43] The last place that I would say where we have a similar theme is in the convertible bond market. In the convertible bond market there's a part of that market that was actually mining Bitcoin. That's not a very profitable business anymore but when it was profitable before many, many years ago was that you need a lot of electricity so these companies are now rebranding their businesses from Bitcoin mining into data centres. That's another way for us to access that same theme just with a different asset class. A lot of times we'd rather take the exposure in a convertible bond where we can cap our downside, or limit our downside, but get access to the same theme. If the stocks start to move higher and this really starts to run convertible bonds will participate there. Those are one theme but three ways that we've been playing it. The U.S. utilities, some of the Canadian utilities then also in the convertible bond market.

[00:32:37] Glen Davidson: Excellent. Why don't we conclude with this, we had a question come in saying, hey, you've recovered so well since Liberation Day, how did you do it? If I may, I think it's because you're able to be opportunistic. You're able jump into areas that are mispriced. The team and the fund has done a very good job of that. Would you concur?

[00:32:57] Scott Mensi: Of course, that's a great summary of what we try to do. To get a little bit more specific, we kind of moved as the opportunities came our way. In April as things were selling off the first place we went was to high yield in the fixed income market, talking with our analysts there saying, what bonds and loans were trading at par a couple of days ago that are now down five points? That was an area that was easy for us to say this company is going to be around regardless of what happens with tariffs. It was par yesterday, nothing has changed other than the noise in the market, let's capture this five point discount and get the attractive yield. We did a lot of that and we saw our high yield exposure go up into the high 20s, the high yield bank loan, that piece of the portfolio, go into the high 20s.

[00:33:44] Now, those spreads have contracted a bit, as we discussed earlier, so that part of the portfolio has come down. One of the other things we had been doing during that period in April is we have been historically always underweight the Mag Seven and a lot of those stocks that have been driving returns prior to April in technology. With that reset in valuation we decided to close a lot of those underweights in that part of the portfolio. That was a great move by us to say, okay, DeepSeek is going to potentially be a threat but when we looked at what was actually happening, boots on the ground, the spending, basically, everywhere in terms of this isn't slowing down, let's get into these stocks now at a much lower valuation. They've done quite well. Getting reconviction within things like the tankers, the Alberta utilities, and we didn't even talk about emerging market debt which there's a unique opportunity there in Brazil. Those are the different areas of the market that we've been playing in to help us. I was looking at the U.S. dollar performance today and we're almost matching the S&P 500 on a year-to-date basis and doing it with less than 50% equities over 2025 here.

[00:34:57] Glen Davidson: There's a lot that we didn't discuss today because there's so much at your fingertips for the portfolio but I can conclude by saying there's lots of opportunities when it comes to yield, also with the capital preservation and capital appreciation with the equity side of things. You've got huge resources around you, lots of opportunity, lots of future opportunity and risk controls overseeing it all. Thank you so much, Scott Mensi, for joining us today.

[00:35:19] Scott Mensi: It's great to be here.

[00:35:21] Glen Davidson: Thank you for joining us today on Fidelity Connects. Coming up on the webcast tomorrow, Jacqueline Power, Director of Tax and Retirement Research will present a French webcast at 10:30 a.m. followed by Fidelity Connects at 11:30 a.m. Eastern. Jacqueline will discuss estate strategies for passing down your cottage smoothly and tax efficiently. From wills and ownership transfers to navigating family dynamics learn how to protect your legacy with smart planning.

[00:35:44] On Thursday join us for a special two-hour Regulatory Connects webcast starting at 11:30 a.m. Join Andrea Rigobon, Director and senior legal counsel at Fidelity as she brings together top experts in the regulatory field to discuss safeguarding integrity and trust, conflict of interest and much, much more. Thursday's webcast will be presented in English with live French, Mandarin and Cantonese audio interpretation.

[00:36:07] We'll wrap up the week on Friday with Denise Chisholm, Director of Quantitative Market Strategy for her latest sector thesis. Thanks very much for watching. I'm Glen Davidson. Take care.