Tax Exempt Fixed Income - Strategy

A review of 2001 interest rate patterns reveals that yield levels on longer maturity municipal securities ended the year essentially unchanged from the beginning of the year. Furthermore, in sharp contrast, yield levels on shorter maturity securities fell sharply. By year end 2001 short term tax exempt yields had fallen 190 basis points, from 4.0% to 2.1%.

Despite the fact that the long end of the municipal yield curve changed very little during the year, it did maintain a heightened level of price volatility, especially in the long end of the yield curve. Since November, principal values have declined almost 4%, as investors struggle over the prospects of renewed economic growth and a massive supply of new bonds entering the markets. It appears the aggressive lowering of short term interest rates by the Fed is being viewed as bad news for inflation, rather than acknowledging a need for stimulus to combat the recession.

This did not come as a surprise to us at Oakwood. As pointed out in last quarter’s municipal bond comment, we noted that long interest rates could come under pressure as the economy and stock market began to improve and inflation hawks viewed the Fed’s actions as overly aggressive. Furthermore, we stated that the weakening economy would alter the budget plans and revenue sources of most municipalities. Unfortunately, as widespread revenue shortfalls did mount, the calendar of new municipal offerings began to reach massive proportions, even though the higher interest costs are passed on to the issuer. In fact, the new issue volume during the last quarter alone reached close to $90 billion, while new issue volume may reach $300 billion in 2002.

During this period, we did not feel investors were being properly rewarded for the incremental risk that had crept into the municipal marketplace. In fact, even though yield levels on short-term investments fell rapidly to around 2%, we remained steadfast in our decision to avoid the temptation of investing in long bonds, regardless of yield improvement. Furthermore, we implemented a decision to require a minimum underlying quality rating of AA on all new purchases and have embarked on a program to sell all non-insured California positions.

We believe this negative environment will soon pass as the higher yields are viewed as attractive. Unlike the taxable markets that may continue to be driven by other technical factors, municipal bonds now offer good value and should continue to pull money away from very low yielding money market funds. As we begin to see 5% yields in the 15-year area, we will begin to extend shorter positions. To prepare for this, we will shortly be transitioning our portfolios to include approximately a 25% allocation to the 10 to 15 year maturity areas. This represents an increase from 15%. For California clients, where supply was once scarce, we will begin to reverse a previous excellent decision involving the use of out of state bonds. This action will result in an after tax yield gain.

In general, because the markets may continue to have difficulty adjusting to the near term onslaught of new supply without further yield adjustments, we will implement our new strategy in a gradual fashion. Despite these near term concerns, municipal bonds over the past 2 years have played an important role in risk reduction and should continue to generate good positive returns in excess of inflation during 2002.