Global Fixed Income Strategy—2024 Semi-Annual Investment Review

Alka: Hello everybody. Welcome to Dodge & Cox’s Semi-Annual Global Fixed Income Review Audiocast. Thank you for joining us. My name is Alka Singal. I’m a Client Portfolio Manager here at Dodge & Cox, and I’m joined by my colleague today, Jose Ursua, a member of our Global Fixed Income Investment Committee, as well as Macro Sector Head. Thank you for joining me today, Jose.

Jose: Hi Alka, happy to be here.

Alka: For the next 20 minutes, we’re going to dive into the world of global fixed income. First, we’ll make sure to cover the global macro backdrop and discuss what’s happened in the first six months of 2024. Next, we’ll address the Global Bond Fund’s performance, attribution, and shifts we’ve been making. And then finally, we’ll talk about where we’ve been finding opportunities and our outlook for the Fund. Jose, before we begin, there have been many global cross-currents at play in the first six months of this year. What would you say is the key headline takeaway for our audience members today?

Jose: Definitely a challenging period for fixed income assets. It’s been challenging for rates and currencies. It’s been somewhat better behaved for corporate spreads, which remain at relatively tight levels. But volatility remains high, especially on the back of geopolitical risks and elections that have happened all over the world. All in, however, we have continued to find interesting opportunities, and we have used the tenets of our investment philosophy, our process, and our teamwork decision-making to put together a Fund that we are excited about for the future.

Alka: Let’s talk about that global macro backdrop in more detail. You talked about a challenging environment for rates and currencies on a year-to-date basis. Looking at slide five, can you elaborate on those comments a little bit more, starting with rates?

Jose: Absolutely. If you look at the upper left-hand side table, what you see is a move in yields over a variety of example markets. The first chunk of the table shows developed markets, and the lower part shows emerging markets. In the developed side of the world, the Fed (Federal Reserve) and the BOE (Bank of England) continue to be at peak rates, but the European Central Bank has started a cautious easing cycle. The Bank of Japan, instead, has hiked its benchmark interest rates for the first time in 17 years, ending a long journey into negative interest rates. This backdrop of rising yields in the developed side of the world have certainly affected emerging markets, which have also been driven by idiosyncratic developments. Examples of these include elections in Indonesia, South Korea, parliamentary elections, South Africa, India, [and] Mexico. And then, as the quarter was coming to an end, elections also in France and the UK (United Kingdom) on the back of the European parliamentary elections that happened in June. So, in general, a world where these geopolitical election, idiosyncratic type of elements have mixed with the cross-currents of monetary policy and the potential for some of the cuts that have been priced earlier in the year to be delayed on the back of some volatile inflation prints at the beginning of the year. If you look at the upper right-hand side chart, this shows the result that these currency moves and other developments have had on the currency world and the U.S. trade-weighted dollar, meaning with respect to its main trading partners, has actually appreciated again after having depreciated over the course of the second half of 2023.¹ And if you look at the other columns, you see that this has been the case relative to the euro or relative to the Japanese yen, which is now at multi-decade lows relative to the [U.S.] dollar and also with respect to emerging market currencies.

Alka: And in this environment of higher interest rates and a stronger U.S. dollar, you talked about credit spreads trending to more expensive levels year to date. So, if you look at the bottom left-hand chart, you can see credit spreads have generally trended downward in 2024. Jose, how should our listeners think about credit in today’s environment and the causes for this?

Jose: It’s definitely been a stronghold of the fixed income world, and I think it comes from the back of at least three drivers. The first is it’s been a very strong economy. Economic momentum has been strong, activity has been priced to the upside, especially in the U.S. but also in other countries. Recessions have not really materialized, contrary to earlier fears that they would occur on the back of monetary policy tightening. The second reason is that the labor market also remains very strong. It started to loosen and adjust as monetary policy effects have kicked in, but by and large, it’s not that dramatic of an adjustment of the labor market. And the third would be that corporate balance sheets actually remain pretty strong. As a Fund, we don’t own the credit indices but our exposures are somewhat correlated to the credit indices, obviously. And so, what we see here is that spreads have continued to remain at relatively tight levels, not as low as 2021, but near those levels. And this, obviously, correlates with the generally friendly environment for global risk that you see in the lower right-hand side table, for example, exemplified by positive performance for risk assets on the equity side as well.

Alka: And in this environment with higher rates, a stronger [U.S.] dollar and lower credit spreads, the Global Bond Fund returned -0.68% on a year-to-date basis.² If we look at slide six, how would you decompose the drivers of that return?

Jose: You know, it’s interesting. These are three main drivers that you can decompose the returns into, and we obviously hope that they’ll all perform well as many times as possible, but sometimes it doesn’t happen. And as we discussed now, it’s been a challenging environment for currencies, which is reflected in the negative contribution from currencies, especially the Japanese yen and the Brazilian real, which suffered over the course of the first half of the year, but also other exposures that we have in the Fund. The second column shows the negative contribution from duration and yield curve.³ These come at the back of rises in yields that we discussed before in the United States, but also again in other emerging market exposures. But excess returns have somewhat offset these declines and have contributed positively to performance. These come mainly on the back of corporate exposures, but also some government-related and securitized products type of exposure. All in, that -0.7% I think is driven by these divergent reflections of the fixed income environment we discussed before.

