Taxable Fixed Income Strategy

2006 was a very good year for Oakwood fixed income clients. Bond returns exceeded reported levels of inflation and comparable performance benchmarks, after enduring a string of 17 consecutive interest rate hikes by the Federal Reserve. Additionally, on a risk adjusted basis, our high quality bonds provided a less volatile alternative to high yield bonds, commodities and other investments.

We are pleased with our ability to produce these solid results, especially during this period of relatively low yields. The keys to our success are as follows:

1. A mathematical advantage – The advantage was due to a careful placement of investment choices throughout the entire maturity spectrum. As an example, we know that most taxable indices have a sizeable representation of Government securities in the shorter 1 to 3 year maturity areas. To provide this mathematical advantage, we utilized market discount callable Federal agency investments with higher return characteristics, regardless of interest rate direction. Going forward, as we near a shift to a more accommodative Fed policy, we will take gains and avoid a risk that price performance will lag as the ability to call these bonds before maturity becomes a consideration. At that time, we will consider the use of non-callable Federal agencies owing to favorable changes to their accounting methods that have bolstered their appeal. They offer improved liquidity, respectable yield and good performance potential.
   
   
2. Corporate bond decisions – During this period of interest rate uncertainty, cash flow yield from coupon payments and market stability are essential ingredients to capital protection and relative performance. When combined with solid liquidity features and an improving quality trend, the return profile is optimal. We are careful to only own bonds issued by corporations with a solid earnings trend and to avoid those that could be negatively affected by an unexpected leveraged buyout. As a safeguard, we prefer financial obligations where the maintenance of high quality is crucial to the daily management of company operations.
   
   
3. Duration control – Duration control entails the proper positioning of investments along the maturity curve in order to control price changes from numerous interest rate factors. Because predicting interest rates and yield curve movements can be difficult, we rely on a systematic investment approach that has been successful for several decades. This is especially important during this confusing interest rate climate. As yield levels now appear to be moving higher, we are implementing swaps designed to shift very short holdings into the 2 to 5 year maturity areas, with a minimal impact on our desire to remain near term market neutral.
   
   
4. Flexibility in our investment process - Possibly the most important feature to a well managed portfolio is proper security placement and the ability to recognize and adapt to changing market conditions. This involves the initial process of selecting securities that best suit client investment objectives. We then seek out opportunities based on return benefit, or sell securities that reach performance benchmarks, or that have deteriorating fundamentals. We take pride in our ability to adapt to market changes that affect portfolio decisions. Because we are inundated with information on a daily basis, we are careful to identify indicators pertinent to our market forecast. We then monitor these indicators to validate or challenge our expectations. As an example, Fed Chairman Bernanke repeatedly stated the critical importance of monitoring inflation expectations. As a possible offset, the housing sector has weakened as well as other select economic variables. With the potential for confusion, we prefer to stay focused on the Fed’s clear priority to contain inflation.

Looking further ahead into 2007, we expect bond returns to reflect coupon generation and modest market price growth. While we are unsure of the timing of a bond rally, we have a growing sense that a strained consumer may lead to a period of below trend line growth in the economy. Consequently, the Fed may find it difficult to reignite the economy, without cutting interest rates in the second half of 2007. We are hopeful that the Fed will be slow to reverse its current restrictive monetary policy stance. While this may seem counterproductive to bond performance, the longer they remain focused on fighting inflation, the more potential for solid price appreciation. As their success becomes apparent, we intend to extend duration targets versus respective benchmarks.