Tax Exempt Fixed Income Strategy

We are pleased with Oakwood’s 2004 investment results. Returns in fully discretionary accounts were solidly positive and exceeded their established benchmarks. Similar to the taxable markets, the municipal bond market is experiencing a number of crosscurrents with the bulls and the bears interpreting economic data differently. On one hand, the bears point to solid economic growth, plaguing budget deficits, ratcheting commodity prices and US dollar weakness as reasons to avoid bonds. On the other hand, the bulls point to subdued producer and consumer prices, a diligent Federal Reserve policy, strong investor demand for municipal securities and sub-par job growth as reasons to favor bonds.

Some bearish individual investors may be avoiding this investment sector, but far more continue to purchase substantial amounts of tax-free bonds, especially in short and short/intermediate maturity areas. While these investment preferences may seem somewhat inconsistent with the Fed’s current trend of raising short-term rates, the price sensitivity of short maturities is considerably less volatile than longer maturity investments. This demand is exacerbated by a need to reinvest the proceeds of large numbers of previously issued bonds that are being called away prior to their stated maturity.

Currently, short maturity tax-free yields are low in comparison to taxable alternatives and offer little or no after-tax yield advantage. By contrast, if an investor were to purchase a 10-year tax-free bond at a yield of 4.0%, the after tax advantage versus investment quality taxable bonds would exceed 1.0%, even for those clients in a modest 28% marginal tax bracket. We feel this yield advantage is appealing to municipal bond investors and should become more appealing during 2005.

As the Fed continues to address the fundamentals surrounding inflation, market confidence should return, prompting investors to invest new cash or lengthen existing positions, in favor of longer higher yielding bonds. Independent of this decision, the demand for tax-free bonds should remain strong, as new supply is managed. In fact, the overall holdings of municipal bonds grew in 2004, while taxable Treasury and corporate sector holdings actually fell. Statistics show there was an influx of money market fund holdings, at the expense of permanent assets, as taxable corporate bond yield spreads narrowed to less appealing levels.

Our goal in 2005 is to remain patient and await an attractive opportunity to lengthen the profile of client portfolios. To accomplish this, we will reduce an overweighting in short-maturity bonds, in favor of 10 to 20 year investments. However, we intend to maintain our preference for higher coupon securities. In fact, an above market or premium coupon security has several distinct advantages during periods of market uncertainty.

• Premium bonds tend to be less volatile and help to protect market value. As an example, for a given change in interest rates, a premium bond has less par or market exposure. Therefore, mathematically they will experience a smaller percentage price change than current coupon or discount type issues.
  
  
• Premium bonds provide a higher cash flow yield. This is especially important during periods of rising rates or during range bound markets.
  
  
• New issue premium bonds often offer a yield advantage, which can improve the likelihood of a higher return over the life of the investment. In the secondary market, a good trader can buy these bonds cheaper, as many investors avoid this sector.

In previous editions of the Oakwood Outlook, we noted our resistance to owning California State specific debt. This proved to be a good decision, as these bonds underperformed most local obligations. However, we have now begun to purchase select state issued bonds, if backed by specific sales tax revenues. Unless there is a new supply of bonds with a direct cash flow backing, we are likely to avoid further purchases at this time. California’s estimated budget deficit continues to widen, even in the face of an expanding economy and strengthening tax revenues. The State will find it difficult to grow its way out of the problem where severe cutbacks are needed. Unfortunately, California now has the lowest credit quality ranking among US states.

As an alternative, there are countless well-managed municipalities within the State of California available for investment consideration. In fact, in-state yield levels are quite attractive versus out of state municipalities. As this yield advantage begins to return to a more normal historic relationship, we expect California tax-free bonds to outperform other states. Our focus in 2005 will be to canvas all the markets for good investment opportunities. There will be many choices, as US voters approved billions in new bonds at the November 2004 election. Also, there will be future bonds issued as new communities surface throughout the country. They will need to borrow for new schools, firehouses and numerous other services. It seems clear that the municipal bond market will thrive for many years to come. Because we own only the highest quality bonds with excellent liquidity characteristics, we can exercise maximum flexibility in the management of accounts. Furthermore, because we are content with our current structure, we can afford to be patient.