Emery: Interest Rate Risk Still a Concern

Miriam Sjoblom: Hi, I'm Miriam Sjoblom, associate director of fund analysis at Morningstar.

I'm here today with Dana Emery, who is head of Dodge & Cox's fixed-income team, and one of the portfolio managers on Dodge & Cox Income. Thanks for joining us, Dana.

Dana Emery: Thank you for having me.

Sjoblom: They have got some changes in the portfolio this year, and I thought it would be great to just give our viewers an update on some of the moves that you've been making in the Dodge & Cox Income Fund so far this year.

Emery: Sure.

Sjoblom: And one thing: last year, in 2011, was a really good year for the Barclays Aggregate Index, and for duration and interest rate sensitivity, and your portfolio had a lower interest rate sensitivity than the benchmark that year, and you have brought it even lower this year. Can you talk a bit about why you made that change this year?

Emery: Yes. Well, interest rates are near historic lows. We've seen interest rates in our fund, for example, the overall yield of the fund, is below 3%, and the yield for the benchmark itself is under 2%. So, you're dealing with an environment where you're getting a very low reward from an ongoing income stream.

So, interest rate risk has been one of our concerns for quite some time. The risk there is that if interest rates rise off these very low levels, you could have price declines that could offset the income earned and actually generate a negative total return over time.

So, we're looking for ways to mitigate against that risk. The main ways we've been doing that is featuring more short to intermediate bonds in our portfolios, also offsetting some of the longer-duration corporates that we have in our portfolio by using a short futures position to keep the overall interest rate exposure of the fund at a moderate level. And we feel that that will help protect against this risk.

Right now we're in an environment where, when you look at U.S. Treasuries, for example, the real rate of interest is negative. You're not getting rewarded through inflation protection by lending out past 10 years in U.S. Treasuries. We think that puts you in a vulnerable position. We don't feature longer Treasuries in our portfolio for that reason, and we feel that if rates back up from these very low levels, even just to get to a point where you're earning a positive real interest rate, you could have a significant price risk. So we try to mitigate that, again, through using more short to intermediate securities.

Sjoblom: I think some fund investors see their managers shorten the duration of the portfolio and think, oh, the risk of rising rates is right around the corner. How much does timing of this eventual rise in interest rates matter to your process?

Emery: The timing matters; if interest rates decline from here in a precipitous manner, we would probably lag, but if it happens over a period of time, we think that the income advantage that we've been able to build into our portfolio will help mitigate that risk.

Vice versa if interest rates rise over time, ... over the coming years, we think the portfolio is very well positioned for that, just through the ongoing cash flows that the portfolio generates as well as having less overall interest rate exposure.

Sjoblom: So, another big significant move in the fund this year was a reduction in agency mortgages, and you’ve been having an overweight relative to the benchmark in that sector for several years now. Can you talk a bit about what made you decide to bring it down?

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Emery: GSE mortgages, or agency mortgages, have played an important role in our portfolios really since the inception of the fund [with] 30% to a little over 50% of the fund asset's invested in this segment throughout our history.

We had, going into the financial crisis, a very high weighting there, and actually allowed the fund to do quite well on a relative basis in that period, and the securities remained very liquid, and we were able to use those GSE mortgages to help fund purchase of corporates that were at very attractive valuations.

Since the financial crisis, we've seen a big change in the housing market, obviously big declines in housing prices, a freezing up of the mortgage banking world, much, much higher quality underwriting standards. So, loans that normally you would have seen be refinanced, higher coupon loans that you would have thought could refinance, had a lot of difficulty in this environment.

So, we started to see the government, obviously, paying a lot of attention to this and creating policies to try to free up lending in this area. And the most successful one to-date has been what's called the HARP program, the Home Affordability Refinancing Program. The second version of it that was instituted in December of '11 really freed-up the ability for the underlying borrowers to refinance and created incentives for the banks to do this, because it was quite profitable for them.

So, we saw this coming, and we decided to start reducing exposure to those mortgages in the portfolio that are most vulnerable to this risk and made a significant reduction. We went from a 40% position at the beginning of the year to just over 30% in the fund. So, that's a big change for our style--we're very long-term oriented--in a relatively short period, because we were seeing this big change coming.

And the reason that we wanted to do that was the valuations were such that the bonds were trading over 110 dollar price, and any prepayment that comes in would cause a 10-point drop in that cash flow. So we had the real risk of actual principal loss from the market value of those bonds through this prepayment, and since it was an environment where the valuations were such that we could sell them at these very high dollar prices, it was, from our perspective, sort of a win-win. We could reduce the exposure but not take a loss on the sale.

Sjoblom: Has the market caught on at all to this increased prepayment risk that you're concerned about?

Emery: Well, definitely you're seeing the prepayments increasing. They've gone from about a 20% prepayment rate to over 40% in some cases. So it's definitely there, but the valuations interestingly still remain over 110, and I think it depends on the type of analysis you're doing, how long you think this prepayment environment will last, and also just the tremendous demand that's out there for high-quality assets in this very, very low interest rate environment.

Sjoblom: Let's talk about credit and ... if you're selling down mortgages, lowering interest rate risk, where are you finding some opportunities? And one interesting theme that's a bit different from your history, too, is that you've been going to non-U.S. issuers who are issuing in U.S. dollars. Can you talk about why, and some examples?

Emery: Yes. So all of our bonds are U.S. dollar-denominated, and we're talking about foreign issuers that are issuing in U.S. dollars. We've invested in these issues throughout our history, but we've generally stayed somewhat close to home with Canadian issuers and supernationals.

Since the financial crisis, actually, you've seen yield premiums widen dramatically in certain segments. So anything exposed to the eurozone, U.K.-related banks, for example, and so we found some very interesting investment opportunities there in the U.K. Banks such as Lloyds, Barclays, HSBC, RBS, and then in certain industrial names like Telecom Italia and Lafarge.

This year, using our team of analysts that do both equity and credit research for us, we found some other opportunities. We bought the bonds of Petrobras, which is the largest oil producer in Brazil, the largest company in Brazil, has 67% ownership by the Brazilian government, which we think is a positive. We think that they continue to support this company, given the importance to their economy. They also enjoy low-cost financing from a Brazilian development bank for 25% of their funding.

So we think that you have strong fundamentals at an attractive valuation that we hadn't seen historically. Their bonds trade at a historically wide level versus the Brazilian sovereign, for example, and also add an elevated level relative to other energy companies. The reasons for that are that they've taken on more leverage in order to do more deepwater drilling, which is a risker type of drilling. But our analysts ultimately were able to get comfortable with that, because of the strong technology expertise that they have and their success in this over time.

Another investment that we made was in Export-Import Bank of Korea (KEXIM). We brought intermediate bonds. Those bonds were trading at an elevated level. KEXIM is 100% owned by the Korean government. Export-import is a very important part of their overall economy. So we think it's an important entity for them. The bonds became elevated in their yield premium because of various concerns--concerns around North Korea, concerns about their loan book mix, and so we thought that there was a compelling entry point where the bonds were trading at historically wide levels. We stayed with intermediate bonds, and we've seen those bonds improve dramatically this year in terms of their relative pricing.

Sjoblom: Great. Thank you, Dana, for joining us today and sharing your thoughts.

Emery: Okay. Thank you for having me.