U.S. Fixed Income Strategy—2023 Annual Investment Review

Alex: Welcome to Dodge & Cox’s 2023 U.S. Fixed Income Investment Review. I’m Alex Chartz, and I’m a Client Portfolio Manager. It’s my pleasure to introduce Lucy Johns, our Director of Fixed Income. Thanks for joining us, Lucy.

Lucy: My pleasure, Alex.

Alex: Over the next 20 minutes, we’ll review what transpired in markets last year, the Income Fund’s strong performance, including how we adjusted the portfolio to capitalize on the dynamic environment, and our outlook for fixed income and the Income Fund. Lucy, before we jump into specifics, what are the high-level takeaways?

Lucy: Well, it took some patience along the way, but 2023 ended up being a good year for bond returns, which was a welcome change from the very negative returns that we saw in 2022. And as we think about drivers of these 2023 returns, it was really the higher level of yields that was available in the market in the past year, which was a lot higher than what we’d seen in some time, as well as particularly strong performance from the Corporate Bond sector. The second thing I’d note is that it was a volatile year. Interest rates, as well as mortgage and Corporate sector spreads, fluctuated quite a bit and that drove fluctuations in returns. It was somewhat challenging to navigate, but ultimately, for an active manager like Dodge & Cox, this was a great environment for shifting our positioning to capitalize on opportunities and generate outperformance. Lastly, I’d say as we look forward, we continue to be optimistic. Yield levels remain attractive, inflation and recession risks have arguably declined since going into last year, and we’re still finding opportunities in various sectors and issuers in the market.

Alex: Let’s take a look at the market backdrop last year. Remarkably, the 10-year [U.S.] Treasury yield ended the year right where it started at 3.9%. That masks quite a bit of intra-year volatility, which you can see in the upper-right chart on slide five. Lucy, can you walk through what impacted markets?

Lucy: Yeah, as we look at that upper-right chart, with interest rates moving up and down, we were really seeing changes in market expectations for inflation, for Fed (Federal Reserve) policy, and for recession risk. And early in the year, it turned out that inflation was stickier than many people expected. The economy looked more resilient than many expected. So it became clear that interest rates were going to stay higher for longer. However, as the year progressed and the Fed continued to hike rates, ultimately the market started to get more comfortable that the Fed really was winning the battle against inflation. The data started coming down. Some of that economic resilience started fading a bit, including a little bit more balancing in the labor market. That ultimately got the market more comfortable with the Fed starting to cut in 2024 and also that there would be a soft landing and we would avoid recession.

Alex: How did spread sectors perform last year?

Lucy: As mentioned earlier, credit was really the star of the show last year, and if we look at the bottom left on slide five, we see what happened with credit spreads. It was bumpy, but overall the trend is clearly down, which meant that credit valuations were getting higher throughout the course of the year. In terms of structured products, the road was not as one dimensional. They were really quite volatile throughout much of the year and struggled at several points, partly given the rate volatility that we saw, also a lack of the Fed buying as they were under QE (quantitative easing), and bank buying after the regional banking crisis earlier in the year. That part of the market lacked a bit of sponsorship, which ultimately weighed on spreads. But overall, [Agency¹] MBS (mortgage-backed securities) spreads did improve quite a bit in the fourth quarter and had strong performance.

Alex: Can you put the fourth quarter [of 2023] return in context?

Lucy: The fourth quarter was absolutely exceptional for the bond market with a return of 6.8%, which is the strongest quarterly return in 30 years. So really that tightening in spreads in both credit and structured products, as well as rates, drove that really high return.

Alex: Turning to performance, which you can see on slide six, the Income Fund returned 7.7% last year, outperforming the Bloomberg U.S. Agg (Bloomberg U.S. Aggregate Bond Index²) by more than 200 basis points³ (bp).⁴ Long-term numbers are likewise very strong. Lucy, what else would you like to highlight on performance?

Lucy: I’d say certainly we’re happy to see that very strong outperformance in 2023. It’s a larger number than we’re accustomed to, but proud of that outperformance. Longer term though is what we really focus on here at Dodge & Cox as we think it’s important to not just generate performance in certain environments, but really to generate performance through market cycles and in different types of environments over the long run. So looking toward those longer-term numbers is where we focus.

