A Bond Fund to Be Thankful For

The following is our latest Fund Analyst Report for Dodge & Cox Income DODIX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

An experienced team, a thoughtful long-term approach to investing, and an attractive price tag support Dodge & Cox Income's Morningstar Analyst Rating of Gold.

This fund stands out for its relatively patient and at-times contrarian approach to investing. The fund's managers, who average 22 years of experience, start with a time horizon of three to five years in evaluating investments. They tend to favor corporates, noting that the yield advantage offered by these securities is an important contributor to total returns over time, and run a fairly compact, mostly cash-bond portfolio.

The managers are also not afraid to go against the crowd when they're confident in their analysis. So, for example, as plunging energy prices took a toll on corporate valuations in 2014 and 2015, the team built its corporate stake to a near-historic high of 46% of the portfolio as of December 2015, adding to positions such as the hard-hit energy company Kinder Morgan and an asset-backed security tied to the Brazilian oil company Petrobras. These names subsequently rebounded sharply, as energy prices stabilized and--in Kinder Morgan's case--companies repaired their balance sheets. By September 2017, the team had reined in the fund's corporate exposure to 37% of the portfolio, citing relatively rich valuations.

The fund's corporate focus and at-times contrarian approach can leave it out of step with its index and peers, as can a duration that has historically run short of its Bloomberg Barclays U.S. Aggregate Bond Index. For example, during the roughest stretch of the energy-led credit sell-off that ran from June 2015 through February 2016, the fund's 1.6% loss trailed close to 90% of its distinct peers. However, the team's demonstrated bond-picking skill and willingness to take advantage of market volatility to search out bargains has rewarded investors: The fund's 5.1% 10-year annualized gain through October 2017 topped roughly 80% of its distinct peers.

Low expenses only add to the appeal of this strong choice.

Process Pillar: Positive | Sarah Bush 11/16/2017 The fund's managers know what they're good at, and they stick to it. They invest with a three- to five-year investment horizon in mind, balancing the goal of outperforming the Aggregate Index with minimizing the risk of loss over that stretch.

The managers view income as an important driver of long-term returns, so they aim to assemble a portfolio that delivers more yield than the index. That has often resulted in overweightings to agency mortgages and corporates, as well as a 10%-plus stake in high-yield debt at times. The fund's corporate stake is where much of its risk resides. The managers concentrate that corporate exposure in around 50 issuers. They aren't afraid to court controversy with their picks: The team bought Wells Fargo debt in 2016 against the backdrop of that company's fraudulent account scandal.

That corporate emphasis plays to the strengths of the firm's extensive industry research resources. An often-sizable stake in U.S. government-backed agency mortgages also counterbalances the fund's credit risk. The team doesn't get fancy with more-esoteric structured products or currency plays, though the managers do use a modest amount of Treasury futures to manage the fund's duration.

Overall, the fund's long-term approach and deep analytical focus separate it from peers, earning it a Positive Process Pillar rating.

The fund's focus on yield has translated to a long-standing overweighting to corporates relative to the Aggregate Index, with this stake typically running between 30% and 50% of the portfolio. That said, the team's value discipline has shown in adjustments to this stake over time. During mid-2014 and into 2015, for example, the team was quick to take advantage of the energy-led sell-off in corporates to add to particularly hard-hit names, such as Kinder Morgan. The fund's exposure to corporates climbed to 46% of the portfolio as of December 2015, up from 40% as of mid-2014. Then, as energy prices stabilized and corporates rallied, the team gradually reduced this position to 37% as of September 2017.

The remainder of the portfolio typically includes a slug of agency mortgage-backed securities, which stood at 34% as of September 2017, up modestly over the trailing year. The fund's allocation to U.S. Treasuries, meanwhile, stood at 16%, near the high end of its historic range. The portfolio was rounded out with allocations to asset-backed securities (3%), sovereign and quasi-sovereign debt (2%), and an allocation to taxable munis (4%).

