Tax Exempt Fixed Income Strategy
On balance, 2003 was another successful year for tax-free bond investors as most widely recognized fixed income indices registered returns in excess of 4.0%. For highly taxed individuals, this equates to a taxable return equivalent of over 6.0%, considerably outpacing reported inflation levels of 1.8%.
Looking ahead, we believe 2004 will generate similar results as investors continue to use municipal bonds as a way to reduce tax burdens or as a complement to more volatile equity investments. In the past, during periods of market uncertainty or rising interest rates, municipal bonds preserved more of their market value than taxable bond alternatives.
Even though we are not forecasting a meaningful rise in interest rates at this time, we view the one- to three-year maturity areas as particularly vulnerable to any negative market events. With current yield levels of only 2.0% or less, income generation may not be enough to offset the potential for principal losses. This is especially true if inflation pressures resurface or there is a call for a more restrictive monetary stance by the Federal Reserve. Furthermore, the tax-free versus taxable yield ratio in this area has compressed dramatically. As a result, many lower tax-bracket individuals may begin to view taxable corporate bonds as an attractive alternative to tax-free bonds.
However, yield curve studies do show that on a risk-adjusted basis the seven- to ten-year maturity area is attractive with yield levels above 3.0%. This compares favorably to money market funds where yield levels of less than 1.0% are commonplace. We also see good value in the 13-year maturity area with yield levels around 4.0%. While yields remain near historic low levels, we are avoiding the temptation to “chase yield” or take on more risk by extending shorter, lower-yielding investments into the longer maturity areas beyond fifteen years.
As noted in previous editions of the Oakwood Outlook, for California-specific clients we monitor rate levels throughout all parts of the country, in order to achieve better geographic diversification and to garner additional after-tax yield. Unfortunately, during most of 2003, many local municipalities within California were impacted by the financial woes of the State, which was downgraded three times to reach near junk-quality status. This created a modest amount of under-performance versus other states. We believe this will soon change, as investors begin to look more closely at the financial condition of each issuer, regardless of their geographic location. In fact, we are beginning to use more California investments throughout all client portfolios, regardless of state of residence.
Our decision to hold only high quality investments provides an excellent layer of default protection and adds to our flexibility to meet potential cash needs or changes in portfolio structure. This can be especially important should market fundamentals turn decisively negative. We continue to emphasize an above market coupon profile and premium purchase price. Should interest rates trend higher, market protection on “premium type” bonds is better than “par” or “discount type” bonds. Under a worst case scenario where rates move significantly higher, price accretion on discounted bonds could become taxable due to “de minimus” tax provisions.
The outlined strategies may not result in a push for maximum investment returns, however, portfolio price volatility should be moderate and the inherent risks to more aggressive strategies minimized. Furthermore, our high quality security choices are designed to provide maximum management flexibility and preserve precious market value. In fact, above market cash flow from upcoming coupon payments can actually benefit from higher rates as cash flows are reinvested at higher yield levels. On balance, we feel confident that 2004 will be another year of good competitive returns.
