Taxable Fixed Income Strategy

Federal Reserve policy makers met recently to outline the future direction of monetary policy. As widely expected, they decided to leave the benchmark Fed Funds target rate unchanged at 1.75%, at least for now. However, in response to signs of an improving economy, many observers are convinced the Fed will have to raise this key rate some time this year.

Clearly, during the past fifteen months, the Fed has undertaken a series of aggressive steps to stimulate the economy. Now that there are signs that the economy may be recovering the Fed has indicated that it is moving to a more neutral stance. In order to actually adopt this more neutral stance, some of the eleven consecutive rate cuts may have to be reversed. This may be especially true because of the excess liquidity injected by the Fed into the monetary system with the four rapid-fire rate cuts occurring in the wake of the September 11 tragedy.

However, given the benign inflation picture and the Fed’s need to better evaluate future economic expectations, we believe they may be slow to act, pending several more months of economic data. Despite their ultimate decision, it may be a mistake to conclude that intermediate and long-term interest rates will move in conjunction with this decision and result in higher yield levels. In fact, for the following reasons, we are beginning to view the current interest rate climate as attractive.

First, the previous eleven interest rate cuts, designed to stimulate the economy, may actually be the culprit for the bearish market sentiment that has resulted in the recent rise in longer maturity yields. This is because the bond market views those eleven rate cuts as so stimulative that inflation is likely to be ignited. In fact, since October long Treasury bond yields have risen over one percentage point, resulting in principal losses of 15%. Therefore, an end to the aggressive easing pattern may be the confidence builder needed for bond market stability.

Second, the current higher levels of interest rates could slow the stock market and stall hopes for a new prolonged economic expansion. As an example, the yields on 10-year Treasury notes, to which many residential mortgages are tied, have risen more than one percentage point recently, bringing conforming 30-year fixed mortgages solidly above 7%. Going forward, pent-up demand among consumers for big ticket items may be more subdued now that the low-interest-rate driven frenzy in autos we’ve recently observed has dissipated.

Third, if the Fed moves too quickly to raise interest rates prior to corporations actually reporting higher profits, plans for a sustained economic recovery could easily be derailed. Finally, as a result of the recent increases in interest rates and yield levels, fixed income investments should begin to attract investors seeking good total return potential.

However, until the bond market fully adjusts to the prospects of economic growth and the possibility of Fed tightening, we will remain cautious. Therefore, we will resist all aggressive portfolio changes and instead pinpoint the placement of each security along the yield curve. This is designed to limit interest rate risk and increase overall portfolio yield. As part of this strategy, we have also increased corporate bond positions where appropriate. As an offset, we have selectively reduced Treasury holdings, especially in the intermediate and long maturity areas, where price volatility remains quite high. Finally, we will continue to hold several short maturity positions as further defensiveness and protection against the possibility of still higher interest rates.

We are pleased with our current security choices and, while it is difficult to entirely escape this recent bond market correction, we believe our efforts have paid off. As the markets begin to show signs of stability, we will again buy more Treasuries for their maximum price sensitivity characteristics. Despite ongoing market concerns, we believe that the taxable bond market, by year end, could generate very satisfying returns for the fixed income investor. We further expect that this will be accomplished with limited downside risk from here.