Tax Exempt Fixed Income Strategy

Municipal fixed income clients enjoyed a good year as after-tax returns in 2006 exceeded rates of inflation. Looking ahead, we expect an even better year as the supply of new bonds is met with strong demand and stable tax rates, with the potential for members of Congress to call for higher tax rates on wealthy individuals. However, we are concerned that while tax receipts in California exceeded 2006 projections, the current lack of fiscal discipline will lead to large deficits. Therefore, we intend to avoid State level bond obligations unless the maturity is less than 5 years. Furthermore, we will demand insurance backing or pre-refunded issues with the implicit guarantee of the US government.

In fact, throughout Oakwood client portfolios we already own many issues that are pre-refunded. This resulted from the prior year’s rush to refund existing debt prior to maturity in a very low yield environment or from an effort to seek out these universally accepted bonds. However, despite their highest AAA quality rating, the inundation of supply tempered our return expectations. This year, we expect this to change as the supply of available bonds dwindles due to less issuance and growing demand.

Because of a minimal yield difference between higher and lower taxed states, we have effectively used local level tax advantaged California bonds for both California and out-of-state general market portfolios. As yield levels realign to reflect the proper yield relationship, we see a performance benefit to both in-state and general market residents.

In general, municipal securities out-performed their taxable counterparts last year. As a result, municipal versus taxable yield ratios have become less attractive, especially in 7 year and longer maturities. This provided us with an opportunity to take select gains and reinvest in shorter more conservative securities. This, combined with the passage of time, shortened overall durations from a target level of 5.4 to less than 5 years. Because we are now going through a period in which economic data is conflicted or distorted, we are comfortable with our more conservative stance.

As you are aware, the Fed has openly stated its concerns that inflation could become a problem. The market reacted negatively by pushing yield levels higher. As stated earlier, our shortened maturity profile has provided a level of protection against this event. As interest rates reach peak levels and as yield relationships readjust to more attractive levels, we see an opportunity to again lengthen holdings. The following chart reflects current yield levels and our forecast for the first half of 2007.

Shown is a modest decline in yields throughout the maturity curve. Specifically, most of the decline is reflected in the shorter 2 to 5 year areas, as the expected adjustment in municipal to federal taxable ratios will mute the yield decline in longer maturities.

As you are aware, forecasting the precise timing of a rally can be unreliable; nonetheless we are confident that yields will ultimately fall well below our forecast. Currently, market participants remain somewhat skeptical that the economy will slow enough to prompt Fed easing. On a short term basis we agree, however, we stand ready to act quickly. History often shows a directional change in interest rates is commensurate with a change in market fundamentals and sentiment. Therefore, we encourage clients in the higher marginal tax brackets to remain invested in tax-free bonds.