Alka: Thank you, Jose. So, taking a step back and contextualizing year-to-date performance over longer-term performance, you can see on page seven, at the top of the page, the calendar-year performance for the Global Bond Fund since 2014. And at the bottom, you can see the average annual total returns as of the end of June. So, I’d like to focus on the 10-year number as we recently celebrated the 10-year anniversary of the public launch of the Fund. During that period, we’ve been able to generate strong [average annualized] returns of 2.89% in a very challenging global macro and fixed income environment. Moreover, if you look at the calendar-year performance at the top of the page, you’ll see that we’ve had very strong performance over several different calendar years. When we have had negative performance, we have generally outperformed the broad market, as well as had strong performance follow that period of underperformance on an absolute basis. Jose, can you elaborate more on performance as you think about it?

Jose: Absolutely. When I look at this slide, it’s almost like going on a journey. We really try to build a portfolio that over multiple years is able to weather a wide range of environments and as I look back at these past 10 years, there’s been periods of significant macro surprises. So, if you think of it in 2015-16, volatility increases, commodity price selloffs; in 2018, the trade war between the U.S. and China, involving also some European countries; in 2020, we went through the first part of the COVID[-19] pandemic; [and in] 2021-22, the inflation overshoot and the rate selloff as well. So, every one of these instances, I think, has caught the Fund in a relatively solid footing. We’ve actually used some of the selloff occasions to add to exposures that we think are unjustly priced by the market relative to those long-term fundamentals that we have in mind. So all in, our efforts have gone and will continue to go towards building a portfolio that is able to weather both expected and unexpected types of events and cumulatively, over multiple years, offer good risk-reward for our clients.

Alka: Weathering these different environments can certainly be seen if you look at the historical portfolio allocation on page eight, which shows how the Fund has incrementally evolved over the past 10 years. Jose, can you walk the audience members through the different charts on this page and some of the key takeaways for each of them?

Jose: Absolutely. This slide is a bit like looking under the hood of the car of the Global Bond Fund because it allows you to see how the team has reacted to different types of environments and what have been the main tenets of the moves of the levers that we have to generate that attractive risk/reward that I talked about before. The upper left-hand side chart shows you the allocation by sector and so that one illustrates a few things. If you take the light blue line that corresponds to corporate credit, it shows how, over the course of the pandemic shock, we increased significantly our allocation to corporate credit as spreads widened significantly and, we thought, indiscriminately relative to the long-term fundamentals of the issuers that we have exposure to, or we sought exposure to. More recently, we have actually narrowed down, or ratcheted down, our exposure to corporate credit as spreads have tightened.⁴ And on the back of that, we’ve increased our exposure to securitized products, which is a light gray line that you see in that chart. So we are reactive to market changes relative to our assessment of multi-year fundamentals.

If you look at the right-hand side chart, it shows currency positioning. It does not appear like we’ve deviated much from a share of non- [U.S.] dollar currencies that hovers between 22 and 25%. That’s usually what we would have in the Fund. But under the hood of that, there’s been significant changes. In recent years, we have increased significantly our allocation to developed market currencies as yields in these countries have risen and currencies in these countries have depreciated to levels of valuation that we think are attractive from a multi-year perspective.

Importantly, if you look at the lower left-hand side chart, that one illustrates something that’s relatively new for the Fund, which is a very high level—compared to history—of our duration exposure, meaning our exposure to interest rate risk. And this has come on the back of increases in U.S.-dollar contributions to duration, mainly as U.S. yields have risen on the back of Fed tightening and the recent inflation outbursts that we experienced. But also in other parts of the world where we think that duration is attractive, mainly in emerging markets where the yield curves are high and they’re actually pretty flat. We think that from today’s point forward, the declining yields that we expect relative to spot and forward rates [are] likely to accrue to returns and, thus, the higher duration exposure.

Last but not least, the lower right-hand side chart shows our exposure to emerging markets. This continues to be a very fertile ground for us to use and apply our fundamental, very detailed, methodic research to try to parse out opportunities. We try to shy away from those that do not offer a good risk/reward but actually go actively into places where this is attractive.

Alka: Thank you, Jose. Drawing your attention, a couple points on this page. If you look at the top left-hand side and the corporate exposure, the Fund is now at its almost lowest corporate exposure over the past 10 years, as Jose had mentioned, just as we’ve made incremental trims based on valuation in the credit markets. If you look at the Fund’s duration at six years, we are now at the highest level that we’ve been over the Fund’s inception. If you think about year-to-date changes and incremental moves that we’ve made in the portfolio, and turn to slide nine and look at the credit trims overall, what are some of the items you’d highlight, Jose, in terms of adds and trims to the portfolio?

