Taxable Fixed Income Strategy
The year 2005 has been an exciting and challenging year for taxable fixed income investors as the Federal Reserve pledged to keep the economy and inflation in check. In fact, at each of its eight scheduled policy meetings, Fed officials opted to raise the key overnight lending rate by 25 basis points. When combined with the five prior rate increases that started in June 2004, the Federal Funds rate now stands at 4.25%. The following graph compares the changes in US Treasury yield levels throughout this process.
The left side of the graph depicts the direct impact of these interest rate hikes in the short maturity areas. We believe the significantly higher yield levels should begin to slow the economy as well as calm inflation worries. The far right side of the graph shows a very different yield pattern. In sharp contrast to the short area, yields in long Treasuries actually fell. In fact, because short-term yields moved higher and long term yields moved lower, all yields regardless of maturity area are almost identical. In our view, for this “curve flattening” event to occur, foreign and domestic investors must be confident that the Fed will be successful in its mission to halt inflation concerns and contain economic growth. As a comparison, normal yield spreads between 2 and 10-year Treasuries on a historic basis have averaged around +90 basis points. Typically, there is inflation risk as investors await repayment of their initial investment. The absence of this “risk premium” implies that inflation is expected to moderate and a change in monetary policy is near. This may further imply a possibility that the Fed may even begin to lower interest rates later in 2006 or in early 2007.
At Oakwood, we are pleased with the performance results in client portfolios. In spite of rising short term interest rates and market naysayers who forecasted doom in the bond market, client portfolio returns were positive throughout all Oakwood bond strategies. While market observers continue to debate the significance of a flat or inverted yield curve, we expect interest rates to move lower, as consumers lose the huge boost to discretionary spending from home refinancing and as the flattened curve penalizes banks, finance companies and other investors who try to profit from borrowing short to lend long.
In the most recent edition of the Oakwood Outlook, we alluded to the difficulties in pinpointing a change in interest rate direction and its effect on yield levels throughout the curve. We prefer to adjust portfolios in gradual steps, based on prevailing return opportunity, market risk assessment, and as the early signs of a change in market sentiment surface. As an example, we feel there is a developing opportunity to extend some of our 10-year Treasury investments to the 12-year maturity area. This swap provides an ability to improve yield and gain generous coupon cash flow while providing a potential to add more return as the yield spread advantage disappears. Pending the end of Fed tightening, we continue to add zero coupon positions that compound at a purchase yield level. Complementing this strategy, we hold market discount callable Federal Agencies in the 2 to 3-year area. This segment of the agency sector adds comparable yield with only a slim chance of early redemption, especially as many of these holdings pass their one-time-only call date.
Because we are forecasting a slowing of the economy, we have tightened quality standards on approved corporate holdings. While the credit cycle has not turned decidedly negative, many companies are beginning to lose earnings momentum. As a result, we have completed a review of all existing corporate holdings with the intent to extend only issuers that pass our very stringent quality standards. This select extension program is designed to enhance portfolio yield and shift overall duration on discretionary portfolios to a modestly aggressive posture.
As you are aware, at Oakwood we are active and opportunistic bond managers and remain prepared to alter our forecast and portfolio strategies should market conditions warrant. At this time, we believe 2006 will be a good year for bond investors.
