Dodge & Cox Funds fixed income mid-year review.
Dodge & Cox Funds 2015 Fixed Income Mid-Year Review – Transcript
Tom Dugan: So Dana, let’s discuss fixed income markets in the first half of 2015, particularly the factors that influenced returns that bonds generated over this time period. And secondary of interest, particularly among our clientele and other market participants, is interest rates generally as well as the state of credit markets, which have been quite dynamic lately. So how would you characterize fixed income markets over the course of the first half?
Dana Emery: The first half of 2015 was a tough environment for fixed income as interest rates rose and returns were essentially flat. But it’s really a tale of two quarters. The first quarter was characterized by very negative economic growth, declining interest rates, and very strong returns from fixed income securities. And then that was essentially reversed in the second quarter as economy improved, interest rates rose, and there were significantly negative total returns in fixed income. It was a period where ten-year Treasury rates during the second quarter rose to almost 2.4% by quarter end, so a significant rise and negative price movements associated with that. In addition, the market began to price in an increase in federal funds target rate later this year. Interest rate volatility picked up significantly over a very benign volatility environment last year. Some of this was due to concerns about Greece potentially exiting the Eurozone, concerns about a China slowdown and the feed-through into global economic growth due to their frothy equity markets. In addition, the oil prices declined precipitously earlier this year and seemed to languish. And then the dollar was very strong and the impact of that on economic growth is of concern. We saw the credit markets reprice significantly over the past year. The basis points premium over Treasuries increased by about 50%, so up to 150 basis points by quarter end. That was due to a releveraging of corporate America moderately as well as M&A activity and a lot of that was debt financed. And we also saw a mix shift, that banks are issuing a greater percentage of subordinated bank debt in order to get ahead of impending Dodd Frank legislation. The mortgage market, which is a significant component of the broad investment grade bond universe, performed very well relatively due to their high quality, their short duration, and a relatively benign prepayment environment.
Tom Dugan: With that market backdrop, the Dodge & Cox Income Fund produced a small positive return, about ten basis points, and the broad market a small negative return, minus ten basis points. There are really four key factors driving some of that relative performance advantage. The first is on interest rate risk we are more defensively positioned, vis-à-vis interest rate risks. And what that means is that as rates rise the portfolio doesn’t do as poorly as the broader market and that was certainly the case over the first half of the year. Secondly, specific issues that we feature in the portfolio have relatively strong performance. Two Brazil related holdings, Petrobras and an asset-backed security called the Rio Oil Trust – these are U.S. dollar denominated bonds, of course – had really strong performance in the first half, bouncing back from a really weak second half of 2014. Two other corporate bonds had relatively strong performance: Cemex, the Mexico City headquartered global cement company, as well as Telecom Italia. A third area of relative strength was our agency-mortgaged securities. They had relatively strong performance versus their peers, particularly versus short and intermediate term Treasuries and corporate securities. And finally, the portfolios feature a yield advantage relative to the broad bond market and over the course of half a year, some of that yield advantage becomes income and that also provides a tailwind to performance. The most significant drawback to relative performance in the first half references your comments about the credit markets. They were quite weak in the first half of 2015. We feature a significant overweight to credit and that was a headwind to relative performance in the first half. So Dana, let’s turn to two areas of focus, both by questions we’ve received from our clients as well as broader market participants, and that is interest rates and the state of credit markets.
Dana Emery: We’ve been concerned about interest rate risk for quite some time and it’s something that we think we’re starting to see an indication that the Fed will increase their target fed funds rate at some point later this year. The market is very focused on this because that short rate can feed into expectations around longer rates and you have a much bigger price impact of rising rates on the long end of the market. The Fed has been starting to unwind their extraordinary policy that they’ve been following the last few years. Last year they ended their quantitative easing, although they’re still reinvesting in Treasuries and mortgages, and they’ve been starting to signal through their communication efforts that they’re getting closer to lifting off the zero bound. So the market is very focused on this. We are much more concerned about the pace of increases as well as the terminal or normal fed funds rate that could occur, and the market, as measured by the forward rate, is really pricing in a very slow pace as well as a lower terminal fed funds rate than even the Fed is projecting. So we get concerned that there could be a risk of a negative surprise in the marketplace, price declines associated with the market repricing towards the Fed views or even our own views, which we think are faster and a higher terminal rate than the market is pricing in currently. Drivers of higher rates in the future could be around the Fed tightening faster than expected, as well as stronger economic growth, both in the U.S. and globally, as these accommodative factors start to take hold, and also inflation expectations increasing off of very low levels. Given our concerns about the potential rise in interest rates and the low reward that you’re currently receiving in this low-rate environment, we’ve been positioning the portfolio defensively with respect to this risk. We have a shorter overall duration. We’ve been featuring more bonds that mature in short to intermediate timeframe and we’ve also been shorting U.S. Treasury futures as a way to mitigate some of the price effect of rising rates. So overall we have the portfolio positioned just over 70% of the duration of the overall market.
