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Lower Your Expectations for Bonds

The manager of Dodge & Cox Income says last year's stellar returns are unlikely to recur.

One peculiarity of the past year’s stock-market rally is that individual investors keep pouring money into bond funds, dwarfing their contributions to stock funds. Tom Dugan, co-manager of Dodge & Cox Income fund (symbol DODIX), finds this pattern bemusing.

In 2009, Dodge & Cox Income, a member of the Kiplinger 25 list of top mutual funds, returned an impressive 16%. But “the kind of returns we had in 2009 are extremely unlikely to recur,” Dugan cautions. “You shouldn’t come into the bond market with the idea that 16% is achievable.” This refreshingly candid manager notes that the unusual economic and bond-market landscape that pertained in early 2009 “bears no resemblance to the current environment.”

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For one thing, interest rates seemingly have nowhere to go but up. Dugan notes that at the end of 2009 (for which the fund most recently disclosed its portfolio), Dodge & Cox had allocated only 4% to Treasury bonds, a massive 27 percentage points below the overall bond-market index’s allocation (Treasuries had been as much as 30% of the fund’s assets in recent years). “We’re avoiding Treasuries more than ever before,” he says.

Instead, he says, he and his nine co-managers are finding better value in corporate bonds (ranging from HCA, the nation’s largest for-profit hospital company, rated triple-C, to double-A-rated GE) and in government-agency mortgage-backed securities. And to defend against the inevitable rise in rates, the fund is keeping its weighted-average duration (a measure of interest-rate sensitivity) much lower than that of the overall bond index.

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Here’s another indication of Dodge & Cox’s views. This outstanding San Francisco fund family manages five quality funds, among them Dodge & Cox Balanced. Dugan, who is also a co-manager of Balanced, notes that 72% of the fund was allocated to stocks at last report (the end of December), with the rest in bonds and cash, compared with a benchmark weighting of 60% stocks and 40% bonds.

Dugan of course can’t tell you or anyone else precisely what returns to expect next from bonds. But he’s clearly advising that you dampen expectations for total returns. He notes that over long spans, the average weighted yield to maturity of bonds in a portfolio has been a good predictor of the total long-term returns. At the end of 2009, the Income fund’s portfolio had a yield to maturity of 4.2%. That’s a fair target, though in a normal year, this fund is capable of doing better. But “you’re promising alchemy if you promise something much higher,” he says.

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