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Dodge & Cox Income Back on Track

The Gold-rated fund’s exposure to corporate bonds has gone from a headwind to a tailwind. 

Cara Esser, 11/27/2016

With a three- to five-year investment time horizon, Dodge & Cox Income’s managers have an eye for the long term. This approach leads to low turnover (typically a third of the portfolio each year) as the team is willing to be patient with its picks. A veteran and well-resourced team, time-tested process, low expenses, and an impressive long-term track record earn this fund a Morningstar Analyst Rating of Gold.


A focus on income as a component of total returns leads to a yield that's generally higher than peers' (3% as of September 2016) and to an overweighting to corporates, including an often 10%-plus allocation to junk bonds. Corporate exposure tends to be concentrated in around 50 issuers, and managers aren’t afraid to take sizable positions in downtrodden names, including Brazilian energy firm Petrobras, which the firm stuck with through its more recent troubles. Meanwhile, as the firm has built its global bond resources, this fund has added to its non-U.S. stake. As of September 2016, the fund had about 18% in non-U.S. corporate bonds, from both emerging and developed markets.

The focus on corporates and a duration that has historically run short of its Bloomberg Barclays U.S. Aggregate Bond Index benchmark can leave the fund out of step with the index and peers at times. For example, during the most recent credit sell-off from June 2014 to February 2016, the fund underperformed both peers and the index. As the market turned, however, and credit rallied, it outperformed 85% of peers and the index for the year to date through October 2016. Investors can also expect the fund to hold up better than most during periods of rising rates. For example, it did better than most peers and the benchmark during the taper tantrum of 2013. Going forward, the fund’s lower allocation to Treasury bonds and shorter duration (4 years versus 5.5 for the index) should lead to better returns if rates rise, though the large allocation to corporate bonds will hurt if credit sells off. In all, over a market cycle, investors remain in good hands.

Process Pillar: Neutral | Cara Esser, CFA 11/22/2016 

The fund's management team invests with a three- to five-year time horizon, balancing the goal of outperforming the Bloomberg Barclays US Aggregate Bond Index with minimizing the risk of loss over that stretch. They also aim to assemble a portfolio that delivers more yield than the index.

The income focus results in overweightings to agency mortgages and corporate bonds (with a 10% stake in high-yield, typically) compared with the index and peers. Corporate holdings, where much of its risk resides, are typically concentrated in around 50 issuers. The fund’s managers aren’t afraid to take unusual positions either. For example, during credit crunch from mid-2014 through early 2016, the team added to positions in beaten-down energy firms including Kinder Morgan. The firm believed that the bonds were oversold, especially given that the firm’s profitability is only partly tied to oil prices, with the bulk of its revenues coming from contracted revenue streams. The fund has since reduced its energy stake as the market bounced back in mid-2016.

An often-sizable stake in U.S. government-backed agency mortgages helps to counterbalance credit risk, and managers can use a modest amount of Treasury futures to manage duration. Overall, the fund’s long-term and deep analytical focus separates it from peers, earning it a Positive Process Pillar rating.

The fund’s duration has generally been shorter than that of the Bloomberg Barclays US Aggregate Bond Index since mid-1998. That said, the fund doesn’t typically stray too far from home. As of September 2016, duration was 4 years versus 5.5 for the index.

The credit sell-off starting in late 2014 through early 2016 gave managers opportunities to scoop up what they viewed as fundamentally sound, beaten-down names. Then, following a rebound in credit that started in March 2016, managers trimmed credit positions, mostly in energy. The corporate stake dropped to 43% (11% junk-rated) as of September 2016, from 47% last year.

Exposure to Treasuries has changed over the years as valuations in corporates have looked either attractive or overvalued. Since 2004, Treasuries have trended downward (from about a third to 11% as of September 2016), though the allocation dropped to as low as 4% in fall 2015 when credit spreads widened and managers saw particularly good opportunities in the sector. The team then added to Treasuries as it trimmed corporates through fall 2016.

