Is the Time Right to Consider High Yield?

Would a rational investor want to own securities in a company that is rated "non-investment-grade"? Maybe if the price is right, and, he or she is prepared for a relatively high level of risk and performance volatility. Let's take a closer look at how high-yield securities work, why now may be a prudent time to invest, the type of investor they may be right for, and some ways Fidelity can help you take advantage of this opportunity.

What are high-yield securities?
High-yield securities are a special breed of investment that is viewed by both analysts and investors as riskier than securities issued by companies with the strongest balance sheets or otherwise higher credit ratings.

There are three main types of high-yield investments:

1. High-yield bonds
2. Leveraged (or "floating rate") loans, and
3. Leveraged company stock (equity in companies that issue non-investment-grade debt or have a leveraged capital structure).

Credit-rating agencies—such as Standard and Poor's, Moody's, and Fitch Ratings—evaluate the ability of public companies, governments, and other borrowers to make income and principal payments to their debt-holders. The debt of those organizations best prepared to do so is rated "investment-grade" (BBB and higher), while the debt of those organizations most vulnerable to default is rated "non-investment-grade" (BB and lower). Distressed companies and leveraged companies—due in large part to their relatively high ratio of debt to equity—tend to struggle more than better-capitalized companies during economic downturns. To compensate investors for purchasing these types of securities and thus taking on increased risk, such as default risk, the debt of these companies typically offers higher yields (hence the terms "high yield" ).

The high-yield investment risk spectrum below compares the recent volatility of total returns of high-yield debt versus investment-grade debt, as well as leveraged-company stocks versus domestic and foreign stocks:

Close price adjusted for dividends and splits.
* Arrayed by actual standard deviation of monthly returns for three-year period ending March 31, 2009.
Standard deviation for each asset class is based on the returns of specific indices: (a) Barclays Capital 3-month U.S. Treasury Bill Index; (b) Barclays Capital U.S. Intermediate Government Bond Index; (c) Merrill Lynch U.S. High Yield Master II Constrained Index and Standard & Poor's/Loan Syndications and Trading Association Leveraged Performing Loan Index; (d) Standard & Poor's 500 Index (S&P 500^®) and Morgan Stanley Capital International Europe, Australasia, and Far East Index; (e) Credit Suisse Leveraged Equity Index.

Why now may be a good time to take advantage of this asset class
Here are two reasons why now may be a good time to take advantage of this asset class.

1. High current income: As of early June 2009—with the 10-year Treasury bond yield at 3.89%—the average yield for taxable high-yield bonds was 13.41%,¹ a difference (or "spread") of nearly 10 percentage points. This spread, although it has narrowed over the past six months, is still well above historical norms and close to the peaks reached during two previous periods of economic distress—1991 and 2002—as seen in the chart below.

2. Potential price appreciation: In addition to receiving income, high-yield investors have the potential for capital appreciation if the price of their bond(s) improves. The average price for high-yield bonds had improved from 61% of face value at year-end 2008 to 77% of face value as of May 31, 2009. The trend toward price improvement may continue if economic conditions continue to improve.

The combination of the relatively high yields and the potential for capital appreciation discussed above can lead to equity-like returns for high-yield bonds and loans as economic conditions improve.

As shown in the chart below, when the stock market recovered from the decline of 2000-2002, the total calendar-year return of high-yield bonds, for example, was within 1% of the return for domestic stocks in both 2003 and 2004. And, in a reversal of last year's deep losses, year-to-date high-yield bond returns (as of May 31, 2009) are nearly 26%.¹ It is important, however, to remember that past performance is no guarantee of future results.

Categories above are tracked to the following indices: (a) Standard & Poor's/Loan Syndications and Trading Association Leveraged Performing Loan Index; (b) Standard & Poor's 500 Index (S&P 500^®); (c) Merrill Lynch U.S. High Yield Master II Constrained Index; (d) Credit Suisse Leveraged Equity Index.

Who should consider investing in high-yield securities?
An allocation to high yield may be appropriate for an individual who is well-diversified, risk-tolerant, and has a long-term investment timeframe. Typically, these types of securities appeal to investors looking for additional income and the potential for capital appreciation and are not appropriate for investors whose primary goal is steady income and capital preservation.

According to Matt Conti, portfolio manager of Fidelity^® Focused High Income Fund (FHIFX), "Periods of economic stress may provide the best time for investors who can tolerate volatility to consider an allocation to high yield. This is not just due to high coupon income, but also because at some point we'll likely emerge from the current downturn, which could help some high-yield securities prices recover and potentially achieve capital appreciation."

Tom Hense, chief investment officer for Fidelity's high-yield investment group, also encourages leveraged-company investors to seek the widest possible diversification across industry sectors and individual issuers. "Even with the benefit of our extensive research team, we have active 'buy' recommendations for our mutual funds on only about three out of 10 non-investment-grade issuers at this time."

Next steps
There are many ways to invest in the high-yield bond asset class, including actively managed mutual funds, exchange-traded funds (ETFs), or directly through individual high-yield bonds. Given the inherent credit risk associated with these types of bonds, Fidelity believes that it is very important to diversify across many different issuers from different industries, especially when considering high-yield investments. For the average investor, we believe the best way to achieve this type of diversification may be through a more diversified investment vehicle like a mutual fund.

