Taxable Fixed Income Strategy

The year 2003 ended with a modest rise in rates throughout most maturity areas, the only exception being very short rates of less than one year that experienced a drop in yield. This is a direct result of the Federal Reserve’s policy decision to lower the target Fed Funds rate for the thirteenth consecutive time, from 1.25% to 1.00%. This environment is in stark contrast to the many predictions for 2003 of much higher interest rates, accompanied by higher inflation and a call for an end to the monetary stimulus stance that began three years ago. While these predictions may be realized at some future point, for now ongoing productivity gains throughout private corporations are having a positive effect on inflation and are assisting in keeping interest rates near historic lows.

At current levels, interest rates appear to be in balance with present economic conditions and should remain within a defined trading range until a new trend is established. The direction of the trend is somewhat muddled, as reported economic data points to either a sustained period of strong growth or waning momentum.

Meanwhile, the corporate bond sector continues to provide investors with solid returns, especially compared to lower yielding US Treasury securities. The fact that the lowest quality-ranking corporate bond sector outperformed higher quality levels in 2003 has proven to be a reliable forecaster of the recent rebound in economic activity.

We continue to reevaluate our security choices and revisit the fundamentals of each industry classification within the corporate bond sector. While 2003 was a period where the entire sector performed well, the period ahead may see a dichotomy into individual winners and losers. A look at the retail sector provides an example. During 2003, the consumer was a driving force behind a rebounding economy and solid earnings within the retail sector, with companies such as Sears Roebuck benefiting. However, with recent signs that consumers are moderating future spending plans, these companies may begin to underperform as their yield levels widen out versus higher quality Treasury securities. In contrast, we continue to favor the energy sector as a whole and currently hold positions in Occidental Petroleum and Kinder Morgan Incorporated.

Our goal is to seek out those companies that cut unnecessary overhead and now operate in a more efficient manner. It is our belief that well positioned industrial-based companies like United Technologies Corporation and General Electric will supplant the retail sector in its contribution to positive bond performance during 2004.

The capital markets will continue to play a vital role to clients seeking stability of principal and modest return potential. As part of our daily management techniques, we continue to modestly extend shorter holdings for yield gains. In our view, the four- to five-year maturity area offers a good balance between yield pickup, income generation and price stability. However, due to present market uncertainties, we are especially careful to keep portfolio durations within a suitable range of the selected benchmark. We are mindful that, in the past, holding the Fed Fund target rate at abnormally low levels for long periods of time can breed inflation and interest rate volatility. Therefore, in the event that the economy grows too rapidly or inflation returns, we are prepared to act quickly to shorten portfolio duration as a means to protect capital.

At this time, we see a risk to maintaining large cash positions. Federal Reserve Chairman Alan Greenspan has a history of being an inflation fighter and is unlikely to abandon these efforts. We will monitor his actions and statements closely for signs of a return of inflation and a consequent tightening of interest rates. Meanwhile, we view the stubbornly-high energy prices as a potential impediment to sustained economic growth. To date, strong productivity gains have hindered the job front; however, the return to more normal levels of productivity will aid in job formation.

For 2004, the bond market will undoubtedly face many challenges. An outcome could be one of rapid economic growth accompanied by higher interest rates. In response, we intend to keep duration targets on the conservative side of respective benchmarks. However, if interest rates drift higher with no meaningful change in market fundamentals, we are prepared to take advantage of the higher yield levels by extending shorter positions or reinvesting ongoing cash flows and coupon payments at attractive yield levels.

Conversely, if the economy begins to falter, we will participate nicely in a bond rally as we are not holding large cash positions in portfolios. On balance, we believe the key to success in 2004 is to avoid erratic shifts in portfolio structure. This is an environment that punishes overreaction to daily market events and volatility.