The allocation to mortgage-backed securities has remained relatively stable over the past few years (a third of assets). The fund favors 15-year mortgage bonds with high coupons issued before 2008 that are less rate-sensitive relative to recently issued bonds, which make up the bulk of the index’s exposure.

Performance Pillar: Positive | Cara Esser, CFA 11/22/2016 

Historically, the fund has held more than half of its portfolio in corporate bonds, which represented a substantial overweighting versus the Bloomberg Barclays US Aggregate Bond Index and many peers. As a result, the fund tends to flourish when credit markets are strong but underperform in weaker credit markets. So, the fund struggled from June 2014 to February 2016 as Treasuries outperformed corporate bonds in a generally risk-off environment, trailing its average peer by nearly 100 basis points and the index by more than 200. But, as the market quickly turned, returns bounced back. For the year to date through September 2016, the fund beat 90% of peers and outpaced the index by 180 basis points.

The fund’s long-standing shorter-than-benchmark duration makes it less sensitive than its competitors to changes in interest rates. For example, the fund underperformed peers and the index during 2011’s credit crunch thanks to a short duration and its sizable credit stake, but during the so-called taper tantrum in summer 2013, the fund’s shorter duration helped relative returns as rates rose.

Over the long haul, patience and a focus on fundamentals has paid off. The fund’s trailing 10-year return of 5.3% beat 85% of peers and outpaced the index handily. It also looks strong on a risk-adjusted basis, with a better-than-average Sharpe ratio over the same period. The fund earns Positive Performance Pillar rating.

People Pillar: Positive | Cara Esser, CFA 11/22/2016 

Dodge & Cox’s fixed-income investment policy committee serves as the management team for this fund. Turnover here is low, though two members retired in 2015, bringing the committee to eight from 10 members. In all, the committee is a seasoned bunch, with each member having one to three decades of investing experience; most have spent the bulk of their careers at the firm. A large group of industry and regional analysts supports both the stock and bond managers' efforts. The team believes cooperation between the firm’s equity and fixed-income teams helps differentiate the fund because the fixed-income team can hear a more open conversation with managers about plans to declare dividends, buy back shares, or make acquisitions, all of which affect a firm’s bonds.

A group of dedicated corporate-bond generalists focuses on the nuances of the corporate-debt markets, conducting additional downside analysis and assessing individual securities' structure and covenants, and handles trading. Another experienced group runs the fund's agency mortgage, government, asset-backed, and taxable muni stakes. Three global bond analysts were added in recent years, as the firm and this fund added to bonds issued outside the U.S.

The low turnover, long-tenured team has been thoughtfully built out over the years as the firm has expanded its investment universe, earning the fund a Positive People Pillar rating.

Parent Pillar: Positive | 05/02/2016 

Dodge & Cox is an exemplary firm. CEO and president Dana Emery and chairman Charles Pohl are also lead members of the investment team and run both the firm and its funds with a long time horizon. The average fund manager tenure of more than 20 years is exceeded only by a few boutiques and is much higher than is typical for a large fund company.

There are no stars here; each fund is run collaboratively by an investment policy committee. Ideas can come from any analyst but must survive extensive peer review. Although the funds have seen outflows in recent years, the firm has continued to build the investment team at a slow-and-steady clip. It totals roughly 60 managers and analysts, most of whom become partners.

Dodge & Cox has rolled out only six strategies since it first opened in 1931. The most recent is a global fixed-income offering that launched in May 2014; the firm developed its foreign-bond capabilities as a natural extension of its international-equity expertise. While the firm has eschewed marketing, it is among the largest mutual fund companies today. Asset growth can hinder execution, but management has proved willing in the past to safeguard its strategies by closing funds.

Managers are heavily invested in the funds and the firm and have ample incentive to serve shareholders, as evinced by low costs, clear communications, and a sober long-term approach.

Price Pillar: Positive | Cara Esser, CFA 11/22/2016 

The fund's 0.43% annual expense ratio falls into the lowest quintile of no-load intermediate-term-bond peer group and earns the fund a Positive Price Pillar rating.

 

Cara Esser is a closed-end fund analyst at Morningstar.

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