Alex: The three main levers in the portfolio for outperforming the benchmark—security selection, asset allocation, [and] yield curve⁵ positioning—were all strongly positive in 2023. Slide seven describes how these three factors contributed to the portfolio’s 216 bp of outperformance last year, with the summary in the upper-left [corner]. Of note, security selection added significantly to relative performance with several lower-rated and higher-beta issuers performing well, including Pemex, Charter Communications, UniCredit, and Telecom Italia. The underweight to Treasuries and overweight to Credit also added to relative returns, as did the below-benchmark duration⁶ positioning. We adjusted duration positioning quite a bit throughout the year, and we’ll talk about how that added to returns. Lucy, how does this breakdown of attribution compare to longer-term periods, say over the last five years?

Lucy: I’d say it’s generally in line with the longer-term contributors to our results, and it’s what we would expect to see. Notably, the fact that security selection is the largest contributor, that is an area that we focus [on] a lot given our approach, our valuation discipline, [and] our bottom-up fundamental research. And so that is very consistent with the longer run. Also, asset allocation in a year like this—where there there’s a lot of volatility and spreads—we can shift in, again using valuation discipline. It’s not surprising to see that there. So overall, the ranking of these contributors is quite consistent with the longer term.

Alex: Moving to portfolio changes, can you walk through the adjustments we made last year starting with portfolio duration?

Lucy: Of course. So coming into 2023, we started the year with about a 5.5-year duration. We had lengthened during 2022 as rates started selling off. And so, as the year progressed, we actually early on in the volatility saw rates fall quite a bit. Maybe the market got ahead of itself, at least that was our perception in terms of the level of rates, and at that point we actually incrementally reduced the portfolio’s duration. However, later in the year as we saw rates continuing to rise and really start to bake in large expectations, it seemed like for some combination of the neutral-rate inflation and a term premium, the level of real and nominal yields that we started to see drove us to get more comfortable with interest rate risk. We extended duration to end the year at a 6.0-year duration, and this is compared to 6.2 for our benchmark, the [Bloomberg] U.S. Agg. This is more or less neutral—which is notable—because it’s been many years since we have been neutral. We’ve been defensive on duration for some period of time. But again, at this level of rates, we feel optimistic about the future.

Alex: How about sector positioning? Can you describe the changes we made there?

Lucy: Sure. On the credit side, given that march higher in valuations that we talked about earlier, we were generally reducing our exposure to the Credit sector. So overall, we reduced credit by nine percentage points, and we did that incrementally each quarter of the year. We’re ending the year with about 40% of the portfolio in Credit.⁷ Now we focused on trims of longer maturity securities where valuations had become fuller after the strong rally. We also tended to trim more Industrials as compared to Financials because Financials spreads didn’t have the same rise in valuations that we saw for several Industrials. And of course each of these trims was done on a bottom-up, individual basis. Some of the names I might mention that fit in these categories are Oracle, ExxonMobil, and CVS, but there was really a long list of incremental trims that we made.⁸ I want to mention that even though the main trend was trimming, given our investment style, in any market environment we can find ideas, and we did actually make a few adds during the year. For example, in the midst of the regional banking crisis earlier in the year, all spreads sold off, especially in Financials, and we added to a couple positions, notably [Charles] Schwab and UBS [Group] at what we thought were quite attractive levels. Those have performed well so far. In addition, in the fourth quarter, we participated in a new issue for Raytheon, a large aerospace and defense company. They issued a lot of bonds to fund a share repurchase at what we deemed was an attractive level for a company that is non-cyclical, very durable, and has a credible debt reduction plan. So those are some examples of still finding opportunities even in a broad market environment that isn’t quite as exciting for credit. Within the securitized part of the portfolio, we made fewer adjustments. This part of the portfolio consists largely of mortgage-backed securities and asset-backed securities, but we did add slightly to the Fund’s large and diversified portfolio of Agency MBS, and we think that that part of the market remains attractively valued.

Alex: Can you describe where we’ve invested the proceeds from those credit trims?

Lucy: They’ve primarily gone into Treasury and cash securities, which provide flexibility and liquidity should we see more opportunities in credit or structured products going forward.

