Dodge & Cox Income Playing Defense Against Rates

Sarah Bush: Hello, my name is Sarah Bush. I'm an analyst with Morningstar, and today I'm here with Tom Dugan, who is associate director of fixed income at Dodge & Cox and a member of the investment policy committee there.

Thanks very much for joining me today, Tom.

Tom Dugan: Nice to be here, Sarah.

Bush: We're in a challenging environment for bond investors. Absolute yields are very low. We have just seen a huge rally in risk assets coming off of 2008 lows. In that context, we will talk just a little bit about where you're finding opportunities today, and I thought interest-rate risk and yield-curve positioning might be a good place to start.

Dugan: Interest-rate risk really rose to that fore in 2013. That may be the primary story about bond markets. People have talked about it for a long time: "When will interest rates finally go up?" And in 2013, they finally went up. We had a negative return for the broad bond market in 2013, the first since 1999 and the worst calendar-year returns since 1994. Overall, the bond market was down 2%.

The Dodge & Cox Income fund came out of 2013 with actually a positive return, slightly above zero. We managed those challenges pretty well, and the biggest factor in that was how we managed interest-rate risk. We came into the year defensively positioned, which is to say a portfolio that had less interest-rate risk and a lower portfolio duration than the broad bond market. And that protected the portfolio on average from the price declines that the index had, so it was very beneficial.

What is interesting, and of course, our interest-rate risk and duration strategy is an evolving thing, and as 2013 evolves--and rates did rise primarily in the middle part of the year--we always revisit that positioning. What we did was with rates higher, and in effect the yield give-up associated with featuring generally shorter, fewer interest-rate-risky securities in the portfolio became even higher, we thought was appropriate to move out our duration somewhat.

We remained defensively positioned overall. We're concerned about interest-rate increases from here even though we are quite a bit higher than where we were, for instance, in the summer of 2012 and in the spring of 2013.

Nevertheless on an unhistorical basis, interest rates remain quite low. We remain worried about it, and we're positioned for it. But there is less significance of a discrepancy between the Income fund's duration and the index duration that had lower levels of rates.

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Bush: Turning to sector selection for a moment, I know, financials have been a big theme within the portfolio for some time now. How are you thinking about that sector today?

Dugan: You're absolutely right. The financials have driven a lot of the incremental return we've generated for our investors over the course of the last five years. That was a very beaten-up sector in the wake of the financial crisis. That was effectively the nexus of concern in the corporate-bond world, and valuations cheapened considerably because of that concern.

We identified a significant move toward much higher creditworthiness in financials early on in that process and built up a very significant position. I believe the position went as high as 23% of the income fund, and over the course of the last three or four years, the gap between financial valuations and, for instance, Treasury yields began to narrow as financials did better and became more creditworthy and investors appreciated that creditworthiness.

As we look at it now, the two factors driving that significant overweight--one, a broad trend toward much better creditworthiness among the individual banks and insurance companies and other things that make up our financials weighting; and two, the significantly inexpensive valuations--we think the credit trend is still generally in place, that these entities by and large remain on a positive credit path.

But the valuation is not as compelling as it has been in the past. As you can see from the Income fund, we've begun to reduce our overweight in financials. I still think it's a good place to invest right now. The magnitude of our overweight is what has come down, respecting the fact that valuations aren’t as compelling as they have been in the past.

Bush: Another area that the team has sort of more recently been finding opportunities is outside of the United States. Could you little bit about what those opportunities look like and maybe a particular name that you found?

Dugan: Just a little bit of perspective, as recently as probably 10 years ago, there was very little in the Dodge & Cox Income fund as a percentage of the overall portfolio from non-U.S. issuers, and that has risen somewhat incrementally over the course of the last 10 years, call it, and is now over 10%.

There are a couple of factors that are driving that. First is our growing experience and expertise and depth of knowledge outside the U.S. And that comes from following non-U.S. companies since the '90s, investing in these companies, and for example, our international-stock fund which came into being in 2001, and just the building out of our research and understanding. So what we know and who we know has grown considerably outside the U.S. So that's a critical factor in what we bring into the portfolio. So that’s number one.

Point number two; in the post-crisis period, there've been a lot of geopolitical developments that have caused a lot of strain and a lot of uncertainty in different parts of the globe. This has resulted in valuation changes of a dramatic nature.

I think really those two factors have come together, our growing expertise and confidence in our ability to invest in non-U.S. issuers, though it's all still U.S.-dollar-oriented, and the opportunities that have been brought about by some of the macroeconomic and geopolitical uncertainty of the last five years are creating interesting opportunities.

A couple of examples come to mind from Europe, a continent that has had more than its share of geopolitical uncertainty in the last couple of years. There are some real slow-growing countries around the periphery that we found opportunities in, for example, Italy. Telecom Italia is an example; Enel, an enormous utility provider, not only in Italy, but Europe and elsewhere. And then in terms of a straight sovereign, the Kingdom of Spain is an issuer that we purchased in the first quarter of 2013.

Our expertise and our confidence in investing outside the U.S. has really enabled us to grasp some of these opportunities, and you've seen an incremental increase in the proportion of the Income fund's holdings that are actually from non-U.S. issuers.

Bush: Finally, I just wanted to talk a little bit, I know Treasuries are relatively small part of the portfolio today, but are there any other areas of the market that you're concerned about or avoiding?

Dugan: I think Treasuries is what probably jumps out at you, first and foremost, when you look at the Dodge & Cox portfolio, that is well over a third of the overall index, it represents a much smaller portion of what we do. We typically underweight the Treasury sector, and that remains in place and will vary over time.

Right now there are enough opportunities in credit generally and in mortgage-backed securities that we feel very comfortable having that significant gap between the benchmark's weighting in Treasuries and ours.

Another area of the market where [we have low presence] is mortgage-backed securities. Even though we have a significant commitment to agency mortgage-backed securities, about 35%, very little is committed to the low-coupon 30-year MBS that make up the majority of the index's mortgages, and that is by design. We think that for the amount of duration and some of the convexity challenges of those securities, there are better alternatives elsewhere, and almost all of our mortgages tend to be somewhat shorter, somewhat more seasoned, and somewhat higher-coupon than those.

So that's another area where we're not really present that makes up a not-insignificant portion of the benchmark. I wouldn't label them extremely risky; these are government-sponsored-enterprise-guaranteed. The GSEs are under conservatorship right now; we just don't find them that attractive.

Bush: Thank you, Tom, for joining us today. We really appreciate having you here.

Dugan: Great. It was really nice to be here.

Bush: For Morningstar, this is Sarah Bush.