Shifting Dynamics in the Bond Market

Miriam Sjoblom: Hi, I am Miriam Sjoblom, associate director of fund research at Morningstar. I'm here today with Tom Dugan, who is one of the portfolio managers of Dodge & Cox Income.

Thanks for joining us today, Tom.

Tom Dugan: Thanks, nice to be here.

Sjoblom: So, Tom, 2012 was a really fantastic year for the corporate-bond sector, investment-grade and high-yield corporates, and corporates are really a significant part of your portfolio. Can you talk a little bit about what was driving performance last year?

Dugan: Sure. As you mentioned, it was very a strong year for corporate bonds, and in fact most of the return generated in the bond market came from the corporate sector and certainly in the case of Dodge & Cox Income fund. The key attributes for the corporate-bond performance in 2012, you have to start with valuations, and corporate bonds entered 2012 with very inexpensive, very compelling valuations.

So, that in combination with a modestly growing economy and some very supportive policies by central banks and policymakers across the globe, created an environment for corporate bonds to do really strongly, and that's what happened. So, many of the most significant contributors to overall bond market returns, and particularly returns for the Dodge & Cox Income fund, were from the corporate sector.

We favor corporates and came into 2012 with a very significant overweight to that sector, almost 50% of the portfolio versus about 20% for the overall bond markets, so a lot more corporates in the Dodge & Cox Income fund. So, we did well because of how well corporates did and simply having more.

On top of that, one of our major focuses within the corporate-bond sector was on bank bonds, and that is a subsector of the corporate area that really had the strongest performance of all. Some of our individual holdings had returns in the 20%-30% range in 2012.

That was an area that was badly beaten up in the second half of 2011. Their valuations become very inexpensive. We retained a lot of confidence that these were good credits. We added in periods of weakness, and 2012 ended up being a pretty rewarding year for owning bank bonds and then obviously owning corporates in general, as well.

Sjoblom: Well, now that corporates have performed so well and the yield spreads on corporates over Treasuries have come in significantly. Do you think there is still significant value in the corporate sector?

Dugan: Yes. We have kept our overall corporate weighting roughly similar. We make adjustments on an ongoing basis in terms of the composition, but we still find corporates relative to the alternatives--Treasuries and mortgage-backed securities and other for instance, assets-backed securities--we think they remain one of the more compelling alternatives in the investment-grade bond space.

What you bring up, though, is an excellent point. The valuations are not as compelling as they were at the beginning of 2012. They have gone from very, very inexpensive, in our opinion, to much closer to reasonable, but we still think that the corporate bond investor was well rewarded for taking credit risk. What we do at Dodge & Cox, one of our key and unique attributes, is the reunderwriting of every corporate issue that we invest in.

So we don't own the overall corporate bond market. We own 45 or 50 individual corporate issues that we believe in their credit worthiness, we understand their businesses. So that's different than having an opinion about the overall corporate bond market. These 50 issuers that we're invested in, we have a lot of confidence in, we think the valuations still remain in pretty good shape, albeit not as cheap, certainly as they were to be in the year 2012.

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Sjoblom: We talked a little bit earlier about how it's been a good few years for corporate-bond investors. The companies have been sort of managing for the benefit for corporate bondholders. Do you see that dynamic shifting? What is the risk that your team is particularly focused on?

Dugan: I think that is sort of a growing risk. As you mentioned, many companies have adopted very conservative policies since the crisis and since the recession in 2008 and 2009. They have built up their cash positions and maintained big liquidity. They have really focused on very solid balance sheets and done a lot of things that we as bond investors would applaud.

Now as they develop more confidence in the economic recovery, as the memories of 2008 and 2009 begin to recede, it doesn't seem like a huge leap to assume that corporate managers may become a little more offensive and a little more aggressive in how they are thinking about things. That could come to the detriment of corporate bondholders. Things we might worry about are for instance in the news lately a leveraged buyout at Dell.

LBOs haven't been much of a worry since before the crisis. But that's something that we have our eyes on, and we regularly scan the portfolio and do analyses to get a feel for whether any of our individual holdings might be susceptible to an LBO. But there are other less dramatic things than LBOs. Companies can repurchase a greater number of shares. They can issue more debt. They can be more aggressive in terms of mergers and acquisitions, hiring, and capital expenditures.

So we watch all these things on the individual credits that are in the portfolio, and we think they bear watching. I think that this turn in sentiment is probably likely and will play out over the next couple of years.

Sjoblom: I've heard some managers talk about the sort of sluggish pace of growth in the economy as a reason to avoid talking a lot of credit risk. Are there areas where Dodge & Cox is more optimistic about taking credit risk?

Dugan: Absolutely. I mentioned we are still very optimistic about banks, and that's an area of a really secular improvement in credit worthiness since the crisis. You've seen extraordinary increases in liquidity, in capital, and in adhering to really solid underwriting practices. We think that trend continues. That's an area where we have a significant overweight.

There are other areas of the corporate market that we favor, as well. We own significant holdings in the cable companies--there are very stable dependable cash flows there--and in other areas, as well. So generally the corporates remain relatively attractive, and we continue to find individual opportunities.

A last area where we've grown some of our exposure off late is in companies that are domiciled outside the U.S. Now we are only investing in U.S. dollar-denominated issues, so these are companies, global companies, that issue debt in U.S. dollars. So, the expanding reach of our group of industry analysts has really opened up some new playing fields, and we have incorporated this growing reach into the kind of companies we can get to know, get to appreciate, and invest in their debt. Some recent examples might be the Brazilian oil producer Petrobras as well as the Export-Import Bank of Korea.

Sjoblom: In recent years there's been a phenomenon in the market, this risk-on/risk-off as the market gets concerned about systemic risk. You might find corporate bonds selling off which is partly why corporates did so well in 2012--they were recovering from fears over the eurozone crisis. Looking ahead, do you think there is still potential for systemic shocks out there, or has that lessened?

Dugan: I think there's always the possibility, but I think what you say is true. I think the probability certainly from the eurozone of the worst-case scenario is lower than it was, for example, a year and a half ago. The European Central Bank took very significant steps last year to take what we think is the worst-case scenario--basically an implosion of the eurozone as an economic entity--off the table, and I think markets reacted very, very favorably to that.

The base-case outlook for the eurozone is not a great one, but investors can get more comfortable with the knowledge that perhaps the worst-case outcome is significantly less likely now. So, I don't think we've seen the end of overall systemic risk. There will continue to be issues as we move along through the years and through the decades, but certainly that systemic risk seems to be lower than it was before.

See the continuation of this interview here.