Alex: These adjustments leave the portfolio positioned as you see on slide eight with the brown bars representing the Income Fund and the blue bars representing the [Bloomberg] U.S. Agg. Despite the recent adds to the Treasury sector, we remain underweight there. The portfolio is overweight to securitized, mostly Agency MBS, and then the portfolio is overweight to credit if you combine the government-related and Corporate sectors that represents credit. Lucy, a couple questions we’ve been getting from clients on the portfolio’s relative positioning. It seems like we’re less enthusiastic about credit at current spreads. What’s the reasoning for remaining overweight?

Lucy: Yeah, it’s a fair question given that current spreads are below their long-term average value. It’s reasonable to be skeptical, but one thing I’d point out is the difference between what’s in the benchmark, or the broad credit market, and what’s in our portfolio because there are a lot of differences. For one, our portfolio is very carefully selected with our fundamental research and stress testing through cycles and, for example, in a recession. Secondly, we have a higher level of spreads in our portfolio relative to that of the market. That additional spread provides cushion against price volatility, and that can be very important when thinking about prospective returns. Also, just the composition that I referenced a little bit earlier. We right now have more Financials relative to Industrials because the Financials part of the market has more attractive valuations relative to Industrials. And again, we’re also right now holding more intermediate and short credit versus long credit. So I think all in, our portfolio has some attractive characteristics that may protect us from some of the worst-case scenarios. And then just zooming up a bit, big picture, I’d say that the fundamentals of credit right now and the fact that we may be heading into a soft landing, that’s our base-case expectation, may actually justify current spread levels and they could stay at these levels for some time. So if you think about that extra yield from credit, and how that may compound over time, that should beat Treasuries in a range of scenarios going forward.

Alex: What’s the Investment Committee’s rationale for remaining somewhat short duration (0.2 of a year) at this point?

Lucy: Yeah, I consider the duration positioning fairly neutral at this point given sort of the history of the Fund and how underweight we’ve been. But I guess we are slightly short and where that shortness comes from is a little bit less exposure to some of the long end of the yield curve. I’d say we have a little bit of caution because even though inflation seems to be coming down well, the last mile is the longest mile in terms of getting all the way to the Fed’s 2% target, and the success of the Fed in doing so is not a foregone conclusion. So I think we retain some humility and acknowledge the uncertainty there. And when we think about the risk/reward at different points on the yield curve, you’re not getting a lot more yield to go out the yield curve. It’s still sort of inverted and flat depending on which parts you’re looking at. So you’re not giving up much yield further out the curve, and we have seen a pick-up in interest rate volatility in the long end of the curve. And so just the risk/reward in that part of the curve is maybe not quite as attractive as some other parts.

Alex: Putting this all together, how do you think about the future prospects of the Income Fund?

Lucy: I’d say we’re still pretty optimistic. As I mentioned at the beginning of the call, we’re still at attractive yield levels in the market and for our portfolio. And if we think about returns going forward, we have that yield and our expectation given what we expect to be a slowdown in inflation and Fed cuts in the coming years should result in rates going down from here, which could also lead to price appreciation for bonds. I’d also point out the yield advantage of our Fund relative to the benchmark is about 80 bp,⁹ and that yield advantage, if we look historically or think prospectively, has been an important contributor to outperformance. Then if I think about the sectors of the portfolio, as I mentioned earlier, Securitized didn’t have the same valuation rise that the Credit sector did in 2023. We feel that given the starting valuation point and that paired with the fact that prepayment risk—or negative convexity in this part of the market—is just incredibly low right now and different than what we’ve seen for decades. That combination of valuation and lower risks gives us a lot of optimism about that sector being able to outperform Treasuries. Then finally credit, as we said, we’re less excited, but we really like the individual issuers that we have selected for the portfolio and think there is still value in those. So overall, we think there are many attractive parts of the market and are excited to continue capitalizing on the market as things evolve. Undoubtedly, we’ll be in for some more volatility this year with elections, changing economic data, so it’ll keep us busy.

Alex: Thanks, Lucy. We also want to thank our listeners for tuning in and for the ongoing confidence you’ve placed in Dodge & Cox.