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By Sarah Bush | 09-06-2013 12:00 PM

Dodge & Cox's Emery: Still Playing Defense

We continue to be concerned about rates, says Dodge & Cox Income manager Dana Emery, but also are eyeing possible areas of opportunity as credit spreads have widened.

Sarah Bush: Hello. My name is Sarah Bush, and I'm a fixed-income analyst with Morningstar. Today, I'm joined by Dana Emery, who is CEO and president of Dodge & Cox, and director of fixed-income.

Thank you very much for joining us today.

Dana Emery: Thank you so much, Sarah.

Bush: It has been a very interesting period in the bond markets recently, and I know Dodge & Cox has had a pretty conservative view on interest rates for some time. So, maybe you can talk just a little bit about that positioning and what your thoughts are in terms of what has happened recently in the markets?

Emery: As you've been following us for a long time, we've been quite concerned about interest rate risk and have positioned the portfolio as well for that for quite some time. We started at the beginning of the year with about 70% of the benchmark duration positioning, so a very intermediate portfolio, and trying to mitigate that risk.

Some of the concerns were really around the absolute level of the rates being at unsustainably low levels, reflecting negative real rates out past 10 years. And then when you couple that with the extraordinary Fed policy and the flight-to-quality mentality after the financial crisis, we were concerned that would eventually have to unwind and get back into a more normal real rate environment. So, we wanted to position the portfolio for that.

When the Fed started talking about tapering, the market started to adjust and very quickly, part of that was the tapering discussion, as well as the change in the Fed forward guidance that reflected more optimism than I think was embedded in the markets at that time. You had a pretty significant backup in rates since the May timeframe, over 100 basis points.

So, we continue to be concerned about a rise in rates; we continue to position the portfolio defensively. But as these rates rise, you start to get better rewarded for taking interest rate risk. It's an interesting environment. There will continue to be volatility. There are a lot of concerns out there in the marketplace, obviously, around Middle East tension, tapering, the timing, how much, uncertainty around that, when the Fed will eventually start to raise short-term rates, fiscal concerns, as well as the debt ceiling. We think it's going to continue to be volatile as the markets try to work through these various [factors]… improving economy in the face of all these other types of headwinds that are facing the markets.

Bush: As you look at these markets, where have been some of the opportunities you've been able to find value? Especially corporates have been a particular area of interest for the fund.

Emery: Yes, we've featured an overweight to corporates for quite some time. We increased it quite a bit in the financial crisis, when spreads were at extraordinarily wide levels. And since then, as the economy has improved from the very dire situation in '09, you've started to see those spreads narrow and come down into a more normal spread environment. When we think about credit just in an aggregate level, we still think investment grade is moderately attractive, it's not as attractive as it was going back. And then the high-yield crossover area where we focus is still, we think, fairly attractively priced. Since this summer as interest rates have risen, some of the credit spreads have widened, especially in the below-investment-grade area, … emerging markets or European exposure has widened a bit as well. So those are kind of interesting areas that still we think offer attractive value. We always believe, though, you don't want to do it on a top-down, high yield versus investment grade. You really want to be looking at name-by-name fundamental research.

Bush: When you look at that name-by-name research, what are some pockets in terms of sectors that have been of particular interest, especially in investment grade?

Emery: Within the credit area, some areas of focus have been financials. We've been overweight financials. We built that position gradually into the financial crisis. We started out with a low weighting and have built that up to be a pretty significant overweight within the portfolio. A variety of U.S. money center banks as well as U.K. banks, and then a variety of insurance companies are the overweights that we have in the financial sector.

Other sectors--within industrials we've been looking at more cyclical companies that are exposed to an improving economy, as well as the cable area and railroads have been an overweight area for us for some time and offer, we think, compelling value given their durable cash flows.

Another pocket that we've been looking at are taxable municipals, which we started building in 2009, and have been very strong performers, and we've been diversifying across a variety of state general obligation bonds, as well as essential-service-backed securities.

Bush: Turning from corporates and moving to mortgages. You mentioned when we were talking earlier, where the fund has had a pretty wide range of exposures to mortgages. Could you talk a little bit about what role mortgages play in the portfolio and how you're thinking about that sector today?

Emery: Mortgages have played a very important role in our portfolios throughout our history. We've had a range of under 30% to over 50% weighting in our portfolio, depending on where we see relative value in the marketplace. And their role is really as short to intermediate, high-quality credit substitutes. And we do the same type of fundamental security-selection work that we do in credit; there we're using specific securities based on their basic cash flow features, and we run a lot of different simulations and analyses to look at the range of returns that we can earn from those securities. And many times they look attractive relative to taking credit risk in that very short to intermediate part of the yield curve.

Bush: Thank you very much for being with us today.

Emery: Thank you so much.

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