Taxable Fixed Income Strategy

We continue to generate positive fixed income results for Oakwood client portfolios in the first quarter of 2004. As shown in the following chart, yield levels throughout all maturity areas moved modestly lower during the quarter, with the five and ten-year area capturing the largest decline.

This downward trend in interest rates suggests that the fundamentals governing the economy, inflation and monetary policy, remain somewhat favorable for the fixed income markets. As an example, corporate productivity gains continue to bolster company profits with only a limited need to raise prices. A stable Federal Reserve monetary policy is helping to keep mortgage rates low and the demand for housing strong, with low monthly interest expense counteracting the inflationary aspects of escalating housing prices.

The current bond market environment is somewhat reminiscent of year-end 2002, a period when oil was also trading above $30. Ironically, US Treasury yields at that time were almost identical to present levels. As highlighted in previous Oakwood Outlooks, one preeminent factor in keeping interest rates and inflation low is the impact these high energy prices have on the economy, and, in turn, on a company’s ability to demand higher prices for products. Another factor is a shortfall in confidence that the economy can sustain strong growth. In fact, even though currently strong, there is a growing concern that the recovery may be slowing, as conflicting economic reports begin to surface. For example, while fourth quarter Gross Domestic Product (GDP) grew at 4.1% and exceeded market forecasts, factory orders rose at only 0.3%, well below predictions and the Chicago Purchasing Manager Index fell from a reading of 63.6 last month, to 57.6. Furthermore, stubbornly high energy prices continue to erode airline profits, despite high passenger volume. Finally, consumers are being forced to spend more of their discretionary income to fill up their vehicles.

Clearly, since the start of this latest economic cycle that began in 2001, the lack of new manufacturing jobs is keeping interest rates low and bolstering the bond market. Future changes may be the key to interest rate direction. Most economists along with Federal Reserve Chairman Alan Greenspan say that patience is needed, as they expect gains in corporate productivity to moderate soon and translate into a need to add jobs. While it is intrinsically difficult to accurately predict the future direction of interest rates, it is even more difficult with bond rates near historic lows. As a result, changes in the economy, world events and small adjustments in inflation can heighten price volatility and easily alter return expectations in bonds.

Therefore, we are initiating several changes in client portfolios. First, we are beginning to reduce the average maturity of our Treasury holdings. While similar maturity corporate bonds are also subject to erosion of principal, their inherently higher yield and potential to be upgraded should provide a market buffer. This is especially true if the catalyst for higher interest rates is an expanding economy, modest inflation and better corporate profits.

Second, the use of short-maturity, high coupon, callable securities provide additional yield versus non-callable alternatives, with an emphasis on the early call dates. Because we insist on a very generous yield to the final maturity, market protection is guaranteed if the security is not retired early. Regardless of the outcome, the high coupon generates above market cash flow, which is an essential part of investment performance.

Finally, concerns over inflation have prompted us to prepare programs to shorten portfolio duration. All precious metals which include gold, copper, platinum and silver, along with oil, are sending commodities prices to multi-year highs.

As the worldwide demand for commodities continues to grow, manufacturing companies are being forced to pay higher prices. In fact, the latest Institute for Supply Management report reflects a sharp increase in respondents who report paying higher prices for raw materials. Unless the situation changes, we intend to initiate duration-shortening beyond our current market neutral stance.

At the same time, we will remain flexible and will be able to easily shift back to a more aggressive posture. We are mindful that the long-term downward trend in interest rates that begin over 20 years ago remains intact. During this period, there have been numerous times when we were able to take advantage of short-term price fluctuations to add value to client portfolios. Because we hold only high quality securities that are highly liquid, we can respond quickly to future moves. For now, we feel our shift to a somewhat cautious structure is a better match for the potential risks.