Dodge and Cox: Views on Fixed Income Markets

We recently received the periodic report for the quarter ended June 30, 2014 from the managers at Dodge and Cox Income Fund (DODIX), with $28 billion of NAUM and a performance record built on a long-standing investment process, a well defined process of internal employee development and portfolio manager succession, and a tradition of all the partners putting their money in their own stable of funds.

DODIX outperformed its benchmark, the Barclays U.S. Aggregate Bond Index by 70 bp, with the fund generating a total return of 4.6% for the six months ending 6/30/14.

"Demand rose for U.S. Treasuries which as a sector returned 2.7% in the first half, reflecting growing expectations that the Federal Reserve will raise the Fed funds rate at a slower pace compared to previous tightening cycles. with a lower end target."

So, with the new paradigm of Fed Presidents and the Chair thinking out loud about monetary policy philosophy, tools and targets, this is how savvy, conservative, low turnover fixed income managers interpret the Fed's future policy pathway unfolding.

It is hard to understand a fundamental, economic case for tightening in 2015.  Indeed DODIX managers wrote about, ",,,the somewhat confounding environment of the first half of 2014--with a brightening macroeconomic outlook coinciding with rates declining to one-year lows--we reversed the duration extension of mid-2013."

The managers believe that the market rate structure fails to incorporate "the more positive underlying fundamentals of the U.S. economy or the possibility that Fed policy could deviate from the glacial pace of tightening currently reflected in market expectations."  We'll have to see whether this is true or not, but the folks at Dodge and Cox are always worth listening to.

This fund made a brilliant move several years back when they positioned the fund massively over weighted corporate credits relative to the benchmark, with the issuers' strong cash flows, clean balance sheets, and strong management teams providing equity-like returns early in the economic recovery.

Today, they are making a more nuanced comment about corporate credits.  DODIX has been reducing the corporate sector weighting on an issuer-by-issuer basis while shifting the sectoral composition of corporate credits away from Financials, for example.  With regulators making comments about mega-banks "choosing" to get smaller, this rebalancing might be very prescient.

Mega-cap, global technology companies are outdoing each other with big share repurchases and rapid dividend increases.  We've written many times about the formulaic, value insensitive manner in which these buybacks have proceeded.  Dodge and Cox fund managers write, "This (higher amounts of leverage at a low cost) is a source of down side risk for holders of investment-grade corporate bonds."  Further, they write that credits pruned from the portfolio will include those companies which "are likely to alter their capital structure in a manner adverse to current bondholders." (read buybacks and other financial engineering)