Tax Exempt Fixed Income Strategy

The first quarter of 2002 ended with yield levels on municipal bonds essentially unchanged from the start of the year, with the exception of the shorter maturity area. However, even in this area yields are only about 20 basis points higher. This translates into only a slight decline in principal values during the first three months. In fact, after factoring in income flow from coupon payments, Oakwood clients can expect slightly positive total returns for the quarter.

Similar to the taxable markets there are several difficulties facing the tax exempt markets. First, the general direction of interest rates continues to be up, as investors remain concerned about the effects of monetary policy, the economy and inflation. Second, investors worry that municipalities will rush to the markets trying to lock in low rates before the Federal Reserve tightens monetary policy. The bottom of every economic cycle since 1917 has been followed by surges in new municipal bond supply.

In response to several of these market uncertainties, we have allowed our maturity structures to shorten with the passage of time. At the same time, we remain very selective on new investment choices and have resisted the temptation to overpay for bonds. As an example, for California clients, we have been reluctant to switch from the out-of-state positions we currently hold in favor of California specific issues. Until yield spread differentials garner a tax advantage to our clients, we will maintain our current high quality, very liquid general market holdings.

Furthermore, during the past year and in anticipation of the growing evidence that the bond rally could stall, we were proactive in targeting bonds with a coupon level above 5%. This provides protection to the portfolio in two ways. First, higher income flow provides a partial buffer against the negative effects of rising interest rates. While many managers found themselves extending to long maturity bonds to pick up additional yield, we primarily focused on income generation as an essential component of future returns. Second, a deterioration in market values could leave lower coupon securities vulnerable to the “de-minimis” effect, whereby future market appreciation of discount type securities are taxed at a higher ordinary income tax rate then capital gains.

While some market participants may worry about excessive supply, we look forward to a plentiful amount of new California specific and general market bonds. As an example, in California, the prospects for substantial budget shortfalls remain likely, even after factoring in a mid year budget cut of $2.2 billion. To address this dilemma, the State has already started to issue bonds with its latest offering totaling $1.1 billion. Despite Standard and Poors’ affirmed A+ rating yield levels had to be raised in order to attract investors. As a result, we did participate in this bond offering; however, we purchased only those bonds receiving credit enhancement, thereby making them Aaa rated.

While some market participants view an expanding economy as a negative to interest rate direction, we view it as a basic ingredient to strong credit quality. In fact, we believe that any upward adjustment in yields from here will prove attractive to investors. Money market funds are flush with cash from investors fleeing the stock market. Although some of those funds will flow back into stocks, a fair amount is destined for the bond markets, once yields look more attractive.

The decline in tax revenue attendant to the recent recession has wreaked havoc with the budgets of many states and municipalities. This has resulted in numerous downgrades while many still remain on negative credit watch. Oakwood has protected clients from this potential problem by emphasizing only the highest quality bonds in client portfolios. Looking forward, municipalities will have to realign their expenditures in order to close budget gaps. We are pleased with our current portfolio choices and this provides us with maximum flexibility to take advantage of future market opportunities as the year progresses.