Thursday, June 11, 2009

It Beats The Talking Heads

I don't listen to any cable talking heads about the equity or credit markets. I prefer to keep up with active, market participants who've proven their approach over many market cycles. The folks who run the Dodge & Cox Income Fund recently issued their first quarter report, and it makes for instructive reading.

I'm not writing this note as any form of investment advice, and I am a shareholder in this fund, so please note these caveats. I used to provide sell side research to the equity side of Dodge & Cox many years back, and I've always been impressed by their sobriety, structure, and the fact that all the key personnel are heavily invested in their own funds.

DODIX outperformed its benchmark, the Barclay's Capital Aggregate Bond Index (BCAG) by 14 basis points in the first quarter, but the sources of the outperformance were interesting. This fund has a long-standing bet on corporate bonds from quality institutional issuers; the fund is 46.7% weighted in corporate bonds versus 17.4% for BCAG.

The fund overweighted relative to BCAG in Financials, and this dragged their performance down, as Citigroup, Bank of America, and GMAC were particularly weak. The bond performance, together with the ongoing news from Citigroup, probably signals that the company is a true basket case and will be a continuing ward of the state. Dabbling in the equities of financials, which some value investors are doing will probably be limited to a relatively few names, of which Wells Fargo is most often heard, with even Warren Buffett talking his book.

Mortgage backed securities, measured by the Barclay's Capital US MBS Index, returned 2.2% in the first quarter. Asset backed securities measured by the BC ABS Index returned 7.6% in the quarter. So, Bill Gross's long avowed strategy of "shaking hands with the government" seems to working for this fund too.

The corporate index yield premium to Treasuries was near its all-time high at the end of the first quarter. For us, a significant downward movement in this spread has to proceed a meaningful, sustained movement in the broad equity market, and this is not what was seen. The first quarter spread was 543 basis points versus 97 basis points in the first quarter of 2007. Liquidity is still so poor in the high quality, corporate aftermarket that the fund was able to increase its weighting solely through buying new issues. This is not a sign of a healthy credit market either.

Talking to corporate treasurers and CFOs we know indicates that banks are content to enjoy record margins and garner fee income where they can. Lending terms and coverages are significantly tighter than six months ago, even for firms with cash and strong collateral. Again, it's hard to understand what equity markets would be excited about if the fundamentals of the credit markets are still bifurcated and illiquid.

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