Jose: Absolutely. So two points to start. One is that we’re always guided by our investment principles: multi-year investment horizon; valuation; bottom-up, robust, fundamental research; and team-based decision-making. All of these always go into the types of changes that we’ll put in place over the course of any given time period. Over the past six months, what you notice in this chart is that most of the changes that we’ve made are incremental. As conditions evolve, we make adjustments to the portfolio but these don’t tend to be drastic changes. If you look at the left-hand side chart, it shows the largest changes in terms of Credit exposure.⁵ The adds pertain to areas where we think that they’re attractive relative to the fundamentals that we see over the longer run. So, for example, Romania⁶ is a new exposure, it’s a euro bond that we think offers very attractive spread relative to those multi-year fundamentals. If you look at most of the exposures on the left-hand side of those bars, which are negative, meaning that we’ve reduced those exposures, they come on the back again of this price discipline. We’ve been nudging down risk exposure in the corporate credit side, in light of relatively less attractive compensation for risk, and we’ve generally brought down duration from those exposures as well, especially those where spreads have tightened excessively relative to our long-term views.

If you look at the currency part, which is illustrated in the upper right-hand side chart, these six months of the year were mainly, I guess, driven towards adding to places or countries or exposures where the valuation does not correspond to longer-term fundamentals and those include, for example, the Chilean peso or the South Korean won or the Indonesian rupiah, which we had owned before and we’ve now opened the small position in. These are all places where we think fundamentals are strong and the combination of carry or FX (foreign exchange) or currency undervaluation present an attractive opportunity. On the other side of that, you see the Mexican peso relatively large decline in exposure. This comes on the back of two things. First, a very strong performance over the past couple of years and B, the outlook ahead being slightly more challenging because of the recent elections that Mexico has gone through, both presidential and parliamentary elections, [and] also the upcoming elections in the U.S., which somewhat because of the starting valuation makes it a bit more challenging for Mexican assets. We still retain an exposure but it’s heavily diminished relative to where we had it before.

Last but not least, the summary of portfolio changes in the lower right-hand side chart shows you by different sectors what changes have occurred. The Corporate one is perhaps the most noticeable one, as you said before, we’ve brought down the Corporate credit weight quite significantly and then others are less noticeable because they haven’t changed as much in terms of the headline, but the under the hood elements have actually changed significantly. Again, the example of the currency part we’ve added to developed market currencies.

Alka: Now, if we think about the main drivers of return and the main levers that the Investment Committee looks at for this Fund—looking at credit, interest rates, and currencies—where are we today and what is the outlook for the Global Bond Fund when the Committee’s thinking about opportunities ahead?

Jose: Absolutely. So we like to think that we buy the portfolio every day, and so what you see on this page is our best thinking for positioning the Fund on behalf of our clients for a multi-year horizon going forward. So what does this tell you in a snapshot? The upper left-hand side shows you the sector composition. Despite these declines in Corporate Credit exposure, we actually remain with nearly 35% of the Fund invested in Corporate Credit. These are issuers that we know well. These are issuers that we think pay us a spread relative to U.S. Treasuries, for example, that’s actually attractive on a multi-year basis and where we think that default risk is basically negligible or very low. There’s also the Government exposure, Securitized exposure. These have been important sources of spread and return for the Fund in the past, and we think it’s likely to be the case going forward as well. These include, for example, some of the emerging market government exposures where yields are very high relative to our perception of risks. The quality composition that you see on the upper right-hand side shows you that we mostly play in the investment-grade area but also significantly in the below investment-grade part. And these are crossover exposures. Some of them are fallen angels,⁷ and these are exposures that we think have much more attractive long-term fundamentals relative to what the market is thinking today.

The lower tables are, I think, a very good snapshot of the Fund’s situation and the prospects for the future. So, if you look at the lower left-hand side table, it shows you four statistics that we think are very reflective of how we’ve positioned the Fund over the next few years. First, the yield to worst⁸ —it’s at 5.8%. And this is a high starting yield relative to both the past and where we think that rates are likely to settle going forward. Second, effective duration⁹ is at six years. We think this is an important tenet of how we’ve positioned the Fund today, partly because we think that rates are likely to decline going forward, but also because the starting level of yield is actually very high in the U.S. and in some of the countries that we have exposure to in terms of duration. Last but not least, emerging market exposure and the number of countries that we have exposure to. In this Fund, the world is our oyster, and we’re able to harvest attractive risk-reward from a variety of sources through active, careful, robust, bottom-up type of research. And we think all these four are likely to set the Fund with a positive outlook over the next few years.

Alka: Thank you, Jose. That was an excellent summary of where we are finding opportunities on a global basis, and I’m excited today and hopefully you, as listeners, also are. Thank you for your confidence in Dodge & Cox and for trusting us as stewards of your global fixed income capital. It’s been a pleasure to speak with you today. Thank you, Jose, for joining me, and I hope everyone has a wonderful rest of their 2024.

Jose: Thank you Alka, thank you to our clients, and thank you to our listeners as well.