Taxable Fixed Income - Strategy

Oakwood fixed income clients had plenty to cheer about this past year. With the Lehman Corporate/Government Index up 11.9% and the Intermediate Index up over 10.1% in 2000, we are pleased to report that Oakwood’s fixed income portfolios have modestly outperformed their benchmarks. These excellent results* represent a generous return advantage over the 2.9% reported inflation level. In addition, Oakwood clients whose portfolios are managed with taxable or tax exempt bonds as part of a balanced strategy generated excellent positive returns as an offset to a difficult year in the stock market.

Unfortunately, those investors who held very low quality bonds as a means to augment portfolio yield, more closely tracked the equity markets and finished the year, in many cases, with negative performance. In fact, the Merrill Lynch High Yield Master Index dropped 5.1% for 2000. Oakwood clients avoided these problems because they were invested only in high quality bonds.

While it is certainly unrealistic to expect bonds to outperform equities on a long term basis, bonds should continue to generate good returns in the months ahead. In addition, they play a critical role in reducing risk, particularly in portfolios which also hold equities. The basis for our positive expectations for bonds is as follows:
 

1.	Stock market volatility should remain high and investors, in an attempt to reduce overall portfolio volatility, have already begun to shift some assets to fixed income instruments. We expect this trend to continue in the coming year.
2.	Evidence continues to point to a further deceleration in the economy with consumer confidence at its lowest point in over two years. A slowing economy should continue to be positive for bonds.
3.	The Federal Reserve Board appears to be completing its battle to disarm any systemic inflation pressures. The Fed raised its target for overnight bank lending six times since June 1999 and the result has been lower inflation rates and a slowing economy. Its diligence in successfully meeting its goals set the stage for an initial rate cut which took place on January 3, 2001. Since the Fed seldom makes just one rate cut, future cuts are likely and this should be positive for fixed income instruments.
4.	There is a liquidity crisis occurring in the high yield, junk bond market, a vital source used to raise capital for future economic endeavors. By the way, Oakwood clients do not own junk bonds. Even the lower end of investment grade bonds are struggling to find investor interest while banks are tightening terms for business borrowers. This phenomenon is causing a flight to quality at a time when higher quality bonds can be expected to perform well.

We believe the keys to successful fixed income portfolio management in 2001 are as follows: First, portfolio quality is essential. This means we will continue to overweight Federal Agency securities. These government sponsored entities, in response to political pressure, have initiated welcome steps to further improve balance sheet liquidity and capital adequacy. They are fast becoming a market substitute for the shrinking supply of Treasury issues, a result of the U.S. Government’s plan to buy back outstanding debt. We especially like the two to four year area and expect Agency yield levels to fall further than those of their U.S. Treasury counterparts, providing investors with greater appreciation.

Secondly, similar to past periods of economic downturn, we again expect only the most financially sound companies to prosper from initial efforts to revive the economy, which includes the ongoing process of lowering interest rates and the expectation of future tax cuts. We believe that any company which must first shore up its balance sheet in order to participate may actually incur further damage or simply be late to the performance party. Now that the Fed has validated the change in monetary direction, hopes for improving credit quality will surface and we can move to reverse, selectively, our previously underweighted posture in corporate bonds. We expect to add new names to our approved list of investments or extend existing holdings to capture increased yield opportunities.

Third, we continue to pursue a longer overall maturity structure or duration profile, depending upon specific client risk parameters. In the current environment we prefer a portfolio structure that will respond favorably to still lower interest rates and one that avoids heavy corporates exposure, regardless of the present yield advantage. Given the slowing economy and volatile stock market, corporate yield spreads could widen further, rendering all but the highest quality corporate bonds replete with risk. However, the markets may be overly optimistic as to the degree of Fed easing. Currently, the five year U.S. Treasury Note is yielding around 4.7%, a full 130 basis points below the 6.0% Fed Funds target rate. Clearly, the market is factoring in a significant economic slowing with several interest rate cuts already priced in to Treasury yield levels. Typically, bond investors would rather anticipate a change in monetary policy than experience the magnitude of this action. Therefore, there may be periods of modest market retrenchment as investors monitor the direction of the economy. Also, we remain focused on the potential inflationary effects of more volatile energy costs to consumers, to include higher natural gas prices, escalating electricity rates and commodities prices (the CRB) that remain in an upward trend.

To start the year, we are reshaping the maturity distribution of portfolio holdings, where appropriate. This includes a shift away from our previously overexposed position in the five year Treasury in favor of two year Treasuries and Agencies. The benefits to this action are twofold. Presently, the two year Treasury’s yield is greater than that of the five year Treasury (the only area along the curve with this experience) and carries less interest rate risk. Second, just as the five year area anticipated significant Fed ease (which greatly enhanced Oakwood’s fixed income returns in 2000), the two year is more directly linked to marked Fed action. While improvement from current levels may be modest, it should still outperform the five year area. In addition, we recently exchanged our nine year Treasury positions in favor of a fifteen year Treasury bond, for a significant yield pickup of over 30 basis points. For full maturity discretion clients, we modestly extended our longer holdings. In 2000, our long Treasury positioning resulted in excellent performance. We expect that these changes, along with existing holdings, will add value in the new year.

* Actual performance is available upon request. Past performance is not necessarily indicative of future returns.