Fidelity Investments gives a select group of employees an unusual perk. It lets them make unsecured loans to the company at annual interest rates that have paid them nearly 20 percent in recent years.

It was the best investment I could have made, said Ani Chitaley, a former Fidelity senior vice president. When I left (in 2007) to start my own company, I had to give them up. That was a sad day.

The promissory notes, officially called junior subordinated debentures, have become a key but expensive source of capital for the world's second-largest mutual fund over the past decade.

The interest on the debt is tax deductible and some of the debentures also double as an equity substitute for top performers and other insiders.

Several current and former Fidelity executives, who did not want to be identified for this story, said the debenture program is a relic of the past when Fidelity's profit margin was substantially higher. And they argue the expensive debt puts the company at a competitive disadvantage.

Analysts at Moody's Investors Service have singled out the employee-held debenture debt as an area of concern.

In our view, the debentures carry substantial coupon rates that have driven FMR's interest expense to very high levels, Moody's analyst Dagmar Silva wrote in an October 27 research note. ...Fidelity's net income margins have consistently been more in line with our expectations for lower rated firms, in part due to its corporate structure.

Fidelity spokeswoman Anne Crowley said the company uses the internal debt to make investments to grow its businesses and better serve its customers. Fidelity declined to make executives available for comment.


We believe our private ownership and capital structure gives us many strategic and competitive advantages that make us very comfortable with our approach, Crowley said.

Analysts at Moody's said that, as a private company, Fidelity can focus on long-term objectives without the distraction of quarterly profit expectations.

Being private, however, limited the financial flexibility of the company to some extent, by preventing it from accessing the public markets for fresh equity capital, Moody's said.

Closely held Fidelity is secretive about its financial statements, but documents obtained by Reuters show that $5.1 billion in subordinated debentures was outstanding in early 2010. More than half of that amount was in junior subordinated debentures. In all, subordinated debentures accounted for 41 percent of the $12.6 billion in debt on the balance sheet of Fidelity's parent, FMR LLC.

In 2007, some of Fidelity's junior debentures generated interest rates between 18.5 percent and 19.5 percent for employees and shareholders. In 2008, the range was 13 percent to 16 percent. And in 2009, it was 8.5 percent to 13.7 percent, according to financial disclosures reviewed by Reuters.

The returns are in stark contrast to investors scrounging for a few basis points of yield from money-market funds amid historically low interest rates. The yield on the 10-year treasury, for example, is about 1.94 percent.

Some participants have been known to borrow money to take full advantage of Fidelity's debentures. Some series of these debentures allow employees to put them back to the company at five- to seven-year intervals.

They are held by a select group of employees, including Fidelity Chairman Edward Johnson III and his family. The program is kept hush-hush. Participants have to sign confidentiality agreements, and availability is usually limited to several hundred employees for each issue. Fidelity employs about 39,000.


But Fidelity isn't the cash cow it once was. Over the past decade, index funds and exchange-traded funds have eroded the market share of the Boston-based company. To make matters worse, investors have lost their appetite for Fidelity's bread-and-butter product: stock mutual funds.

In a recent speech heard by only a small gathering of mutual fund industry executives, Fidelity Asset Management President Ronald O'Hanley warned there could be low stock market participation in the next decade, much like the 1950s.

That leaves Fidelity with a large amount of expensive debt while its higher-margin stock funds suffer from an industry-wide trend of redemptions. There is a direct correlation between Fidelity's management fees and the S&P 500, which is down about 7 percent in 2011.

In 2002, Fidelity generated operating income that was 7.3 times its interest expense. In recent years, that figure has been only 2.3 times to 4.3 times interest expense, financial statements show.

Standard & Poor's analyst Charles Rauch said in a May research report that FMR's overall capitalization was on the low side because the company needs substantial tangible equity to support other financial services businesses, such as insurance and brokerage, and its noncore strategic investments.

During the three-year period that ended December 31, 2009, FMR generated, on average, $20 in total revenue for every dollar in interest expense. During the three-year period that ended in 2002, that ratio was much higher, 38-to-1.


Most of Fidelity's competitors are publicly-traded companies, which incur their own compensation costs when they issue stock options and restricted stock to key executives and employees.

Moody's, which has a negative outlook and an A2 rating on the company, said its concern is mitigated to some extent by FMR's high level of cash and liquid investments on its balance sheet.

FMR deducts debenture interest payments to reduce the taxable income that flows to its shareholders, which include top executives and the Johnson family.

Organized as an S-Corporation in 2007, FMR pays little if any federal income tax. This allows taxable income deductions and credits for federal income tax purposes to flow directly to shareholders. To keep its S-corporation status, FMR cannot have more than 100 shareholders.

In early 2010, FMR sold $63.6 million in debentures to about 600 participants, according to U.S. regulatory filings. The interest rate is typically two times the prime lending rate (currently 3.25 percent), plus what insiders call a 2 percent to 3 percent kicker.

Some of FMR's senior debt is much cheaper, though. Yen-denominated debt, for example, has had annual interest rates below 2 percent, according to financial statements.

In any given year, though, Fidelity's operations can generate between $2 billion and $3 billion in cash flow. And the company's investment portfolio, which has topped $10 billion in recent years, includes a large amount of low-risk, liquid assets, credit-rating analysts have said.

Fidelity can lower annual payouts on junior debentures because one component of the interest rate is pegged to meeting profit targets, financial records show. Fidelity typically asks employees to redeem the debt when they leave the company.

(Reporting by Tim McLaughlin in Boston; Editing by Tim Dobbyn)