If you believe your portfolio can tolerate the greater volatility associated with non-investment-grade securities, Fidelity can help.

Find high-yield bond funds with Fidelity Fund Evaluator or Fund Picks from Fidelity.^®

Learn more about investing in leveraged companies through Fidelity mutual funds.

For investors who are comfortable with the increased risk associated with owning individual non-investment-grade bonds, Fidelity.com offers online access to live quotes, third-party company research, educational support, and tools to search bond inventories.

(Tell us what you think about this article. E-mail comments to Fidelity.Investments@fidelity.com.)

1. As measured by the average taxable bond in the Merrill Lynch High Yield Master II Constrained Index, as of June 8, 2009.

Before investing, consider the funds' investment objectives, risks, charges and expenses. Contact Fidelity for a prospectus containing this information. Read it carefully.

Investment decisions should be based on an individual's own goals, time horizon, and tolerance for risk. Past performance is no guarantee of future results.

Although bonds generally present less short-term risk and volatility than stocks, bonds do contain interest rate risk (as interest rates rise, bond prices usually fall and vice versa) and the risk of default, or the risk that an issuer will be unable to make income or principal payments. Additionally, bonds and short-term investments entail greater inflation risk, or the risk that the return of an investment will not keep up with increases in the prices of goods and services, than stocks. Lower-quality fixed-income securities generally offer higher yields, but also carry more risk of default or price changes due to potential changes in the credit quality of the issuer.

Leverage can magnify the impact of adverse issuer, political, regulatory, market, or economic developments on a company. In the event of bankruptcy, a company's creditors take precedence over the company's stockholders.

Diversification does not ensure a profit or guarantee against loss.

All indices are unmanaged and performance of the indices includes reinvestment of dividends and interest income unless otherwise noted. Please note that you can not invest directly in an index.

All references to the following fixed-income security asset classes and related performance and statistics are represented by the following indices unless otherwise noted:

Short-Term—Barclays Capital (BC) 3-Month U.S. Treasury Bill Index; U.S. Mortgage Backed Securities (MBS)—BC U.S. MBS Index; U.S. Treasuries—BC U.S. Treasury Index; U.S. Investment Grade Corporate—BC U.S. Credit Bond Index; Foreign Developed Markets—Citigroup (CG) G-7 ex-U.S. Bond Index; Emerging Markets—JP Morgan (JPM) Emerging Market Bond Index Global Index; Leveraged High Yield Loans—Standard & Poor's/Loan Syndications and Trading Association Leveraged Performing Loan Index; Taxable High Yield Bonds—Merrill Lynch (ML) U.S. High Yield Master II Constrained Index; Domestic Stock—Standard & Poor's 500 Index (S&P 500^®); Foreign Stock—Morgan Stanley Capital International Europe, Australasia and Far East (MSCI EAFE) Index; Leveraged Company Stocks—Credit Suisse (CS) Leveraged Equity Index.

Barclays Capital^® (BC) 3-Month U.S. Treasury Bill Index is an unmanaged market value-weighted index of investment grade fixed rate public obligations of the U.S. Treasury with maturities of 3 months, excluding zero coupon strips. BC MBS Index covers agency mortgage-backed pass-through securities (both fixed-rate and hybrid ARMs) issued by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). BC U.S. Treasury Index covers public obligations of the U.S. Treasury with a remaining maturity of one year or more. BC U.S. Credit Index covers publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. BC U.S. Credit Bond Index includes all publicly issued, fixed-rate, non-convertible investment grade corporate debt; the index is composed of both U.S. and Brady bonds. Citigroup G-7 Bond Index ex-U.S. tracks the performance of government bonds in developed nations that measure the total principal, interest and returns in each market and provides a realistic measure of market performance, and includes Canada, France, Germany, Italy, Japan,and  the United Kingdom. JPM^® Emerging Markets Bond Global Index (EMBI Global) is an unmanaged market capitalization weighted index of U.S. dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by emerging markets' sovereign and quasi-sovereign entities. Standard & Poor's/Loan Syndications and Trading Association Leveraged Performing Loan Index (S&P/LSTA) is a market value-weighted index designed to represent the performance of U.S.dollar-denominated institutional leveraged performing loan portfolios (excluding loans in payment default) using current market weightings, spreads and interest payments. Merrill Lynch U.S. High Yield Master II Constrained Index is an unmanaged market value-weighted index of all domestic and Yankee high-yield bonds, including deferred interest bonds and payment-in-kind securities. Issues included in the index have maturities of one year or more and have a credit rating lower than BBB-/Baa3, but are not in default. The Merrill Lynch U.S. High Yield Master II Constrained Index limits any individual issuer to a maximum of 2% benchmark exposure. Returns shown for the Merrill Lynch U.S. High Yield Master II Constrained Index for periods prior to December 31, 1996 (its inception date) are returns of the Merrill Lynch U.S. High Yield Master II Index. Standard & Poor's 500 Index (S&P 500^®) is an unmanaged market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance. Credit Suisse (CS) Leveraged Equity Index is an unmanaged market-weighted index designed to represent securities of the investable universe of the U.S. dollar denominated high yield debt market.

These opinions do not necessarily represent the views of Fidelity or any other person in the Fidelity organization and are subject to change at any time based upon market or other conditions. Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund.