Taxable Fixed Income Strategy

An appropriate word to describe the behavior of the bond market in 2004 is “unsettling”. To support this, we have illustrated below the price swings in the 30-year Treasury bond throughout the year.

As shown, this price sensitive benchmark started the year at a premium price of $104.375, or $1,043.75 for each $1,000 par bond. By mid March, its value increased 6.75 points to a price of $111.125, as escalating oil prices and a perceived erosion in economic fundamentals favored bond investing over stock investing. During the two months following this rally, market conditions turned decidedly negative. It became clear that concerns pertaining to the economy were superceded by fears that escalating commodity prices would propel inflation higher in the months ahead. The market price of this long Treasury security plummeted 13.75 points or 12.4%, to a yearly low price of $97.375. This realignment of market priorities led to an immediate call on the Federal Reserve to tighten monetary policy and raise short-term interest rates, even if it meant the economy would suffer.

In response, the Federal Reserve demonstrated its commitment to fighting inflation pressures by embarking on a measured pace of interest rate hikes in its target Federal Funds rate at every meeting since June 2004. With five consecutive 25 basis point increases to date, the rate now stands at 2.25%, over twice the June 30, 2004 rate of 1.0%. As investor confidence returned, the 30-year Treasury bond reversed direction again and rallied to beyond the price level shown at the start of 2004.

To reduce the negative effects of price volatility and to gain comfort in the overall structure of client portfolios, we established a conservative duration target based on each client’s risk versus return parameters. We then established a high coupon profile in portfolios, in order to generate above market coupon cash flow. This strategy was designed to place more emphasis on cash flow generation and less emphasis on market appreciation. In addition, we maintained an over-weighting in higher yielding corporate securities with a history of strong earnings growth. As yield levels compressed to outperform their higher quality Treasury counterparts, this strategy added performance to the portfolios. As a result, we are pleased with the investment results in 2004. The returns for fully discretionary accounts were solidly positive and exceeded their established benchmarks for the year.

Looking ahead, we remain somewhat sensitive to the potential for additional price volatility. Our goal is to continue to provide a level of market stability to accounts and at the same time generate respectable returns. Until the bond market senses an end to Fed tightening, the yield curve should flatten further, as bond yields in the shorter maturity area move modestly higher. We agree with the consensus of market forecasters that expect the Fed to raise rates at least three more times to 3.0% by mid 2005. As shown below, this means that the yield level on 2-year Treasuries could approach 3.50%, up from the year-end close of 3.07%.

Similarly, as shown in the following yield curve comparison, since the Fed began raising short-term rates in June 2004, yield levels on 5-year and longer Treasuries have not moved higher and have actually fallen.

As a result, we will continue to underweight the vulnerable 2 to 4-year maturity areas, in favor of a “barbell” type structure. This strategy combines very short investments (less than 1 year) with 10-year or even longer bonds, where permitted, to achieve our desired duration target.

We begin the New Year as cautiously as we did in 2004 and stand ready to switch to a more aggressive posture as inflation fears are dismissed and interest rates throughout all areas of the yield curve peak. Until then, we are likely to reduce certain corporate bond positions as the return benefit in the sector is no longer attractive. We will then focus on strategic yield curve placement and duration management as tools to generate valuable return in 2005.

We believe a strong basis for an improvement in market fundamentals centers on the dynamics of Federal Reserve policy. Their stated mandate is to orchestrate a sound, steady economy with low inflation. The Fed is raising short-term interest rates in anticipation of inflation pressures, but well in advance of inflation that would become embedded in the system. As their success becomes apparent, the bond market should become less volatile and provide bond investors with the potential for even more favorable risk adjusted returns.