Taxable Fixed Income - Strategy
For the second year in a row, fixed income investors have generated excellent returns in the taxable bond market. In fact, this year, preliminary numbers indicate that Oakwood’s taxable fixed income clients generated average returns in excess of 8.5%, with many clients’ accounts beyond 9%. This is far above the 2% annual levels of reported inflation. We now enter the new year facing a backdrop of economic and stock market uncertainty and a Federal Reserve that may be running out of options to stimulate the economy. However, with inflation expected to remain sidelined and yield levels on high quality corporate securities at around 6%, we again greet 2002 with optimism for fixed income investors.
During the last few months, the bond market hit a wall on the road to historically low interest rate levels. As evidence, since November, the 30-year Treasury bond price, after reaching a low yield of 4.80%, has declined over 13%, to a yield of 5.55%. The catalyst for this setback was an eleventh easing by the Fed in its target Fed funds rate. The thinking by the inflation hawks was that a one-year drop from 6.50% to 1.75% was overly aggressive and would lead to inflation.
We disagree with their conclusion. In fact, it seems unlikely that the consumer will come roaring back, unless they continue to see bargains. With debt levels high, households are shifting their preferences toward savings and balance sheet repair. In a deteriorating cyclical climate, discounting is unlikely to prompt significant new demand and higher prices. In fact, it is possible that zero interest rate financing on cars and holiday discounting is artificially supporting demand. Regardless, historical evidence shows that a healthy economy does not, by itself, lead to higher interest rates. In fact, it is inflation that leads to higher interest rates.
Therefore, we view the recent market setback as an opportunity to lock in attractive yield levels. In fact, our study of the yield curve and its various market sectors points to several attractive areas. First, for more conservative clients, we like Federal Agency issuers in the 4 to 5 year maturity areas. Because we do not expect the Fed to raise rates anytime soon, the steep yield curve is a compelling enticement to extend current positions. Therefore, we will begin to sell shorter agency holdings, in favor of these higher yielding choices. Our new duration target in this strategy is 2.4 years, up from our more cautious 2.1 years.
Second, for intermediate risk clients and owing to the abnormal steepness in the yield curve, we view 15 year Treasuries as an attractive alternative to the 7 to 10 year areas. We believe a 70-basis point pickup in yield is an ample buffer against future inflation projections. During the process of identifying market opportunities for the new year, we are considering the use of a barbell type maturity distribution, wherein intermediate securities would be repositioned at the extremes of both the short and long ends of the yield curve. However, we will not implement such a strategy right now since our forecasts for a less active Fed should provide some stability for short-term rates. If the economy grows too fast or inflation returns in the months ahead, we do stand ready, however, to implement such a strategy.
Finally, for full discretion clients, we intend to extend some of our existing long positions, in order to pick up yield and reach our modestly longer duration target of 5.7 years. We observe that, during the greater part of the past two years, investors were actually able to improve yield by shortening long Treasury positions. At present, investors can pick up at least 15 basis points by reversing this decision, with little additional interest rate risk. In addition, we will continue to overweight corporate bonds. However, the careful monitoring of credit quality remains an important part of our fixed income investment process.
While it is certainly difficult for anyone to consistently predict interest rate direction, as we look forward we think the price risk of investing in bonds is limited at least for the first half of the year. We base this on the likelihood that the Fed will not raise interest rates anytime soon and view the current steepness in the yield curve as exaggerated. Therefore, the yield differential between long and short-term securities should continue to draw money away from money market funds, in favor of more permanent investments.
