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Among the Best Bond Funds

Gold-rated Dodge & Cox Income's relatively patient and at-times contrarian approach has rewarded investors.

The following is our latest Fund Analyst Report for Dodge & Cox Income DODIX

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

This strategy stands out for its relatively patient and at-times contrarian approach to investing. The nine managers, who average 21 years of experience, start with an investment horizon of three to five years. 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. As credit markets sold off and corporate valuations plunged over the end of February and March 2020, the team quickly took advantage. In addition to being very active on the new-issue market, the managers took a 3% position in credit derivatives and an exchange-traded fund to boost corporate exposure to 38% at the end of first-quarter 2020 from 34% in December 2019. As the they deployed capital in names like McDonald's, Coca Cola, T-Mobile, and Home Depot, the positions in credit derivatives and the ETF melted to 30 basis points, but the corporate stake rose to 45% by June 2020.

This tilt toward corporates has made this strategy more sensitive than peers to credit market swings, and its at-times contrarian approach can be a drag on its relative performance. For instance, during the 2020 credit sell-off from Feb. 20 through March 23, the strategy's 6.9% loss lagged its Bloomberg Barclays U.S. Aggregate Bond Index and its typical intermediate core-plus bond peer by 70 basis points and 592 basis points, respectively. However, the team has demonstrated strong security-selection skills, and its willingness to take advantage of market corrections has served investors well: The strategy's 5.1% 15-year annualized gain through September 2020 topped over two thirds of its distinct peers, and its volatility-adjusted return--as measured by Sharpe ratio--landed in the best quintile of its Morningstar Category.

Process | High The strategy's long-term approach and deep analytical focus separate it from peers, earning it a High Process Pillar rating.

The 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 Bloomberg Barclays U.S. Aggregate Bond Index while minimizing the risk of loss over that stretch. They 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 in corporates and agency mortgages, as well as a 10%-plus stake in high-yield debt at times. The portfolio's corporate allocation 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 it does use a modest amount of Treasury futures to manage the portfolio's duration.

People | High Dodge & Cox's fixed-income investment policy committee serves as the management team for this fund. Its nine members count 21 years of average experience, and most have spent the bulk of their careers at the firm. Together with an experienced and stable research team, it supports an upgrade of the People Pillar rating to High.

Research on the strategy's corporate holdings is the shared responsibility of the firm's large 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' structures, covenants, and valuations. A team of dedicated credit traders provides feedback on execution and identifies particularly attractive bonds within an issuer's capital structure. The firm argues that cooperation between the equity and fixed-income teams helps differentiate the strategy 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 of more than 10 people 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 strategy has modestly added to bonds issued outside the United States.

Parent | High Dodge & Cox is a standard bearer in asset management, earning the firm a High Parent rating.

Many of the 89-year-old firm's strengths are deeply entrenched. Its measured lineup consists of only six strategies: three in equities, two in fixed income, and a balanced fund. All are rooted in the firm's patient, contrarian, and value-oriented investment philosophy. Five committees, made up of senior leaders and rising stars, make portfolio decisions in a structure that minimizes key-person risk. The investment staff is steeped in the firm’s culture, with most members having spent their entire careers at Dodge & Cox after training at some of the nation's most prestigious business schools. The employee-owned firm puts fundholders first, offering only no-load share classes with competitive fees and closing funds to protect their investment style.

A generational leadership change is likely in the next few years, but Dodge & Cox has its house in order. Key leaders, such as chairman and CIO Charles Pohl and director of research Bryan Cameron, are in their early 60s, and the firm's owners must begin cashing out their stakes at age 65. As it has in the past, the firm has named capable successors who have plenty of time to learn the ropes. Such transparency and foresight are reassuring. Dodge & Cox remains an exemplary firm.

Price It's critical to evaluate expenses, as they come directly out of returns. The share class on this report levies a fee that ranks in its Morningstar Category's cheapest quintile. Based on our assessment of the fund's People, Process, and Parent Pillars in the context of these fees, we think this share class will be able to deliver positive alpha relative to the category benchmark index, explaining its Morningstar Analyst Rating of Gold.

Performance A tilt toward corporates has made this strategy more sensitive to credit market swings. As corporate bonds struggled between June 2015 and February 2016, the strategy lagged its Bloomberg Barclays U.S. Aggregate Bond Index and close to 90% of its intermediate core-plus bond peers. On the flip side, it rebounded sharply, turning in a particularly strong performance in 2016, as many hard-hit names like Pemex and Petrobras came roaring back. Similarly, the strategy underperformed almost two thirds of its (distinct) rivals between Feb. 20, 2020, and March 23, 2020, but rebounded better than 75% of them through mid-October as corporate credit rallied.

The strategy's long-standing shorter-than-benchmark duration makes it less sensitive than its competitors to changes in interest rates. This structural stance helps it hold up better than its benchmark and most peers when rates spike but also leads to relative underperformance when rates are falling. For instance, after adding significantly to relative returns in 2018 when rates were rising, the strategy's underweighting in duration hampered relative returns over the first quarter of 2019 as Treasury yields plunged.

Over the long haul, patience, a focus on fundamentals, and topnotch corporate credit selection have paid off. The strategy's trailing 15-year volatility-adjusted return--as measured by Sharpe ratio--landed in the best quintile of its category.

Portfolio The managers' focus on yield has translated to a long-standing overweighting in corporates relative to the Bloomberg Barclays U.S. Aggregate Bond Index, 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. For instance, the team took advantage of the energy-led sell-off in corporates to add to particularly hard-hit names in this sector, bringing the fund's exposure to corporates up to 48% as of March 2016 from 38% as of September 2014. As energy prices stabilized and corporates rallied, the team gradually reduced this position to 34% as of June 2018, its lowest level since March 2008. Similarly, the team was quick to take advantage of the sell-off that occurred in 2020 between Feb. 20 and March 23. In addition to being very active on the new-issue market, the managers boosted corporate exposure from 38% at the end of 2020's first quarter to 45% by June 2020.

The rest of the portfolio includes Treasuries and securitized debt predominantly rated AAA. Mortgage pass-throughs and Treasuries are typically used as dry powder, so their weight in the portfolio is inversely correlated to corporate valuations. For instance, combined they represented 46% at the end of 2019 but only 33% at the end of June 2020.

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