Taxable Fixed Income Strategy

On March 22nd, Federal Reserve officials announced the seventh well-telegraphed increase to the Federal Funds target rate. As shown below, since the start of monetary tightening, this benchmark rate increased from 1.00% in June 2004, to its current level of 2.75%.

In an accompanying statement, the Fed continued to emphasize, “longer-term inflation remains contained” while adding, “inflation pressures in recent months are picking up.” In fact, the measurement the government uses to adjust Gross Domestic Product (GDP) for inflation was revised higher, adding to evidence that price pressures are building. This, combined with rising Consumer Price Index (CPI) and Producer Price Index (PPI) prices, is a cause for concern and easily justifies the Fed’s actions.

It seems likely that the markets will continue to struggle for a while longer, as rising short-term interest rates, inflation uncertainty and the dilemma of rising oil prices persists. As the outcome unfolds, we feel confident in our ability to respond to the markets and comfortable that our current portfolio structure is solid. The following is a list of actions taken during the quarter:

1. In the face of a strong economy and rising corporate profits, rather than adding to corporate positions, we have systematically reduced these holdings in advance of a modest widening in yield spreads. In fact, during the first quarter of 2005, the yield benefit in most corporate sectors was offset by heightened “event risk,” causing a modest widening in yield spreads. Our goal is to avoid unforeseen credit risk and take advantage of selling into historically narrow yield differentials relative to Treasuries.
   
   
2. We have maximum liquidity throughout client portfolios due to an over-weighting in US Treasury securities. This overweighting gives us the flexibility to monitor all changes in the corporate bond sectors and the latitude to act on our findings. As an example, we have a renewed interest in General Electric Capital. This very high quality company has low event risk and can be purchased at a higher yield level than in the recent past.
   
   
3. We hold investments beyond ten years, an area in which persistent Fed actions provide comfort to investors who fear inflation will become embedded in the economy. As a result, the market place defines the inflation problem as a short-term issue, not a long-term dilemma. As shown in the following graph, yields in the short and short/intermediate maturity areas of the Treasury curve have felt the brunt of Fed tightening, while yields beyond the ten year maturity area reflect the comfort level investors have found there.
   
   In order to provide balance to the more aggressive nature of longer more volatile investments, we hold highly liquid one-year or shorter positions.
   
   
4. We continue to focus on less risky investments with a predictable return profile. While it is difficult to entirely avoid the negative impact of rising interest rates, our investment choices continue to preserve capital and provide good relative returns to their respective performance benchmarks. As an example, low coupon one to four year callable Government Agency securities are competitive with corporate bonds and offer a solid yield advantage versus Treasuries or non-callable Agencies. Their discounted price and lower, yet competitive coupon eliminate the obstacle of an untimely call. Furthermore, the short final maturity reduces price volatility during these uncertain times.
   
   
5. Existing corporate investments provide an extra benefit as companies take advantage of the “make whole” indenture provisions. This provision allows corporations the ability to retire high coupon debt early, with an advantage to both the company and the investor. Most recently, we held a position in Occidental Petroleum that was called away at a generous premium to the market. With the proceeds, we were able to gain yield and further fine-tune client accounts. Even if these types of bonds do not experience an early call, we still benefit from above market cash flow from coupon payments.

Because the pressures on inflation will more likely be up than down, it appears the Fed has more work to do. Even though extending the duration of client portfolios to gain more yield is tempting, with the absence of conviction, we remain cautious. At some point, it is our goal to sell a portion of both short and long holdings, in favor of more intermediate 5 to 10 year investments. To perform well in this area of the yield curve, the markets must sense a calming in inflation fears to be accompanied by a call for a change in Fed policy.

Meanwhile, we will continue to carefully monitor all client holdings and stand ready to react quickly, should market or quality fundamentals deteriorate. We feel we are getting closer to a better bond market.