Tom Dugan: So Dana, before we turn to describing some of the goings on in the credit markets, I want to take a minute to describe our philosophy about credit investing. We do deep fundamental research and we use our global industry analyst team buttressed by a dedicated credit analyst team to do deep fundamental research on individual companies and industries. We have a long term investment horizon. We look at every investment through a three- to five-year investment prism and thirdly, we’re really focused on valuation: what are the market’s expectations as embodied by the price of the bond versus our expectations. Those are the three key tenets of our philosophy in terms of corporate bond investing. What we’ve seen recently, as we talked about, was much more interesting valuations than before. 50% wider corporate bond valuations. New valuations equals new opportunities and we’ve been quite busy in the corporate bond area of late. In fact, relative to nine months ago, our corporate bond weighting has increased three percentage points. Some of the areas we’ve been focusing on have been some sectors that have had the most turmoil and the most volatility. Energy and the metals and mining sector is an example. The price of oil dropped in half really over the course of the second half of 2014. This provided an opportunity to revisit and review some of the companies that have been repriced because what they produce is worth 50% less than it was before. An area of interest and a recent investment we’ve made is in the natural gas pipeline, what’s called the “mid-stream area,” and we’ve invested in Kinder Morgan, which is a dominant provider of this infrastructure that’s critical to our national energy infrastructure. Another area of recent interest has been new issuance of bond deals associated with large M&A transactions. 2014 was the biggest year for corporate M&A since 2007, and 2015 is at a pace for mergers and acquisitions that’s even higher than 2014. What often happens with these large combinations is a significant amount of debt needs to be sold to fund a portion of the acquisition price. This gives us an opportunity to review the combined entity and ask ourselves whether it’s a dominant provider and a dominant position and whether there’s a credible path to reducing that leverage that was incurred to fund the acquisition. Another example of this merger and acquisition related financing is that we purchased the debt of an Ireland based building products company called CRH. Two of their competitors, Lafarge and Holcim, have agreed to merge. As part of that merger, they were required to dispose of certain assets and CRH purchased those assets and raised debt to finance the purchase. So this is another opportunity that came about from these large scale M&A transactions that we’re increasingly seeing.
Dana Emery: In aggregate we think that credit conditions are still strong and that you’re being amply rewarded for credit risk in these environments. In fact, when you’re starting with a 150 basis-point premium, as we have in the current environment, if you look back at the past 25 years, when you’ve started with this yield premium, corporate bonds have outperformed Treasuries almost 100% of the time. So you’re getting spotted with a very nice valuation. Having said that, we are watching closely the changing attitude towards leverage by corporate America. You’re starting with very high operating margins and so there’s a prospect for those margins to deteriorate from here. So we’re definitely seeing a gradual change towards leverage in corporate America that bears watching. Having said that, we’re pretty heartened by the fact that M&A activity has been financed with a combination of debt and equity such that most of these companies have remained investment grade. In this type of environment, where we’re in a very low yield, relatively low reward environment, diversification becomes even more important, so we’ve been gradually increasing the number of issuers in our portfolio to lower that idiosyncratic risk that comes with individual credit positions.
Tom Dugan: So to summarize our discussion here today, it was a quite a choppy first half of 2015 for fixed income markets and the bond market produced a pretty negligible return overall. Interest rate risk continues to bear watching. We are defensively positioned for it and what that means from a go-forward position, from a go-forward perspective, is that intermediate term returns with the potential for rising rates and today’s low yields are going to be pretty modest. Finally, credit valuations are much more interesting. We’re very excited about some of these opportunities and believe that could be a real driver for relative performance on a go-forward basis. So Dana thank you for joining me today.
Dana Emery: Thank you, Tom.
Tom Dugan: And thank you for joining us.