U.S. Fixed Income Strategy—2024 Semi-Annual Investment Review

Alex: Hello and welcome to our Semi-Annual U.S. Fixed Income Review. My name is Alex Chartz, I’m a member of our Client team. I’m joined by Tony Brekke, Credit Sector Head and member of our U.S. Fixed Income Investment Committee. Tony, thanks for joining me.

Tony: Thanks, Alex. Great to be here.

Alex: Over the next 20 minutes, we’ll cover the U.S. fixed income market backdrop, the Income Fund’s performance, and where we’re finding opportunities. Tony, before we jump in, are there any high-level takeaways that you’d like to provide?

Tony: Yeah, definitely. Thanks again, Alex. You know, from a high level, I would say the interest rate backdrop shifting is probably the highest level, primary takeaway I would apply to the first half of this year. This resulted in negative returns for the Bloomberg [U.S.] Aggregate [Bond] Index¹ (Bloomberg U.S. Agg), and I’m happy to report the Income Fund was able to eke out a slightly positive return in this environment. This was driven largely by security selection, but I know we’ll get into that in detail later. We made a few adjustments in response to this higher rate, slightly tighter spread dynamic, and as you might expect, these are primarily along the lines of duration² extension and credit risk reduction. Nevertheless, this dynamic we find ourselves heading into the third quarter of this year leaves us quite excited for the long-term return potential from fixed income, and we think the Fund still has plenty of levers to pull to help generate alpha³ over the next three to five years.

Alex: Great. With that, let’s jump in and talk about what influenced fixed income markets in the first half of the year.

Tony: So, I’ll start in the upper left-hand section of this slide, and that’s where we’ll talk about that Treasury yield change I alluded to earlier. As you can see, yields shifted upwards by about 50 basis points⁴ in the intermediate and long ends of the curve.⁵ Really, it was the first quarter, characterized by a series of stubbornly high inflation reports that really resulted in, I would say, continual adjustment in what the market perception of the timing and magnitude of Fed (Federal Reserve) rate cuts in 2024.

As you can see in the upper right-hand chart, rates peaked in late April with the 10-year at about 4.7% and the 30-year in the vicinity of around 5% before beginning a general trend lower in early May on cooling inflation data and some signs of weakening labor market statistics. This was interrupted by a couple periodic bouts of volatility, including a late-June mini spike in response to the shifting odds in the U.S. presidential race. The 10-year gradually declined from there, ending the second quarter [at] roughly 30 basis points below that year-to-date peak that we hit in April.

Moving to the lower left, credit spreads remain broadly resilient. The Bloomberg [U.S.] Credit Index⁶ tightened by [approximately] 10 basis points in the first half of the year and this really occurred in the face of near record corporate issuance, reasonably high-rate volatility, as I just mentioned, and some surfacing geopolitical risk into the end of the quarter. I think that the spreads were supported by a couple things. One, inflows. There’s been a lot of money flowing into fixed income, and this has influenced that spread dynamic and helped to offset some of that elevated supply that we saw in the first half of the year. There’s also a broadly held view that [the] supportive macroeconomic backdrop that we find ourselves in is underpinned by sort of moderate growth, moderating inflation. You pair this with what are still pretty reasonable corporate fundamentals and relative conservatism on the part of large companies in the U.S. and abroad. It sets actually a pretty favorable backdrop and has been very supportive of credit spreads for quite some period of time.

Finally, in the lower right, these are the returns from the various sectors of the fixed income market. You can really see that corporates, led in many ways by financial institutions, which returned 1.4% in excess of Treasuries year to date, were quite strong. As we’ll see in the next couple of slides, our security selection helped enable us to do even better than what you see in these broad market sector returns shown on this slide.

Alex: In terms of performance, the Income Fund returned 0.18%⁷ over the first half of the year, representing outperformance versus the Bloomberg U.S. Agg of almost 90 basis points. Tony, would you like to provide some long-term context behind some of these longer-term numbers?

Tony: Yeah, and I’m glad you brought that up. I mean, as thrilled as we are to provide a nice set of numbers, certainly from a relative perspective for the first half of this year, as you well know, we focus on the long term here at Dodge & Cox. We’re just very thrilled to have been able to provide almost 200 basis points of outperformance over the last 12 months [and] well over 150 basis points of outperformance over those three- and five-year timeframes. Of course, you can see the longer-term numbers as well. And, really, this is just a testament to that approach that we take, the philosophy of building the portfolio security by security, name by name, and building in that incremental yield advantage that we think can accrue to the benefit of investors over a long period of time.