In contrast to its at-time aggressive allocations to corporates, the team has generally taken a cautious approach to interest-rate risk. As of September 2017, duration was 4.2 years versus 6.0 for the index.

Performance Pillar: Positive | Sarah Bush 11/16/2017 A tilt toward corporates has helped this fund flourish in strong credit markets but also left it vulnerable to losses in periods of economic weakness or flights to quality. So, the fund fell 1.6% between June 2015 and February 2016 as corporate bonds struggled, lagging the benchmark and close to 90% of its peers. But as the market quickly turned, the fund rebounded sharply. It turned in a particularly strong performance in 2016, as many of the names hardest hit in 2015, including Pemex and Petrobras, came roaring back; an overweighting to corporates and strong performance in several transportation names helped the fund to strong relative returns through the first 10 months of 2017.

The fund's long-standing shorter-than-benchmark duration makes it less sensitive than its competitors to changes in interest rates. As a result, it tends to hold up better than its index and the competition when bond yields spike, as they did during 2013's so-called taper tantrum and in the closing months of 2016.

Over the long haul, patience and a focus on fundamentals has paid off. The fund's trailing 10-year return of 5.1% beat 80% of distinct peers and outpaced the index handily. It also looked strong on a risk-adjusted basis, with a better-than-average Sharpe ratio over the same period. The fund earns Positive Performance Pillar rating.

People Pillar: Positive | Sarah Bush 11/16/2017 Dodge & Cox's fixed-income investment policy committee serves as the management team for this fund. Its members count 22 years of average experience and most have spent the bulk of their careers at the firm. Dodge & Cox has thoughtfully developed this team as the firm has expanded its investment universe, earning the fund a Positive People Pillar rating.

Research on the fund's corporate holdings is the shared responsibility of the firm's sizable and experienced team of industry equity analysts, who run financial models and assess industry trends, and a five-person credit analyst team charged with evaluating individual securities' structure and covenants, and assessing valuations. A team of dedicated credit traders provides feedback on execution as well as identifies particularly attractive issues within an issuer's capital structure. The firm argues that cooperation between the equity and fixed-income teams helps differentiate the fund because the fixed-income team can hear a more open conversation with managers about plans to declare dividends, buy back shares, or make acquisitions, all of which affect a firm's bonds.

Another experienced group runs the fund's agency mortgage, government, asset-backed, and taxable muni stakes. Three global bond analysts were added in recent years, as the firm and this fund added to bonds issued outside the United States.

Parent Pillar: Positive | 10/09/2017 Dodge & Cox is an exemplary firm and earns a Positive Parent rating.

The firm, based in San Francisco, benefits from a strong investment culture. CEO and president Dana Emery and chairman Charles Pohl are also lead members of the investment team; they run both the firm and its funds with a long time horizon.

But there are no stars here. Each fund is run collaboratively by one of five investment policy committees, whose members average more than 20 years at the firm. Moreover, the analyst ranks are broad and deep, with impressive levels of experience. In all, the firm has approximately 60 managers and analysts, most of whom are Dodge & Cox lifers. Indeed, team members rarely leave for any reason other than retirement.

Dodge & Cox’s approach to new strategies is also admirable, having rolled out just six since its 1930 founding. The most recent is a global fixed-income offering that launched in May 2014; the firm developed its foreign-bond capabilities as a natural extension of its international-equity expertise. Management has also proved willing in the past to safeguard its strategies by closing funds.

Managers are heavily invested in the funds and the firm and have ample incentive to serve shareholders, as evinced by low costs, clear communications, and a sober long-term approach. In all, the firm is built to last.

Price Pillar: Positive | Sarah Bush 11/16/2017 The fund's 0.43% annual expense ratio falls into the cheapest quintile of no-load intermediate-term-bond peer group and earns the fund a Positive Price Pillar rating.