Dan Culloton: What are the biggest short-term and long-term risks for fixed-income investors?
Tom Dugan: Short-term risks, I think, are pretty clear. We are at a period of near historically low interest rates, and the fourth quarter, I think, is really a good example of what can happen when you are at historically low interest rates, and you are in a situation where the economy appears to be on the mend.
Interest rates, we expect will rise, as they did in the fourth quarter, and as interest rates rise, bond prices fall, and you can have situations like in the fourth quarter where the overall bond market recorded a loss, the Barclays Aggregate was down 1.3% in the fourth quarter.
So in terms of near-term risks for the bond market, that would have to be number one on the list--the possibility of higher rates going forward, and the possibility of the price declines associated with higher rates impacting and reducing the total returns earned from the bond portfolios. So in terms of some advice with that prospect ... in the fund we are focusing on intermediate cash flows. So intermediate bonds that don't have as much price risk to changing interest rates as for instance 20, 30, or longer-term bonds than that; that would be number one.
Some other risks that the bond market faces: the economy. Our view is that it appears to be on the mend, that some self-sustaining momentum appears to be being generated, but we continue to be in a weakened state, with unemployment at 9% and a lot of excess capacity available. On top of that you have the U.S. government and the Central Bank involved at a very high level in financial markets and the overall economy. So, there is the possibility of a slowdown in the economy, and that would have a potentially troublesome effect on corporate credit, for one, and could also have a significant confidence effect on basically the federal budget and the U.S. Treasury sector as well.
So those are some of the things that we think about, and a third risk I would cite is just the structure of the mortgage finance market looks like it's going to change over the next couple to three years. The administration has put forth a white paper on reform of the GSEs, and we don't know what the future form of mortgage finance is going to be in the U.S., but it seems likely that it won't be the same as it has been, and there may be risks associated with that, there may be actually good things that come out of that.
Culloton: Reasonable expectations are always a key to success for long-term investors. What's a reasonable expectation for fixed-income returns going forward from here?
Dugan: Well, I think, given the importance of income to fixed-income returns, I think any discussion of return expectations for fixed-income securities and bonds starts with the yield, and at this point in time the Dodge & Cox Income Fund, the yield as of year-end was a little over 3.5%. So if every bond in the portfolio pays on time, that's the income stream that is available on an annualized basis for the fund going forward, then obviously that's not a super high number.
So going forward, that would be the start of the conversation for where one could expect three-year returns to be. Our expectations are that interest rates are more likely to rise than fall over the course of the next three years, so there will be some earned income and there are likely, in our view, to be potentially some price declines associated with rising rates as well. And when you add it all together, I think very modest returns over the intermediate term are the likely outcome for fixed-income investors.
Culloton: Well, thank you very much for your answers and for being here with us today, Tom.
Dugan: You are welcome. Thanks for having me.