Alex: Turning to attribution on slide seven, this exhibit walks through the sources of excess return with the summary in the upper left. Security selection added 74 basis points [and] asset allocation added 21 to the overall 89 basis points of outperformance. So the vast majority of it came from those two factors. Tony, can you comment a little bit on what drove returns really within those two areas?

Tony: Yeah, I sure can, Alex, and I’ll guide you to the right-hand side of the page where we list the key contributors to relative results. The first bullet point lists the top three. There were a number of other issuers that contributed to a lesser degree, and how I would describe these three issuers is these are higher beta,⁸ slightly more volatile holdings in the portfolio. They have certainly underperformed over certain timeframes. This recovery represents, in many ways, our conviction, which we build through a significant amount of upfront due diligence before we enter into any investment—certainly internationally domiciled or commodity-sensitive issuers, like those you see listed in this bullet point—and our willingness to hold through periods where the market and other investors might be fleeing those risks. And that paid off to the benefit of Fund shareholders in the first half of this year.

Alex: Turning to the portfolio structure on slide eight, if you look at the sector composition, there weren’t too many changes we made over the first half of the year. It’s largely remained the same although we’ve tweaked exposures at the margin. Tony, can you talk a little bit about those adjustments and how we think about the relative value between Securitized and Corporate?

Tony: Yeah, and I think the two highlights would really be, as you point out, a reduction in the credit risk part of the portfolio. You can really see that in the fact that the brown bar on the Corporate section of the sector composition chart on the upper left is lower than it would’ve been six months ago and much lower than it would’ve been 18 months ago. This has been a gradual reduction in the Fund’s Credit⁹ exposure as [U.S. Bloomberg Agg] Index level spreads and indeed spreads on many of the issuers in the portfolio have tightened to a degree where the risk-reward dynamic is no longer nearly as compelling as it had been previously. A lot of those reductions have occurred in the lower-rated portion of the portfolio. So, if we shift our eyes to the right, you can see that the Fund remains, again, overweight BBBs and with a small allocation to the below investment-grade space, as depicted by the less than or equal to BB+ portion of the chart. These are the issuers where we found the most ripe opportunities for reduction, and almost exclusively, these trims have been driven by relative value considerations as opposed to real credit concerns in the portfolio.

At the same time, we’ve found mortgage-backed securities (MBS) to be much more attractive than they had been over the prior couple of years. Those would be reflected in the Securitized sector composition, which is at roughly 50% as of the end of the second quarter.¹⁰ GSE-guaranteed¹¹ mortgage-backed securities, in particular, trade at levels that we think are quite compelling relative to the risks that these securities face, which as GSE-guaranteed mortgage investors, the biggest risk we have is cashflow timing, prepayment risk. With the overwhelming majority of the MBS in the universe subject to underlying mortgage rates that are well below the prevailing market rate, that prepayment risk has effectively dissipated in the market. We’ve found ourselves, for a while now, in a scenario where the risk profile is dramatically reduced, but due to a number of technical factors in the market, the valuation on the securities remains wider or more attractive than it typically is. It’s been a great opportunity to— as we reduce some of that credit positioning—move some of those proceeds into the GSE mortgages. That’s in fact something we did in the first half of the year, where we reduced Credit by four or 5%, and towards the end of the quarter and added about 2% to the GSE mortgage part of the portfolio. The relative value dynamic between intermediate corporates and structured products, which have basically extended into that intermediate part of the curve, has shifted much more in favor of the GSE-guaranteed mortgages, which are the securities that we tend to favor in this part of the market.

Alex: One of the other adjustments we made in the first half of the year was to the portfolio’s duration. Can you talk a little bit about that? Looking to slide nine here, the recent adjustments? And then how that fits in kind of longer term?

