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What Dodge & Cox Income Is Doing with Derivatives

Dan Culloton

Dan Culloton: Hi. I am Dan Culloton, associate director of fund analysis with Morningstar.

I'm here with Tom Dugan, one of the managers of the Dodge & Cox Income Fund.

Tom, thank you for visiting today.

Tom Dugan: Thanks. Nice to be here.

Culloton: Well, Tom, Dodge & Cox did something within the last year that they hadn't done before in their history, and that was short Treasury futures. A lot of funds do this for tactical reasons in order to express their view on the course of interest rates around Treasuries in general. Is that what Dodge & Cox is doing?

Dugan: I would say our use of Treasury futures was strategic in the sense that we were presented with a pretty unique environment last year, very low level of overall interest rates, but some very attractive opportunities in longer-term, for instance, corporate bonds.

And what we wanted to do was to try to get as much as of the exposure to the attractive credit spreads available in corporate bonds without so much of the interest rate risk in this period of very low interest rates.

And effectively by shorting 10-year Treasury futures, that gave us the opportunity to own a little bit more of the long credit exposure, which has subsequently done pretty well, without bringing into the fund so much of the price risk associated with longer duration exposure to Treasuries.

Culloton: So, really about controlling your overall duration for the fund?

Dugan: Exactly. It's a way to position the fund's duration conservatively and defensively while retaining some of the upside associated with good long-term corporate bond yields.

Culloton: So, anyone who has been used to Dodge & Cox Income as a standard intermediate-term bond fund that they could count on to provide income and the capital preservation, shouldn't worry about Dodge & Cox Income becoming a hedge fund?

Dugan: No, I would assure everybody that we are not changing our stripes. We don't anticipate employing a wide range of different derivative securities. We think our shareholder appreciates their ability to look at the fund and the fund's holdings and understand the positions and understand the various risks being assumed, and we want to continue to provide that transparency to fund shareholders. And this incremental position, reducing fund duration by shorting what is in effect a fairly small percentage of the portfolio in 10-year Treasury futures doesn't really alter that one way or the other.

Culloton: And you've reported that the notional value is about 6% of the portfolio?

Dugan: Exactly.

Culloton: And that's still it.

Dugan: And the net effect in terms of the fund's duration was to lower the fund's duration by three-tenths of a year. So it sounds like a major step, but in fact, it's an incremental change to the fund structure.

Culloton: When investors hear about derivatives being used in fixed-income portfolios, especially in the wake of 2008, they sometimes leap to the conclusion that there is leverage being employed in the fund, and that's not the case with Dodge & Cox Income.

Dugan: Right. That's not the case here. If you were long, for instances, a long position, where you were to buy exposure to a greater percentage with a small margin, that would be different, but in this circumstance being a short position we are not buying excessive exposure and levering the fund. There is no element of that.