Taxable Fixed Income - Strategy
After a series of six interest rate hikes that began in June of 1999 and lasted through May of 2000, the Federal Reserve has clearly reversed its tightening bias. As evidence, Fed policy makers have voted to lower two key interest rate indicators, Federal funds and the discount rate, three times in 2001, to 5% and 4.5%, respectively. Past concerns of an overheating economy with potential labor shortages have given way to fears of a possible recession. In fact, the U.S. economy grew in the fourth quarter at the slowest pace in 5 1/2 years, as consumer confidence plummeted and corporations began to announce layoffs, almost on a daily basis. The Fed’s primary focus on inflation fighting is giving way to marketplace calls for additional interest rate cuts, in order to re-ignite the ailing economy. Even President Bush’s original proposal for tax relief, which is back loaded in order to have a bigger impact in future years, is giving way to growing pressure from economists to effectuate immediate tax cuts that are retroactive to the beginning of the year.
What does this mean to bond investors and where do we go from here?
As shown in the following graph, the above events have resulted in a significant decline in short term yields:
Over the last six months, 90 day U.S. Treasury bill yields fell over two percentage points, from approximately 6.5% to 4.3%. During this same period, balances in money market mutual funds have grown to all time highs (over $2 trillion). While seemingly inconsistent with the large drop in short term yields, most of the positive cash flow comes from investors seeking a safer, albeit temporary, alternative to the stock market. At some point, both stock and bond markets could benefit from this enormous liquidity buildup, especially if short-term yields continue to drop and stocks begin to stabilize, as we expect.
Interestingly, while short-term yields continue to decline, yields on 5-year Treasuries, at 4.6%, have not changed much in 2001. Furthermore, yields on 30-year Treasury obligations, at 5.6%, have actually moved slightly higher. Typically, longer term bond yields reflect the fact that investors tend to anticipate changes in monetary policy. Once the policy change is actually effectuated, the bond market frequently stalls out and may even sell off. Therefore, as the Fed moved to lower key short-term indicators and bolster economic growth, we were not surprised that intermediate and long maturity Treasury yields stalled.
Oakwood clients will again enjoy good positive returns for the quarter. Our portfolios emphasize above market income flow while the shorter maturity positions received a return benefit from declining interest rates. In addition, because Oakwood portfolios have held both Federal Agency and corporate bond holdings, returns have been augmented by the yield spread contraction these issues have experienced. In fact, corporate bonds have put in a remarkable performance this quarter despite heavy new issue supply, declining corporate profits and downward revisions in their earnings expectations. As expected, the compelling attraction of historically wide yield spreads versus comparable U.S. Treasury counterparts received a psychological boost from a friendlier Federal Reserve and prospects of a better economy.
With this benefit behind us, we are now selectively reducing our overall weighting in corporate bonds, in favor of a further over-weighting in the Federal Agency sector. These high quality Government sponsored entities continue to offer good value on a risk-adjusted basis, by providing generous yield and excellent liquidity. While not entirely protected from a possibility of recession, Federal Agency securities should provide more protection against negative events than would those corporations struggling to regain earnings momentum. However, we will maintain some holdings in selected corporations which are involved in the rebuilding of defense, the replacement or expansion of current airline capacity, growing insurance needs or interest sensitive banking operations. Furthermore, we are increasing our research efforts on U.S. dollar denominated Canadian issuers, for increased diversification and potential return opportunities.
We remain cautiously optimistic on the overall direction of interest rates. However, the ultimate direction may depend on the pace of monetary deployment, stock market direction and the duration of the economic downturn. Continued and decisive easing could quickly rebuild consumer confidence and potentially lead to a stock market rally. In this environment, it is likely that the bond market would take a breather, possibly earning only the coupon. Conversely, if the Fed acts more gradually to lower rates and the economy does not respond soon, bond values would move noticeably higher, especially in Treasury and Federal Agency sectors. We must remember that the Fed has already lowered interest rates three times, with a fourth rate cut expected at its May 15 meeting. This may already be enough to rebuild consumer confidence, rekindle the economy and reverse the stock market. In any case, we will closely monitor upcoming events for any changes in our forecast. For now, fixed income securities should continue to act as a buffer to stock market volatility and provide a nice stand-alone investment or complement to other asset choices.
