Taxable Bond Commentary
Changing Environment Requires Close Scrutiny

In previous Oakwood Outlooks, we highlighted the role that economic cycles play on corporate bond attractiveness. We urged investors to overweight corporate bonds as the economy began its recovery. This decision led to solid performance for Oakwood client portfolios in 2009.

Now that higher quality (single A or better) yield spreads have narrowed considerably to Treasury alternatives, we may begin to swap some of our best performing positions to gain added yield from the somewhat lower quality, but still investment grade, Baa area. However, straddling the line of “down in quality trades” requires extensive review of company and market fundamentals. Unlike stock investors who look to future earnings projections to evaluate price expectations, bond investors stress current fundamentals to determine a company’s ability to make near-term coupon payments. For example, a company must maintain and generate high levels of free cash flow to satisfy both coupon payments and to reduce its dependence on debt.

As the economy factors in the growing likelihood of sustained growth, investors are expecting that the Federal Reserve may hike interest rates, perhaps as early as June. In fact the Fed has already announced its intention to slow the injection of reserves by ending their massive purchases of Treasury, Federal agency, and mortgage-backed securities. This initial change to a less accommodative policy is beginning to push longer Treasury yields higher, which in turn is pushing fixed mortgage rates higher.

While expectations of future Fed rate hikes may seem counterintuitive to owning bonds in 2010, at Oakwood, we would welcome such preemptive policy actions. Ultimately, inflation containment is the only way to keep interest rates low. Otherwise, concerns of increasing inflation could well trump the hopes for economic expansion and renewed improvement in the housing market.

We accept that investors may not initially applaud calls for the Fed to act quickly. If it does occur, bond traders may attempt to push rates even higher across the entire yield curve. If 10-year Treasury yields approach 4.25%, we may respond by extending portfolio durations as the impact of higher mortgage rates will act to stall economic progress. The Fed cannot rely on inaction or bond prices will suffer, forcing mortgage rates to ratchet upward – long before the economy and housing can fully recover.

We expect 2010 to be unusually volatile as the economy searches for clear direction. Naysayers are again urging investors to shun bonds. They expect the extreme levels of stimulus to create a stronger economy and consequently higher interest rates. Our view on the economy is more pessimistic than the market’s view. If we prove to be correct, Treasury yields should remain surprisingly low into the year. But in the near-term, we remain cautious because the market has not yet adopted our view.

At Oakwood, we take into consideration market forecasts from multiple sources. As you know, our quantitative investment process results in flexible and active management designed to preserve capital during difficult times while positioning portfolios for future opportunity. Fixed income investments will always play a vital role for clients seeking investment returns greater than the reported levels of inflation or as a complement to higher-risk investment choices.