Taxable Fixed Income Strategy
As we begin a new quarter, the demand for fixed income assets remains quite strong. It seems that economic uncertainty and international events are continuing to push investors into investments they perceive as being less risky. However, unlike the past three years, when the path to lower interest rates seemed almost endless, bond markets are now more volatile and the long-standing rally is climbing a wall of resistance. In fact, after reaching a recent record low yield of 4.60%, long Treasury yields are now 35 basis points higher.
Certainly, some of the lost momentum is attributable to market uncertainty accompanied by day to day shifts in market sentiment. However, the most relevant factor may be basic return limitations, as a result of historically low interest rates. As longer term market fundamentals, which include the economy and inflation, are held hostage to daily technical events, bond markets will experience an increase in price volatility and appear to lack a clearly defined direction. For example, one news item may report a spike in oil prices to $40 a barrel, followed the next day by the largest single day decline in over two years. Another report might reflect a $20.00 per $1,000 price drop in long Treasury bonds, only to be reversed the next day. This is a very emotional time and it is very possible that most of the volatility has little to do with basic market fundamentals.
At Oakwood, we have been bullish on bonds throughout the entire three year period and actually remain somewhat optimistic that interest rates can continue to move still lower. However, on a temporary basis we have shortened portfolio durations from modestly aggressive to neutral and intend to use this period of heightened volatility to our client’s advantage. As an example, on several recent occasions, we have successfully bought and sold the same Treasury position. This action was designed to capture gains in your accounts, to increase cash positions and move to a more defensive posture. Our objective is to augment returns by shifting in and out of the markets within a cautious or modestly defensive framework.
Another strategy being considered is the use of municipal securities in taxable portfolios. Historically, tax-advantaged municipal securities offer a lower yield than U.S. Treasury securities, which are taxable at the Federal level to taxable investors. In many cases, absolute yield levels on high-grade municipal bonds in the 10-year maturity area are equal to Treasury yields. As shown in the following chart, we do not believe this situation will last for long as these relationships will return to the normal range of between 82% to 87% of the comparable treasury yield. This means that municipal bonds would outperform their taxable counterparts or provide a layer of market protection should rates move higher.
Even though Treasury yields are low, we continue to find good return opportunities by investing in corporate securities. In fact, in client portfolios where corporate bonds are permitted, a 40% to 50% representation in high quality corporate bonds is typical. We look forward to a calming in world events to provide the catalyst needed for renewed corporate and consumer spending. Unfortunately, recent reports show consumer confidence at its lowest level in almost a decade. In the event that an unwinding in military action leads to economic growth and better corporate earnings, we are prepared to switch existing high quality corporate bond positions to choices of incrementally lower quality. This action will capture additional yield and, as yield spreads compress toward Government securities, relative returns will be enhanced.
We continue to see many opportunities ahead. Independent of an interest rate assessment, volatility and daily price fluctuations can be utilized as an effective tool to reduce risk, preserve market value or improve returns. We continue to monitor market fundamentals to assess the direction of interest rates. One such barometer is the impact of oil prices on interest rate movements. For now, a market neutral stance is appropriate and patience is required. However, we do remain ready to take action if the situation warrants it.
In conclusion, we believe that fixed income securities should continue to play an important role in wealth planning and risk management. We continue to believe that a conservative approach to the fixed income markets will adequately provide a balance between market protection and return capability.