Tony: Certainly. So, if we focus on the upper portion of slide nine, we go back a couple decades and illustrate how the Fund’s interest rate risk positioning has looked relative to that of the Index. And we can see that after a very long period during which the Income Fund’s duration was significantly shorter than that of the Index. So, from about the time of the Global Financial Crisis, 2008-2009, up until the last year or so, we’ve been significantly underweight interest rate risk in this portfolio. As yield dynamics have shifted, as our outlook for the path of interest rates has adjusted over the course of time, we’ve gradually adjusted the Fund’s duration position commensurate with our outlook to the point where, by the end of the second quarter, we were roughly equal in terms of the interest rate risk profile of the Fund relative to that of the Index. And that change occurred in that mid- to late-April timeframe, as rates had continued their steady march higher. We found ourselves discussing the fact that our outlook over a 2+ year timeframe was for rates to go lower and decided that we would extend the Fund’s duration by roughly one quarter of a year to make it equal to that of the Index.

Alex: Moving on to adjustments in the portfolio. On slide 10, we showed the starting weight in Credit at the beginning of the year and then the ending weight as of June 30, so about a four-percentage point reduction in Credit. Over to the right, we show the actual issuers that we reduced. Are there any broad themes within those issuers? And then, can you comment on one new opportunity?

Tony: Definitely. So you’re right, 4% Credit reduction first half of the year. This is just a continuation of what we’ve been doing for a much longer timeframe. And in terms of themes, I think the interesting takeaway I have from this slide is that it’s hard to really pinpoint any explicit theme. You can see that the sources of reduction span a range of issuers in terms of credit quality [and] sector of the corporate market. You’ve got a couple of Taxable Muni (Municipal) issuers. Now, admittedly one of those, the Los Angeles [Unified] School District,¹² was called away from us. Nevertheless, that [security] has a high-quality, relatively tight spread credit that we don’t think really offers tremendous value at this point. And then you’ve got a couple of telecom companies; a cyclical issuer in Dow Chemical; [and] a bank, which again, HSBC was more a call and tender, but fits into our broader view, which is we want to have less Credit than more Credit at this stage. And then another notable one being Telecom Italia. This is a below investment-grade issuer that we’ve owned for a long period of time, and we’ve looked to this May of 2024 maturity and certainly have welcomed that at various points in the Telecom Italia history. We’re still comfortable with the credit, but this is, you know, something that’s been in the portfolio for a while and it played out. The thesis played out and it matured at par in May, and that was a fairly substantial holding in the portfolio. As with all of our decisions, each of these is made through a lens of, do we think the compensation we’re being offered to own these securities is adequately compensating us for the risks associated with owning it? And when the answer to that is no, or much less so than it used to be, then we tend to act and reduce it. The Foundry JV HoldCo is a very small position in a joint venture between Brookfield Asset Management and Intel Corp to fund the construction of a semiconductor chip manufacturing plant in Arizona. Without getting into too much detail on that particular investment, I would just suffice to say that we are ever vigilant for new and interesting opportunities, even in a market that broadly is much less compelling from a risk-reward perspective.

Alex: So even with the reduction in Credit in the first half of the year, we remain overweight Credit on a market value basis. Can you talk a little bit about the reason for that given your role as the Credit Sector Head?

Tony: Yeah, it’s a great question. First and foremost, our Credit holdings are very different from those in the Index. So that is really the primary reason we maintain a headline overweight to Credit at this point in the cycle. These are all issuers that we’re comfortable with where we think that the spread and the yield on offer are at least fair to maintain a position in them.

Alex: Can you talk a little bit about the Investment Committee’s outlook and why we’re excited about the current portfolio?

Tony: I would say the primary reason is yield. As we saw a couple slides ago, the portfolio yields¹³ about 5.5% as of the end of the second quarter. Now, this is a tremendous level of yield relative to what the market was offering as little as a couple years ago. So, the income generating power of the portfolio is significant and something to be enthusiastic about. Secondly, our macro team and our Investment Committee share a view that the likely path for interest rates is lower over the next couple of years, and if that view plays out, there should be some opportunity for price performance tailwind associated with that dynamic playing out. And then finally, as mentioned earlier, the credit portfolio—even though broad market valuations are less than compelling—we remain quite enthusiastic about the selective holdings in our portion of the credit portfolio and think they offer a great opportunity for return generation going forward. And I guess I would say, lastly, we can’t forget the mortgages. It’s almost half of the portfolio. It’s an incredibly important part of the portfolio and the outlook going forward. GSE-guaranteed mortgages are priced at a level that leaves us quite enthusiastic for their return potential over the next couple of years as well.

Alex: Great. Well thanks for joining me, Tony, and thank you all for listening in. We really appreciate your confidence in Dodge & Cox.