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By Sarah Bush | 04-02-2014 03:00 PM

Dodge & Cox's Dugan on Keys to Bond Investing

A three- to five-year investment time frame and the discipline to fully understand an issuer's creditworthiness have served Dodge & Cox Income well, says manager Tom Dugan.

Sarah Bush: Hello, my name is Sarah Bush. I'm a Morningstar analyst, and today I'm joined by Tom Dugan. Hi, Tom, thanks for joining us. Tom is an associate director of fixed income with Dodge & Cox and a member of their fixed-income policy committee.

Again, thanks for joining us today.

Tom Dugan: Nice to be here.

Bush: We are glad to have you. First of all, I just wanted to talk to you a little bit broadly about the process at Dodge & Cox Income. Could you talk a little bit about your primary approach to managing fixed-income security selection?

Dugan: I think one way to boil it down is when investing in a fixed-income security and a bond, you are effectively making a loan. And first and foremost you want to assure yourself that this is a loan that can be repaid. So understanding the creditworthiness characteristics of the issuer is paramount in terms of selecting securities.

Within the fixed-income universe is a range of issuers. There are issuers we don't have to worry about that with--the U.S. Treasury for instance. There are other government-guaranteed issuers where that is not much of an issue. But there are credit issuers where that's the fundamental point of distinction, and we spend a lot of time trying to understand companies, their fundamentals, and their ultimate ability to repay that bond's interest and principal. So that's an absolutely key characteristic in terms of security selection.

The other ones I mentioned, those without a lot of credit risk, government-guaranteed ones, typically may have other issues. Government-guaranteed mortgage-backed securities have cash flow timing issues because of the prepayment option that a mortgage borrower has, that portions of the bond could be prepaid next month or 10 years from now. And so assessing the durability of cash flow and the predictability of those payments is the paramount concern for issues like that.

It's a range of things. But again, it all starts with creditworthiness of the issuer, and are we comfortable that they have the wherewithal to repay us.

Bush: Your strategy is a fairly credit-intensive one, and corporates play a big role in the portfolio. What are the risks of that approach and that strategy if things aren't implemented correctly?

Dugan: As I mentioned earlier, figuring out the creditworthiness of the company that you are lending money to, which is what you are doing when you are buying a bond, is of paramount importance, and we spend a significant amount of our time on that. We have a deep and talented team of industry analysts who follow companies across the globe doing that, leading that effort, credit analysts looking at the covenants and the terms of the deal are all part and parcel of this research process.

The most fundamental risk of this is getting it wrong; through this process of identifying creditworthiness, [the risk is] perhaps making a mistake and overestimating the creditworthiness, underestimating the potential industry risks, and underestimating the potential for a credit-changing event. Those are the kind of things that are true risks to the process. What we do to mitigate that risk is, again, spend as much time as we possibly can, understanding the investment and its risks, and then of course diversification.

Typically, one of our credit positions on average is about 1% of the portfolio, with a maximum somewhere between 2% and 3%. We have a broad, currently about 50, group of corporate issuers, so diversification is a key element of risk control in terms of credit.

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