Taxable Fixed Income Strategy
U.S. Treasury securities have rallied since the end of November when the return of United Nations weapons inspectors to Iraq heightened concern of a pending war with the Middle East oil producer. This is just one in a growing list of factors playing a role in the economy and the overall downward direction of interest rates. The end result is that good quality fixed income securities generated solid positive returns for the third straight year. For your review, the following chart shows an example of the year-to-year change in Treasury yields.
It is interesting to observe that the 2-year Treasury note experienced a yield decline of 1.40 percentage points, to close out the year at the lowest level since its first issuance in 1972. This is the direct result of twelve Federal Reserve interest rate cuts over the past two years. While the consumer readily took advantage of these low interest rates to purchase cars and other big-ticket items, corporations have been laying off employees during the period and have been slow to invest in new plant and equipment. As a result, the nation’s unemployment rate stands at 6%, an eight-year high. Looking ahead, this condition may be a factor that keeps short-term rates low and Federal Reserve policy on hold throughout the year.
Returns on our most conservative Governments-only strategy approached +8% while Oakwood’s other taxable fixed income strategies have achieved returns well above that number, depending on the client’s willingness and ability to extend maturities and use corporate securities.
As stated earlier, the impact of higher energy costs can have a negative effect on economic growth. This is especially true as the economy struggles to gain consistent momentum. However, once the markets begin to sense a resolution to this issue, either through war or a notable drop in energy prices, expectations for a stronger economy may mark an end to low inflation and low interest rates. Therefore, we intend to modestly shorten portfolio duration until a clearer picture emerges.
Despite this more cautious view, we continue to see solid opportunities in corporate bonds. Unlike last year, when a ratcheting down in earnings expectations severely damaged most corporations and forced yield spreads to historically wide levels, many corporations have now been forced to take steps to reduce unwanted overhead and improve credit fundamentals. However, because many will lag this process, we continue to be very selective and remain diligent in our research efforts. We see the attractive high yields on selected corporates as an opportunity to bolster performance and, as yield spreads benefit from contraction, we should receive an added boost to returns, even if interest rates move modestly higher during the year. Unlike 2002 when most corporations were hurt by weakening credit fundamentals, 2003 should see a wide range of winners and losers.
To add another layer of market protection against the potential for higher interest rates, we are transitioning portfolios to a modified barbell-type maturity structure. This will entail a reduction in intermediate 3 to 6-year investments, in favor of both shorter and longer investments. It is our goal to take advantage of the positive slope in the yield curve by adding to 13-year maturity holdings and to offset the risk of this action by purchasing very short maturity Treasuries and callable Federal agency securities. When complete, it is our goal to modestly shorten the overall duration on accounts versus their respective product benchmarks. Our primary concern is that any increase in inflation expectations could prompt a call for Fed interest rate tightening. However, we remain mindful that many market economists have been calling for a strong economy and an end to the bond market rally for some time. To date, we have not shared in this viewpoint. However, we now see enough conflicting evidence and uncertainty to justify a level of caution and market protection.
While expectations may be for lower bond returns in 2003, the bond marketplace will continue to be buffeted by economic and world events. This is likely to create periods of bond volatility and will create opportunities to reposition bond portfolios to gain a return advantage. As active bond managers, we expect this environment to afford us many chances to add further value.
