Tax Exempt Fixed Income - Strategy

Similar to the excellent performance experienced by our taxable bond clients, returns* on Oakwood municipal bond portfolios for 2000 were also excellent, both on an absolute and taxable equivalent basis. During 2000 tax free investments preserved capital and, during 2001, should continue to play an important role in risk reduction for individuals who are in moderate to high tax brackets.

During the year, we saw the inventory of available securities disappear. In California, this scarcity has forced yields to such expensive levels that investing in out-of-state securities appeared to be warranted. After confirming that yields could be improved by such a move, even after adjusting for the payment of California State taxes, we made selective choices in these bonds to good effect in the portfolios. For non-California clients, this larger and more diverse selection of securities provided a greater variety of high quality choices.

The expected new supply of bonds should be manageable and, when combined with the prospects for additional interest rate declines, should continue to foster strong investor demand as a result of either new cash flows or the reinvesting of scheduled interest payments. Adding to the favorable supply/demand ratio is the ongoing reduction in Treasury debt. As yield levels on longer municipals now approach parity to the taxable Treasury sector, traditionally taxable investors, in certain circumstances, will switch to municipals to take advantage of this historic yield aberration. On balance, we also view longer municipal rate levels as attractive and will continue to selectively extend some shorter maturities for good yield gains and further appreciation potential.

Owing to the uncertainties surrounding the economy and the future potential impact on state and local budgets, we are beginning to re-emphasize insured or government collateralized issues in the longer maturity areas. This is especially true in California where consumers are likely to see much higher electrical bills. This added layer of protection might seem unnecessary to some investors. Those investors cite the negligible experience of defaults (less than ¼ of 1% last year) and the prospects for renewed economic growth from Federal Reserve interest rate cuts as reasons to relax not tighten credit standards. Despite this view, we at Oakwood remain willing to sacrifice some yield until the economy rebounds.

The election of President Bush substantially increases the likelihood of tax changes this year, particularly since tax reform is featured as integral to his legislative agenda for the first 100 days. Lower marginal Federal brackets across the board are part of the Bush tax plan as are the elimination of the marriage penalty and estate tax reform. Tax bills can languish in joint committees for months but this President will presumably be working with a friendly Congress. Such a bill, if passed in a reasonable time frame, would likely be signed into law during an environment of weak economic growth accompanied by rising bond values. Therefore, the impact on longer maturity municipals as yields adjust to new tax considerations should be modest. There would be some effect on shorter municipal rate levels as investors would be likely to look to the taxable corporate bond market as a higher after-tax yield alternative.

We are bullish on tax free bonds but remain mindful that the markets anticipate change well in advance of an actual event. Should the interest rate picture begin to turn less positive for any reason, we derive comfort from our opportunistic, yet cautious, investment approach. As an example, our current average maturity target is 7.5 to 8 years, up from 7 years. By contrast, we continue to highlight an above market coupon structure and exemplary quality, as protections against any negative market events.

In 1999, our disciplined approach to tax exempt bond management met the challenges of an ever rising interest rate environment by preserving capital in client portfolios. Last year, our approach demonstrated that it could add value in a more positive environment for tax exempt securities. We now enter 2001 with the confidence that we will continue to add value and that our clients can expect good relative and absolute returns in the year ahead.

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