Tax Exempt Fixed Income Strategy

This past year has been an interesting and challenging year for tax-free investors. Until now, most economists were confi-dent that the economy would remain resilient and the impact on the overall economy from sub-prime mortgage losses would be limited. Unfortunately, delinquencies on mortgages to the riskiest borrowers reached a 20-year high in the third quarter. While the total number of these types of loans may be somewhat small in relation to the entire housing market, repossessions accompanied by distressed sales are sending property values lower. This in turn will begin to reduce the level of tax receipts to towns and cities throughout the country. Even the more historically stable states such as Vermont and Texas are seeing weakness in the housing sector.

As a result, we have seen yield differentials between AAA municipal bonds and lower or unrated debt widen three fold, or 2.5 percentage points, to well over 6%. This deterioration is a result of fear, especially for the mutual fund manager or individual investor that invested heavily in low quality securities. Unfortunately, the price erosion can be quite negative while the liquidity of their holdings is severely hindered.

In past issues of the Oakwood Outlook, we stressed the importance of retaining only high quality bonds and we emphasized our reluctance to “chase yield” by compromising quality standards. Because of this, our yearly performance is very favorable and the liquidity of the securities in our portfolios remains very high.

This provides us with some advantages as we enter 2008. Our first recommendation for the year is to invest in those states that impose little or no state tax on their residents or to pick local municipalities managed in a fiscally responsible manner. Specific to California, with its high state tax, we have placed a mandate to purchase only the municipal bonds of strong local communities or bonds with a direct revenue stream in support of its debt. This means that we have chosen to avoid state level California debt, unless it is collateralized by Government securities or has insurance attached, and a final maturity not to exceed four years. As we enter 2008, we have not changed our view on these security restrictions.

Second, over the past several years, we placed an emphasis on “above market” cash generation from scheduled coupon payments, as a protection against higher interest rates. Recently, many of these holdings are becoming pre-refunded and are now backed by Government collateral. This dramatically improves the liquidity of these holdings and allows us the potential to swap in favor of yield improvement.

A factor weighing heavily on the markets is the deterioration in most municipal bond insurance carriers. As an example, bonds sold by state governments make up about 33% of the insurance premiums collected by MBIA and 50% of revenue for AMBAC, two leading insurance companies that offer municipal bond insurance. They too found themselves straying into risky structured products such as collateralized debt obligations (CDOs). While most of the municipal bond insurers should retain a high quality rating, it places the burden of quality directly on the underlying creditworthiness of the town or city that issued the bonds. Prior to the announcement of these problems, we had taken protective measures by requiring that holdings in Oakwood portfolios have a strong single A minimum underlying quality rating, or AA rating without insurance. On the positive side, Warren Buffett recently received approval to establish a new bond insurer, and has received the highest AAA credit ranking from all of the major ratings agencies. This will help to stabilize the markets and provide a future source of new securities.

As outlined above, our previous decisions have proven to be of benefit to our clients. We are in an excellent position to meet any client cash needs and have the flexibility to take advantage of future market opportunities. Looking ahead, we believe this year will be very rewarding to tax-free investors. The yield separation of tax-free versus taxable Treasury investments is at its narrowest separation in many years. As this relationship begins to return to its historic normal range of 75% to 85%, the municipal bond sector should easily outperform taxable bonds, especially on a taxable equivalent basis.