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Dodge & Cox's Emery: Prepare for More Modest Bond Returns

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. We are in San Francisco visiting with Dodge & Cox, and I am here today with Dana Emery from Dodge & Cox Income Fund, one of our favorite funds in the fixed income space. She is going to tell us a little bit about what she is seeing in fixed income and where she is finding opportunity. Dana, thanks for joining me.

Dana Emery: Thank you very much.

Stipp: On the first question for you, with interest rates still very low and risk aversion still very high, a lot of investors have been putting money into bond funds, they have been moving perhaps out of money market funds and moving into bond funds to get a little bit more yield; we have seen it in our fund flow data. With more money going into fixed income, has it been more difficult for you to find attractively priced opportunities in this space. And I guess a follow-up question on that would be given all the interest that investors have in fixed income, are there unrealistic expectations about what the performance of their bond funds might be?

Emery: Definitely, Dodge & Cox Income Fund has experienced similar types of flow. So we're definitely seeing a lot of flows into our bond fund, and we've seen interest rates come down pretty dramatically from the levels they were during the crisis. So the yield of our fund, for example, was around 8% in October of '08 and is now under 4%. So interest rates have come down dramatically, and that means the total returns in these funds have been very good.

So I think I share your concerns that perhaps investors will have undue expectations for returns, because of what has happened in the recent past. We think investors need to think about the starting yields of funds and right now intermediate bond funds are generally yielding less than 4%, the indices that we're measured by are under 3%. So you are starting from a very low base and returns from here should be fairly moderate. So I guess from our perspective, it really depends on your time horizon.

Stipp: On the valuation front, I am sure you're looking issue by issue and trying to find some opportunities in the market, has your opportunity set narrowed at all? I mean is it harder to find the kind of investments that you'd like to invest in because of valuations may be different now than they were a year or a year and a half ago?

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Emery: We definitely have to get used to the new valuation levels and have return expectations that are more modest. So, again, with the yield starting so low, the return prospects are fairly low. What we're trying to do in the fund is mitigate the interest rate risk by being fairly short in maturity and duration in our fund, so that the longer the security, the more interest rate risk there is. So we're trying to be somewhat moderate in our interest rate exposure. We also feature about 42% of the fund in GSE mortgages, which are fairly high quality. And then the corporate securities in there were very careful security selection to be sure in our mind that they can pay back in a timely manner.

Stipp: Sure, I'd like to ask you a little bit more about the corporates in a moment, but since you mentioned the interest rate situation and certainly in a lot of cases it seems like rates don't have much direction to go except up ultimately, and we don't know necessarily when that will happen. You know one thing that we are concerned about at Morningstar is that as folks are reaching for yield, they might go into riskier and riskier securities, maybe more than they anticipated.

When you're thinking about trying to get a better yield on the investments you look for, are there any areas where it seems like you can get a little bit better yield without taking on a lot of extra risk, maybe some areas that have been overlooked by the market.

Emery: I wouldn't say necessarily overlooked, but I would say it depends on your time horizon, again. So from our perspective, we invest with the three to five-year investment horizon, so that it gives us a little bit of cushion in terms of thinking about – concerning about price volatility in the intermediate term.

So from our perspective, Treasury rates are very low and don't offer a significant amount of return at this point. They make sense if people want to be in risk-free instruments, but they're giving up a lot of yield for that safety.

So based on different maturity points along the yield curve, mortgages, the GSE mortgages, still look very interesting to us, offer a very attractive relative returns in our opinion relative to buying Treasury securities for example.

Then corporates, again, we need to be very careful in selecting them. So that's why we use our research team to help us really look at both the upside and the downside risks of each investment in the portfolio.