The following is from a new ‘mini’ white paper from Dodge & Cox income fund, where the managers discuss finding value in the fixed income sector. Dodge & Cox is finding value in European corporate debt it seems. Below is the full letter.
U.S. investment-grade corporate bonds have performed extremely well over the past 18 months, returning over 12% and strongly supporting absolute and relative returns for the Dodge & Cox Income Fund (the “portfolio”). Following this impressive run, the new valuation dynamic and broader market environment leave investors facing a different opportunity set in 2013. We have made a number of incremental changes to the portfolio strategy over the past twelve months in light of these factors. That said, we have confidence in the long-term return prospects for the corporate bond investments in the portfolio. Our investment approach, rooted in deep fundamental analysis of individual issuers, close study of security terms, and a long-term investment horizon, provides us with confidence despite the fresh challenges and risks we face in the evolving market environment. We will explore these topics in greater detail in the following paragraphs.
Corporate Bond Valuations Are Fuller, but Opportunities Remain
Corporate bond yield premiums have narrowed substantially since the height of the financial crisis and over the past twelve months and are near their long-term medians. At the same time, absolute yields for investment-grade corporate bonds are now at record lows. In addition, as illustrated below, yield premiums for Financial Institutions (where we maintain a large overweight across portfolios) were approximately twice those of Industrials as recently as 18 months ago; they are now essentially equal.
These valuation changes leave many investors questioning whether current valuations are justified by the fundamentals, and also whether corporate bonds remain attractive long-term investments. We believe the answer to both questions is yes. Despite the strong recent performance and fuller valuations for corporates generally, we believe that the portfolio’s corporate investments continue to offer attractive long-term value.
Credit fundamentals have strengthened generally since 2008, despite macroeconomic headwinds. In the Industrials sector, balance sheets are strong by historical standards: liquidity is high, leverage is low (both as a percentage of EBITDA and of total capitalization), and the amount of short-term debt has declined. These improvements, largely a byproduct of improving profitability and more conservative leverage philosophies of issuers post-crisis, provide some comfort that credit risk is relatively low and therefore justify lower spreads. A similar story exists for Financial Institutions, particularly systemically important financial institutions (SIFIs). Since 2008, bank capital ratios, liquidity and credit quality have been steadily improving, especially in the United States and the larger Eurozone countries, due to various regulatory reforms enacted since the crisis. While valuations have caught up with these improved fundamentals to some extent, yield premiums remain higher than long-term medians and continue to offer an attractive return versus Treasuries.
Rigorous fundamental credit analysis drives individual security selection at Dodge & Cox. In our search for individual investment opportunities, we focus primarily on the investment grade corporate sector but also invest in high-yield and emerging market credits on a limited basis. We invest with a long-term investment horizon, utilizing a rigorous fundamental research process and a strict valuation discipline, with the goal of constructing a diverse portfolio that will produce above-market returns over a three- to five-year time frame. Sector exposures are the result of our bottom-up issuer selection process.
We begin our credit assessment of individual investment opportunities by looking at the economic and industry factors that affect a company. We then explore a number of issuer-specific factors, including the company’s operating position, capitalization philosophy, legal structure, and financial flexibility. Our process emphasizes downside analysis in the event that an issuer experiences a challenging operating environment or a liquidity event that could impair its ability to service its debt. In the case of financial institutions in particular, a good understanding of the regulatory landscape and the risks to bondholders under recovery and resolution regimes is also critical. Our 25 industry analysts, who conduct research on a global basis across our equity and fixed income strategies, provide important insights into individual issuers and industries. Their knowledge and experience, combined with the analysis conducted by our fixed income analyst team, provide an important advantage as each investment is closely scrutinized by a large team of investment professionals.
Our fixed income team also closely evaluates security terms and protective covenants that compensate bondholders if voluntary degradations in credit quality occur. We often seek protections, prior to making an investment, in the form of change-of-control puts (which allow bondholders to sell their bonds back to the issuer if a takeover occurs that results in a below-investment grade rating) and step-coupons (which require higher interest payments if the bond issuer is downgraded). We have invested in securities with these features in recent years, including Macy’s, Legg Mason, and Lafarge. Our investment approach, which facilitates opportunity recognition, also serves as an important risk mitigator— a crucial consideration especially in today’s environment of low interest rates and growing idiosyncratic / event risk.
Adjustments to Portfolio Strategy in Response to Changing Valuations and Risks
We adjust the portfolio’s exposures in response to changing fundamentals and/or relative valuations. The area of greatest change in recent years has been in financial institutions. We raised our core target weighting in banks from under 3% at the end of 2006 to over 11% in 2012 to capture compelling valuations in this area. We have since reduced this weighting to 9% in light of valuations that more fully capture the fundamental improvements of the sector at this point and new risks introduced by regulatory reforms. All of these changes were made on a bottom-up basis as we identified specific companies and securities that in our opinion offer a more attractive risk/reward profile.
