Despite its recent dip, Fidelity Floating Rate High Income should weather any further turmoil. By Elizabeth Leary, Contributing Editor July 6, 2007 No sooner did we extol Fidelity Floating Rate High Income, a member of the Kiplinger 25, for its remarkable stability in the face of rising interest rates that the fund's share price sank for the first time in three months. The fund lost five cents a share, or 0.5%, during the last three weeks of June. This isn't a calamity for shareholders, but the drop should remind them that Floating Rate is not the same as a money-market fund.Floating Rate invests in loans that banks make to corporations, typically those with below-investment-grade credit ratings. The loans carry interest rates that reset every one to three months, "floating" a few percentage points above a short-term benchmark. That feature protects the fund from the downward pricing pressure of rising rates (prices of bonds and similar fixed-income investments tend to move inversely with interest rates). But rate resets don't protect against potential credit problems of the underlying companies -- or against investor perceptions about problems with borrowers. Although bank loans enjoy much lower default rates than regular corporate junk bonds, credit problems elsewhere in the market contributed in part to Floating Rate's recent dip. Concerns over contamination from the ongoing sub-prime loan crisis have fueled a flight to quality, depressing prices on riskier, below-investment-grade IOUs. The average junk bond fund lost 2% during June. Christine McConnell, Fidelity Floating Rate's manager, isn't worried yet. She says the bank-loan market just needs time to absorb current supply and demand pressures. Booming merger-and-acquisition activity, valued at more than $1 trillion in the first half of the year, has created a glut of supply in the bank-loan market. Many recently announced mega-deals, including those involving Chrysler and Dollar General, are just now turning up on McConnell's desk as potential investments. Advertisement Simultaneously, many new issues appear to be exceptionally weak. Usually, borrowers must meet certain "covenants," or measures of financial well-being, to remain in good standing on a bank loan. But more and more new loans are described as "covenant-lite," meaning that borrowers have lower accountability standards. That added risk has placed further downward pressure on loan prices. Ironically, another cause of Floating Rate's recent price decline is McConnell's tendency to invest in larger, safer issues. She likes large companies that could sell assets if they got into serious financial trouble. The problem is that the debt of larger companies tends to be more liquid. Junk bond funds, which often hold some bank loans, have been selling their liquid bank loan holdings to meet the recent increase in shareholder redemptions. "When there's disruption in the markets, typically what you see is the larger and more liquid names in the category come under more pricing pressure than other loans," McConnell says. Despite its June hiccup, Floating Rate (symbol FFRHX) was still up 3.0% for the year through July 3. That matches the gain of the average high-yield bond fund and beatings the average investment-grade bond fund by about two percentage points. The fund gained 5.5% annualized from its August 2002 inception through June 30 and currently yields 6.4%. (An older, broker-sold version of the fund, Fidelity Advisor Floating Rate High Income A, returned 5.0% annualized over the past five years.) Although a deeper crisis would be a major test of the fund's price stability, McConnell's conservative approach should limit the damage. She invests heavily in senior-secured loans, which have first dibs on a company's assets in a bankruptcy situation. But, McConnell emphasizes, subprime problems have had no concrete impact on the bank-loan market. "Pricing pressure today is not because defaults have picked up," she says.