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By Miriam Sjoblom, CFA | 02-07-2013 12:00 PM

A Time to Make Bond Adjustments

The factors that drove bond prices higher in 2012 are much weaker in 2013, and investors should have a modest intermediate-term outlook on their fixed-income holdings, says Dodge & Cox's Tom Dugan.

See the preceding portion of this interview here

Miriam Sjoblom: Are there any issues that you are focused on for 2013 in particular?

Tom Dugan: Yes. Washington continues to generate a lot of the headlines and be very impactful on the financial markets, and particularly the debt markets. So many investors have their eyes on very important issues like debt-ceiling negotiations and the sequestration issues.

An area that we haven't talked about much, that we think is interesting is just what kind of changes might be coming in terms of housing and mortgage finance policy. The administration has been reasonably active in the last three years, particularly in terms of its Home Affordable Refinance Program and the Home Affordable Refinance Program part two called HARP 2.0. They've continued to tweak this, and we think there's the possibility of more tweaks. And so this is something where we have 30% of our portfolio in mortgage-backed securities. These securities have sensitivity to prepayments and adjustments that the administration might be considering to these programs, [which] could have a real effect. So we are watching that very closely and monitoring it all the time.

Sjoblom: You've already made significant adjustments to your portfolio this last year, based on that?

Dugan: Exactly. The second version of HARP, HARP 2.0, we looked it over and thought this is really making some changes that are going to remove some of the obstacles from borrowers in older higher-coupon loans to be able to refinance. And so we had exposure to those types of borrowers in our mortgage-backed securities portfolio. We saw kind of the handwriting on the wall in terms of the prepayment speeds, which is the primary risk you face with these securities.

We saw the real possibility of significantly higher prepayment rates, and so we basically took the step of reducing our mortgage-backed securities weighting by about 40% at the beginning of 2012 to below 30% at the end of 2012, focusing on those mortgage-backed securities that we thought would be most susceptible to these changes. And that's kind of what has come to pass. The securities we sold have in fact experienced pretty high prepayment rates to the detriment of the holders.

Sjoblom: After we had great year for corporates, what do you think bond investors can expect in terms of return from the market?

Dugan: I think as we look out into 2013 and beyond, the intermediate outlook is a modest one for fixed-income investors. What drove returns for example in 2012: the corporate sector rebounding, as you mentioned, from a very weak second half of 2011 and very inexpensive valuations. Basically that was three fourths of the nearly 8% return that Dodge & Cox Income produced in 2012. That’s not in place for 2013. Valuations are higher. There isn’t that opportunity to have price gains to supplement earned income as there was in 2012.

So as we look out into 2013 and beyond with interest rates still low and with valuations on the non-Treasury sectors closer to reasonable, we are looking at expectations for returns that are much closer to the yield and income produced by these portfolios. Those aren’t high numbers. The yield at Dodge & Cox Income is little bit above 2%; the yield of the broad bond market is below 2%. So really intermediate term, we're looking at pretty modest numbers from the bond market.

Sjoblom: So investors should manage their expectations accordingly.

Dugan: Yes, I think that’s absolutely right. There is an ongoing role for bond portfolios, and this is not a call to take all the bonds out of your portfolio. There is a very strong case for keeping bonds within a diversified portfolio. On the margin, though, the return outlook is not that strong, and if there are some adjustments one could consider making, it's not a bad time to do it.

Sjoblom: Tom, thank you for being with us today and sharing your thoughts.

Dugan: Thanks. Nice to be here.

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