In an era of ultra-low interest rates, stocks continue to be the obvious choice for most investors. But is that approach wise?

 

Even as stocks continually post new highs (and carry stretched valuations), a variety of serious economic and geopolitical risks means this is not a good time to be over-exposed to equities. In the current environment, the S&P 500 could easily fall 15%-to-20% or more if the global landscape delivers one of its periodic shocks.

 

#-ad_banner-#Maybe this is a time to give bonds fresh consideration. And one of my favorite ways to get exposure is the Dodge & Cox Income (NYSE: DODIX) fund.

 

It carries a respectable 3% yield. By comparison, the overall bond market is yielding 2.5%, and the dividend yield on the S&P 500 now stands below 2.0%. To deliver the superior yield, you might presume that the fund takes on extra risk by loading up on so-called corporate junk or maybe even foreign bonds issued by developing countries at high risk for default.

 

But I assure you, it doesn’t.

 

Foreign bonds account for just 12% of Dodge & Cox’s assets, with only modest amounts of emerging markets debt. The portfolio has an overall credit rating of BBB, which is investment grade.

 

Credit Rating	DODIX	Category Average	Barclays Capital U.S. Aggregate Bond Index
AAA	55%	43%	70%
AA	1%	10%	4%
A	10%	21%	13%
BBB	23%	20%	13%
BB	9%	4%	0%
B	2%	1%	0%
Below B	0%	1%	0%
Not Rated	0%	1%	0%
Avg. Credit Quality	BBB	N/A	AA

As you can see, Dodge & Cox doesn’t focus on the most highly-rated, lowest yielding bonds. Instead, the fund holds a greater concentration of corporate issues and agency mortgage-backed securities, both of which are riskier than Treasuries and regular U.S. government agency bonds.

 

However, management isn’t going overboard on risk in its quest for higher yield. The fund’s corporate and MBS holdings are typically from well-rated, familiar firms or government-related agencies. Among them: Verizon Communications, Inc. (NYSE: VZ); Bank of America Corp. (NYSE: BAC); the financial arms of General Electric Co. (NYSE: GE) and Ford Motor Co. (NYSE: F); the Federal Home Loan Mortgage Corporation (a.k.a Freddie Mac) and the Federal National Mortgage Association, or Fannie Mae.

Bond Type	DODIX	Category Average	Barclays Capital U.S. Aggregate Bond Index
U.S. Treasury	18%	17%	39%
U.S. Agency	1%	2%	3%
Other Government-Related	0%	9%	4%
Corporate	35%	25%	23%
Agency Mortgage-Backed Securities (MBS)	33%	5%	20%
Non-Agency Residential and Commercial MBS	0%	19%	2%
Asset-Backed	4%	3%	1%
Municipal	4%	1%	1%
Cash	4%	11%	6%
Other	1%	8%	2%

What’s more, the fund constantly manages risk. For instance, it recently cut back on corporate bonds, putting the current allocation about 5% below where it was early in the year. The fund managers were especially careful to pare exposure to richly valued financial sector bonds and industrial firms that were aggressively using leverage.

 

At the same time, this fund’s managers sought better values in foreign corporate bonds — like the 0.5% position recently established in the debt of Pemex,  Mexico’s state-owned oil firm. Among the advantages of Pemex bonds are better yields than Mexican sovereign debt and solid credit prospects, says Dodge & Cox’s management.

 

Overall, though, the fund typically limits foreign bond exposure,  with the allocation ranging from just 3% in 2009 to the current 12%. Looking ahead, I’d be surprised to see the proportion go much higher.

 

Besides the focus on quality, Dodge & Cox keeps a lid on risk by limiting duration, a key metric of a fund’s sensitivity to interest rates. Simply put, duration is the number of years it would take for a fund to receive all the interest payments and principal at maturity from the bonds its holds. Usually, a bond fund’s price will move by the amount of its duration for every 1% change in interest rates.

 

Dodge & Cox, for example, has a duration of about 4. So if rates rise by 1%, then shareholders can expect the fund’s price to drop around 4%. However, they can also expect it to fare substantially better in a rising-rate environment than the overall bond market, which has a duration closer to 6. Since rates could go up soon, Dodge & Cox’s policy of maintaining a shorter duration is a big advantage.

 

Long-term performance has been stellar, with the fund beating 86% of its peers in the intermediate-term bond category over the past 15 years. During that time, total returns have averaged 6.2% per year, compared with 5.6% for the Barclays U.S. Aggregate Bond Index.

 

After you subtract the fund’s very reasonable expense ratio of 0.4%, its rate of return still beat the broader bond market by 20 basis points. In the generally-subdued world of bond investing, that’s an impressive difference.

 

Risks To Consider: Dodge & Cox Income has only lost money once in the past decade, dropping just 0.3% in 2008. However, with interest rates set to start rising in the middle of next year, the fund could easily be in the red in 2015 and losses could be larger than in 2008.

 

Action To Take –> Stocks currently have a lot downside risk, so holding a substantial amount of safer, fixed-income securities makes a lot of sense. Owning them through Dodge & Cox Income makes even more sense, because the fund is well-positioned to weather the turmoil that could strike the bond market in the near future, when interest rates rise. Plus, the fund is the type of elite long-term performer that makes it a perfect choice for ongoing fixed-income exposure.

 

If you’re interested in the bond market but want to explore your options further, our premium newsletter High-Yield Investing has a portfolio of recommended bonds. To gain access to this top-tier research, click here.