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An Upgrade for This Cost-Conscious, Conservative Bond Fund

Silver-rated Fidelity U.S. Bond Index's tilt toward high-credit-quality issuers provides good downside protection.

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The following is our latest Fund Analyst Report for Fidelity U.S. Bond Index (FXNAX). Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Fidelity U.S. Bond Index is a compelling core bond strategy. It is one of the cheapest investment-grade bond funds available. While its index-tracking performance hasn't been quite as strong as some of its index peers, its sizable cost advantage and conservative credit risk should serve investors well over the long term. It warrants a Morningstar Analyst Rating upgrade to Silver from Bronze.

The fund tracks the market-value-weighted Bloomberg Barclays U.S. Aggregate Bond Index, which includes U.S.-dollar-denominated bonds with at least one year until maturity. Market-value-weighting allows the fund to harness the market's collective wisdom about the relative value of each holding. It also keeps transaction costs low by mitigating turnover and tilting the portfolio toward the largest debt issues, which tend to be the cheapest to trade.

This approach pulls the portfolio toward high-quality government Treasuries and agency mortgage-backed securities, which jointly account for more than two thirds of the portfolio. This should help the fund hold up better than most of its peers when credit spreads widen, which typically occurs in tough economic environments. However, it may not keep pace with funds that overweight lower-quality issuers when credit risk pays off. Like most intermediate-term investment-grade funds, most of this portfolio's risk comes from its sensitivity to interest rates. The average duration of the fund's holdings is currently just under six years.

While this index fund's bias toward high-quality debt could make it a low hurdle for active managers, that does not diminish the case for owning this index portfolio. Bonds' risk and return are closely linked. Funds that regularly earn higher returns are likely taking greater risk. After adjusting for risk, this fund becomes a tougher hurdle to beat.

Over the trailing 10 years through February 2019, the fund slightly lagged the intermediate-term bond Morningstar Category average by 94 basis points annually, largely owing to its greater exposure to Treasuries.

Process Pillar: Positive | Alex Bryan, CFA 04/04/2019
This broad market-value-weighted portfolio reflects the composition of the U.S.-dollar-denominated investment-grade bond market, harnessing the market's collective wisdom. It tilts toward high-credit-quality issuers, providing good downside protection, mitigates transaction costs, and avoids key-person risk, supporting a Positive Process Pillar rating.

The fund employs representative sampling to track the Bloomberg Barclays U.S. Aggregate Bond Index. This index includes investment-grade corporate, government, and securitized debt denominated in U.S. dollars with at least one year to maturity and a face value of at least $300 million. The index weights its holdings by market value and is rebalanced monthly. It may seem undesirable to assign larger weightings to larger debt issuers, but this approach does not lead to high credit risk in this portfolio. On the contrary, about 75% of the portfolio is currently invested in bonds rated AAA.

The management team doesn't hold every security in the benchmark. Instead, it carefully replicates the index's key characteristics, such as duration and credit rating. This sampling approach helps reduce transaction costs. While the fund has hewed closely to its index, over the past five years it has exhibited greater tracking error than iShares Core US Aggregate Bond ETF (AGG) and  Schwab U.S. Aggregate Bond ETF (SCHZ), which track the same index.

This portfolio takes less credit risk than most of its actively managed peers, owing to its market-value-weighted approach. The U.S. government is the largest borrower in the U.S.-dollar market, giving the fund considerable exposure to low-credit-risk U.S. Treasuries. Agency MBS also account for a sizable chunk of the portfolio. These securities aren't legally backed by the U.S. government, though their perceived credit risk is low because they are backed by quality collateral (homes) and many investors believe the government will step up to back them in an emergency.

Low credit risk should help this portfolio weather market downturns better than most peers. However, it also limits the fund's return potential. While some of the fund's peers may be able to boost returns by taking greater credit risk, such risk doesn't always pay off.

