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By Miriam Sjoblom, CFA | 08-29-2012 10:00 AM

Emery: Interest Rate Risk Still a Concern

The Dodge & Cox Income manager discusses the fund's ongoing rate-risk mitigation, recent reduction in agency mortgages, and non-U.S. dollar-dominated picks.

Miriam Sjoblom: Hi, I'm Miriam Sjoblom, associate director of fund analysis at Morningstar.

I'm here today with Dana Emery, who is head of Dodge & Cox's fixed-income team, and one of the portfolio managers on Dodge & Cox Income. Thanks for joining us, Dana.

Dana Emery: Thank you for having me.

Sjoblom: They have got some changes in the portfolio this year, and I thought it would be great to just give our viewers an update on some of the moves that you've been making in the Dodge & Cox Income Fund so far this year.

Emery: Sure.

Sjoblom: And one thing: last year, in 2011, was a really good year for the Barclays Aggregate Index, and for duration and interest rate sensitivity, and your portfolio had a lower interest rate sensitivity than the benchmark that year, and you have brought it even lower this year. Can you talk a bit about why you made that change this year?

Emery: Yes. Well, interest rates are near historic lows. We've seen interest rates in our fund, for example, the overall yield of the fund, is below 3%, and the yield for the benchmark itself is under 2%. So, you're dealing with an environment where you're getting a very low reward from an ongoing income stream.

So, interest rate risk has been one of our concerns for quite some time. The risk there is that if interest rates rise off these very low levels, you could have price declines that could offset the income earned and actually generate a negative total return over time.

So, we're looking for ways to mitigate against that risk. The main ways we've been doing that is featuring more short to intermediate bonds in our portfolios, also offsetting some of the longer-duration corporates that we have in our portfolio by using a short futures position to keep the overall interest rate exposure of the fund at a moderate level. And we feel that that will help protect against this risk.

Right now we're in an environment where, when you look at U.S. Treasuries, for example, the real rate of interest is negative. You're not getting rewarded through inflation protection by lending out past 10 years in U.S. Treasuries. We think that puts you in a vulnerable position. We don't feature longer Treasuries in our portfolio for that reason, and we feel that if rates back up from these very low levels, even just to get to a point where you're earning a positive real interest rate, you could have a significant price risk. So we try to mitigate that, again, through using more short to intermediate securities.

Sjoblom: I think some fund investors see their managers shorten the duration of the portfolio and think, oh, the risk of rising rates is right around the corner. How much does timing of this eventual rise in interest rates matter to your process?

Emery: The timing matters; if interest rates decline from here in a precipitous manner, we would probably lag, but if it happens over a period of time, we think that the income advantage that we've been able to build into our portfolio will help mitigate that risk.

Vice versa if interest rates rise over time, ... over the coming years, we think the portfolio is very well positioned for that, just through the ongoing cash flows that the portfolio generates as well as having less overall interest rate exposure.

Sjoblom: So, another big significant move in the fund this year was a reduction in agency mortgages, and you’ve been having an overweight relative to the benchmark in that sector for several years now. Can you talk a bit about what made you decide to bring it down?

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