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By Sarah Bush | 06-20-2014 10:00 AM

Bank Loans Not the Same as Money Markets

The risk of bank-loan defaults is muted at the same time investor demand for such products remains elevated, but this volatile asset class is not for near-term cash needs, says Fidelity's Eric Mollenhauer.

Sarah Bush: Hello. My name is Sarah Bush, and I'm an analyst with Morningstar at the Morningstar Investment Conference. I'm here today with Eric Mollenhauer, manager on Fidelity Floating Rate High Income.

Thank you, Eric, for joining us today.

Eric Mollenhauer: Thanks for having me.

Bush: You took over Fidelity Floating Rate High Income about a year ago, in April 2013. Can you talk just little bit about what you've been doing with the portfolio and any changes you've taken during that time frame?

Mollenhauer: Sure. When I took over the portfolio I said there were a few things that I wanted to do with it. First, the cash balances in the portfolio typically run in the 10% to 12%, 13% range. And I felt given the liquidity in the market that we could bring that down a little bit and get that cash invested more.

So, we said we were going to bring cash down from 12% to 5% to 7%. We've done that. We talked about becoming more heavily invested in the names that we like, reducing the absolute number of issuers in the portfolio. We've gone from probably 375 names to closer to 320 names. And the thought process behind this is that, we invest a lot in research, we have a lot of analysts covering companies, and I really want to make sure that the portfolio is positioned that way, that we're really heavily investing in our analyst teams' best ideas. So, by bringing it down, we're focusing more on our researchers' best ideas.

I also talked about bringing the bond exposure down in the portfolio. We'd been running close to double digits in bonds. And I wanted to bring that down for a couple of reasons. One, [the fund is] a floating-rate product. I think if investors want exposure to high-yield bonds, which were typically in the portfolio, they can do that by making choices to invest in a more high-yield product. Two, I didn't want to add a lot of duration [a measure of interest rate sensitivity] to the portfolio. And three, I just didn't see the relative value in high yield relative to loans, especially today, where a BB bond could be trading at 4.5% for 10-year, fixed-rate-type exposure. A BB loan could yield me 4% where I'm secured by the assets and I have floating-rate exposure and no duration. So the relative-value argument to me wasn't as compelling.

So, the big changes people would see in the portfolio is cash is lower, fewer securities, and less bond exposure. But at the end of the day, we've also committed to maintaining the conservative positioning of the portfolio. So we've maintained the BB overweight, the B underweight, as well.

Bush: We just spent a little bit of time at our panel on bank loans talking about the outlook for the bank-loan market, and you've indicated their valuations are attractive relative to high yield. But could you expand kind of more broadly on what does a default outlook look like and how you're thinking broadly about those opportunities?

Mollenhauer: Sure. I think the default outlook for the next couple of years is really pretty minimal. I mean, S&P and Moody's talk about 2% to 3% default [rate] outlooks, and I can't really find any reason to disagree with that. You look, there's been a tremendous amount of demand and new-issue flow in the bank-loan market, and what that's done is it's pushed out the maturity wall, or the amount of companies that have near-term maturities, out to 2017, '18, '19, '20 and beyond.

In terms of near-term maturity risk, there's not a lot out there to kind of put these companies at risk. From a fundamental perspective, the economy isn't growing as fast as people would like, but 2% GDP growth can translate into revenue growth for these companies. It's slight, but it's enough to cover increasing costs. And that's just fine for leveraged credits. When revenues start to turn negative, that's when you start to get worried, but the slow-growth environment is actually pretty good.

For me, I think the default environment is kind of muted. The outlook from a return perspective, I think, we're playing for our coupon. The market's trading at par. Where you're going to outperform is by avoiding the blow-ups and the downside risk, and, hopefully, at the end of the day, we're getting that 4%-type coupon return for the next couple of years.

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