Following the strong recent credit rally, we have examined the portfolio’s positioning and made a number of incremental changes with the goal of increasing the quality of the portfolio’s holdings (either by rating or by sector) without sacrificing yield. Despite fuller corporate bond valuations, we continue to believe that the portfolio holdings offer compelling value versus Treasuries (as noted earlier) and also relative to mortgage-backed securities (MBS). Though we have a favorable view of certain securities in this sector, our enthusiasm for a higher MBS weighting relative to corporates is tempered by the potential for cash flow volatility in an environment where rates may rise and where government policy is focused on increasing refinancing opportunities for borrowers. Furthermore, our analysis indicates that corporate bonds can substantially outperform Treasuries, even assuming unchanged spreads and Treasury yields and a repeat of the worst corporate default rates in the modern era.
Challenges Exist for Corporate Bond Investors…but Opportunities Remain
Event Risk – Low interest rates and strong demand for corporate bonds can be a toxic combination for corporate bondholders. For industrial companies, management teams may increase debt leverage through, among other things, large dividends and share repurchases, increased acquisition activity or, in the extreme case, a debt-financed sale of the company. Increased leverage can result in higher fixed charges, reduced ratings, and poor bond performance. We regularly examine the portfolio for these risks and trim positions when we think the likelihood of credit destructive behavior is too great.
An example of the damage that can be done to investment-grade bondholders is the recent Dell leveraged buyout (LBO) proposal. Dell bonds were A-rated and its long bonds traded at a spread of about 240 basis points above Treasuries at the end of 2012. As a result of the proposed LBO, 2040 maturity Dell bonds traded at a spread of 380 basis points over Treasuries at March 31, 2013. The total return for those securities in the first quarter of 2013 was -18%. With the Barclays U.S. Aggregate Bond Index yielding 1.9%, events such as these can meaningfully detract from performance. We do not hold Dell bonds in the portfolio, and we avoid bonds of industrial companies with low enterprise valuations, modest debt loads, and no bondholder protections, especially where we believe management’s commitment to an investment grade rating is unclear. It is worth noting that the long-dated Dell bonds do not contain a change-of-control put, which would have reduced the downside for bondholders considerably.
Regulatory Risk – Laws have been changed here and in Europe to address the issue of “too big to fail” which most significantly impacts SIFIs. Bondholders are likely to bear losses in future bank restructurings (we have already seen this in Europe), and junior parts of the capital structure are first in line. In response to this risk, we have “stress tested” our bank holdings to understand whether they would have sufficient liquidity and capital to meet regulatory standards and stay solvent in the event of another financial crisis. In constructing the portfolio, we examine the asset quality, capital base, sources of liquidity, and regulatory landscape for each of the portfolio’s holdings. We also engage with regulators to make sure we understand the likely application of government polices and the effect those policies could have on our holdings. Our analysis of the new risk/reward dynamic has led us to exit our portfolio positions in a number of institutions, including Barclays and Lloyd’s, and to reduce positions in other holdings.
Systemic Risk – We also assess broader, macro-level risks in constructing the portfolio. The fiscal crises affecting many of the peripheral nations in Europe has increased the credit risk profile of many sovereign obligors and corporations situated in those countries. Recent strides made by European policymakers to protect against extreme outcomes (primarily through European Central Bank lending programs) have strongly influenced credit performance in the Eurozone in the past year. Although challenges remain—illustrated by the recent experience in Cyprus—and a disorderly exit of a major Euro participant would likely be very destabilizing for all risk markets, opportunities exist to invest in providers of essential products/services with valuable assets and sources of financial flexibility.
We leverage our global industry analyst resources and macro/sovereign capabilities to identify creditworthy U.S. dollar denominated, internationally domiciled companies that are in many cases trading at attractive levels due to sovereign pressures. This has been an area of opportunity for us in recent years and our non-U.S. weighting in the portfolio has increased from 2% in 2008 to 9% as of the end of the first quarter of 2013. Recent new investments include Enel (ENEL), Petrobras (PBR), and Telecom Italia (TI.A).
In summary, we believe corporate bonds offer attractive returns compared to many fixed income investment alternatives, due to improving issuer fundamentals and reasonable incremental yield offered compared to long-term averages and relative to other broad sectors. As with our equity strategies, we construct the portfolio on a bottom-up basis utilizing a process that evaluates both opportunities and the downside risks that could most negatively impact fixed income investors (particularly, event risk and regulatory intervention). While risks have increased, we believe that our rigorous research process and diverse portfolio composition provide important protection for the portfolio in this environment. We have found—and continue to seek—attractive opportunities within the corporate sector as the market environment evolves.