Taxable Bond Commentary
In the Right Place at the Right Time

Sticking to our convictions2008 was a good year for Oakwood’s taxable bond clients. Returns are solidly positive. We credit these results to a significant underweighting in corporate bonds, especially the banking and finance sectors. Instead, we invested heavily in Treasury securities, despite numerous recommendations by strategists to avoid this lower-yielding sector and go for the higher yields offered by riskier securities. In addition, we held steady to our belief that 30-year mortgage rates, which are tied to Treasury yields, must move much lower in order to see a better economy, housing improvement and higher returns from corporate bonds.

Peering around the corner
Now that 30-year mortgage rates are decreasing, we have identified two remaining key indicators that are essential to an improving economy. The first is a significant reduction in energy prices. Lower oil and energy prices combine to reduce the cost of producing and transporting products and are a direct and ongoing stimulus to consumers. Motorists certainly feel relief from the drop in gasoline prices. Along with energy prices, commodity prices have also dropped significantly, as shown in the chart below. This lowers inflation by directly lowering the price of producing and consuming products. As this process continues, hopes for an improving economy and stable earnings should emerge and corporate bond spreads will begin to contract, perhaps sooner than many expect. In anticipation of this, we are currently adding to existing positions.

Housing woes continue to plague the market
In our belief that bankruptcies and declining home values would erode the value of the underlying collateral supporting mortgage-backed securities, we avoided every type of this investment over the past year. The loss of liquidity and widening of yield differentials to Treasuries has become a major cause of underperformance for most of this sector. Going forward, mortgage-backed securities will only be attractive as the inventory of unsold homes declines from its current record level of 11-12 months, to a more stable and sustainable 8 months – the threshold or minimum inventory level for our investment target. We continue to monitor this situation closely to identify the right time to make attractive investments.

Even the darkest clouds have silver linings
Despite generally challenging market conditions, specific opportunities continue to emerge. One example is a new investment vehicle called “FDIC guaranteed corporate bank notes.” This product is designed to help alleviate credit market gridlock by allowing qualified bank holding companies access to the capital markets at a favorable interest rate expense. The notes have a maximum maturity restriction of 3.5 years and enjoy the unconditional guarantee of the US government. To compare, yields levels on similar-maturity Treasuries have fallen below 1%, while these securities yield around 2.10%. We view these securities as especially attractive in an environment where many investors have been willing to sacrifice yield for the safety of their investment.

“It’s tough to make predictions, especially about the future.” - Yogi Berra
At Oakwood, we always employ macro trends as an important component of portfolio structuring. As such, we monitor and forecast economic growth and interest trends, along with commodity prices, currency rates, inflation, etc. Even though we spend countless hours evaluating economic and monetary conditions, forecasting in today’s environment is fraught with uncertainty and drawing preconceived conclusions is at best a guess.

While all factors impacting the markets normally merit our consideration, for now we rely heavily on criteria like risk/reward assessment, quantitative findings and confidence studies. Rather than focusing on forecasting or predicting trends in the economy and interest rates, we will focus on an individual assessment of the value of investment choices in each area of the maturity curve. This involves analyzing advantages and disadvantages for each investment choice, in order to select the best risk-versus-reward investment. The rigor of this method avoids the distraction of potentially unreliable predictions that can introduce more risk to the portfolio.

We expect our bond portfolios to continue to perform well, on both a relative and absolute-return basis. Equally important, all of our investment choices remain highly liquid. This provides us with the ability to seek out attractive investment opportunities while consistently guarding against unknown challenges.