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

Shifting Dynamics in the Bond Market

Concerns of global systemic shocks have lessened from previous levels, and corporate issuers are more likely to take on riskier bets, according to Dodge & Cox's Tom Dugan.

Miriam Sjoblom: Hi, I am Miriam Sjoblom, associate director of fund research at Morningstar. I'm here today with Tom Dugan, who is one of the portfolio managers of Dodge & Cox Income.

Thanks for joining us today, Tom.

Tom Dugan: Thanks, nice to be here.

Sjoblom: So, Tom, 2012 was a really fantastic year for the corporate-bond sector, investment-grade and high-yield corporates, and corporates are really a significant part of your portfolio. Can you talk a little bit about what was driving performance last year?

Dugan: Sure. As you mentioned, it was very a strong year for corporate bonds, and in fact most of the return generated in the bond market came from the corporate sector and certainly in the case of Dodge & Cox Income fund. The key attributes for the corporate-bond performance in 2012, you have to start with valuations, and corporate bonds entered 2012 with very inexpensive, very compelling valuations.

So, that in combination with a modestly growing economy and some very supportive policies by central banks and policymakers across the globe, created an environment for corporate bonds to do really strongly, and that's what happened. So, many of the most significant contributors to overall bond market returns, and particularly returns for the Dodge & Cox Income fund, were from the corporate sector.

We favor corporates and came into 2012 with a very significant overweight to that sector, almost 50% of the portfolio versus about 20% for the overall bond markets, so a lot more corporates in the Dodge & Cox Income fund. So, we did well because of how well corporates did and simply having more.

On top of that, one of our major focuses within the corporate-bond sector was on bank bonds, and that is a subsector of the corporate area that really had the strongest performance of all. Some of our individual holdings had returns in the 20%-30% range in 2012.

That was an area that was badly beaten up in the second half of 2011. Their valuations become very inexpensive. We retained a lot of confidence that these were good credits. We added in periods of weakness, and 2012 ended up being a pretty rewarding year for owning bank bonds and then obviously owning corporates in general, as well.

Sjoblom: Well, now that corporates have performed so well and the yield spreads on corporates over Treasuries have come in significantly. Do you think there is still significant value in the corporate sector?

Dugan: Yes. We have kept our overall corporate weighting roughly similar. We make adjustments on an ongoing basis in terms of the composition, but we still find corporates relative to the alternatives--Treasuries and mortgage-backed securities and other for instance, assets-backed securities--we think they remain one of the more compelling alternatives in the investment-grade bond space.

What you bring up, though, is an excellent point. The valuations are not as compelling as they were at the beginning of 2012. They have gone from very, very inexpensive, in our opinion, to much closer to reasonable, but we still think that the corporate bond investor was well rewarded for taking credit risk. What we do at Dodge & Cox, one of our key and unique attributes, is the reunderwriting of every corporate issue that we invest in.

So we don't own the overall corporate bond market. We own 45 or 50 individual corporate issues that we believe in their credit worthiness, we understand their businesses. So that's different than having an opinion about the overall corporate bond market. These 50 issuers that we're invested in, we have a lot of confidence in, we think the valuations still remain in pretty good shape, albeit not as cheap, certainly as they were to be in the year 2012.

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