Although broad market-value-weighted bond funds like this one have been easier for active managers to beat than their U.S. equity counterparts, that doesn't mean the market is necessarily riddled with mispricings for managers to exploit. If anything, there is probably less room to find an informational edge in the investment-grade bond market than in the stock market because there is less uncertainty about bonds' future cash flows. Bonds that offer market-beating returns tend to come with greater risk.

Performance Pillar: Neutral | Alex Bryan, CFA 04/04/2019
Not surprisingly, this portfolio's conservative credit risk has caused it to lag the intermediate-term bond category average over much of its life. When credit risk paid off over the trailing 10 years through February 2019, this conservative portfolio lagged the category average by 94 basis points annualized. Its category-relative performance was better over the past 15 years. During that time, it beat the category average by 16 basis points, owing to smaller losses during the financial crisis. That return ranked in the category's middle third, supporting the Neutral Performance Pillar rating.

This strategy has provided better downside protection than most of its peers over the past 15 years, owing to its high-credit-quality portfolio. Its maximum drawdown during that period was only 3.89%, a fraction of the corresponding value for the category average (9.87%). Because it tilts toward higher-quality bonds, this portfolio has tended to hold up better than most its peers when credit spreads widen, which often occurs when business conditions deteriorate. This helps the fund better diversify stock risk than more aggressive bond managers, as the payoff to credit risk is positively correlated with the stock market.

This portfolio has hewed closely to its index. It lagged the benchmark by 6 basis points annually over the trailing 10 years through February 2019.

People Pillar: Positive | Alex Bryan, CFA 04/04/2019
Fidelity's fixed-income portfolio management team is small but capable, and it enjoys strong support. It warrants a Positive People Pillar rating.

Brandon Bettencourt and Jay Small have managed this fund since 2014 and 2015, respectively. Bettencourt previously worked in credit research and as a portfolio analyst at Fidelity. Small was previously a corporate-bond trader. They are supported by two quant analysts, who develop the team's portfolio optimization tools for tracking the benchmark and calibrate the risk model to help the managers mitigate tracking error.

This core index management team enjoys the support of Fidelity's broader fixed-income portfolio management department. The managers hand off trade execution to Fidelity's large team of trading specialists, who also support the firm's active managers. This frees them up to focus on keeping the portfolio close to the benchmark. They also leverage Fidelity's broader credit research team as an input to help mitigate tracking error.

The managers regularly review reports that flag potential sources of tracking error, so that they can address those issues before they affect performance. Fidelity's CIO team independently reviews the index portfolios and index-tracking performance. To further underscore the importance of mitigating tracking error, Fidelity links manager compensation to this metric.

Parent Pillar: Positive | 07/06/2018
Fidelity isn't without challenges but remains well positioned enough to compete in a changing industry. It earns a Positive Parent rating. The firm’s diversified asset mix has shielded it from steady outflows from its active U.S. equity funds, with its taxable bond, international equity, and low-priced index offerings attracting assets. Its revamped target-date offerings have improved, and in 2018 the firm plans to launch an additional series combining active and passive funds to better compete in an area where investor interest has grown.

Attracting and retaining talented investment professionals is more important than ever. The equity division came under fire in 2017 amid reports of sexual harassment and a hostile work environment, leading to portfolio manager dismissals and a change in leadership. While Fidelity addressed the personnel issues and is working to improve collaboration through weekly team meetings, more-open floor plans, and improved feedback systems, it remains to be seen how the division may incorporate team-based elements into the legacy star-manager system. Meanwhile, the fixed-income division remains in steady hands following the retirement of a longtime CIO. While the bond analyst and manager ranks have seen more change than usual lately, the team-oriented structure of its investment-grade and municipal offerings helps minimize the impact of departures.

Price Pillar: Positive | Alex Bryan, CFA 04/04/2019
Fidelity charges a razor-thin 0.025% expense ratio for this offering, making it one of the cheapest funds in the intermediate-term bond category. It warrants a Positive Price Pillar rating. There is no minimum investment requirement. Over the trailing three years through February 2019, the fund lagged its benchmark by 11 basis points annually, slightly more than the amount of its expense ratio, partially because of sampling error. 

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Alex Bryan does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.