Taxable Fixed Income Strategy

As bond investors enter the second quarter of 2006, many are wondering “When will interest rates stop going up and begin to once again move lower?” They note that newly appointed Federal Reserve Chairman, Ben Bernanke, at the Fed’s latest March 28th meeting, picked up where Alan Greenspan left off in January. The Fed pushed up its main rate a quarter-point higher for the fifteenth time, to 4.75%. Furthermore, those who were looking for signs that the Fed would stop raising rates were disappointed that Bernanke, in his accompanying statement, left the door open for further rate hikes. This implies that a Fed Funds rate at 5.0% is practically guaranteed, with the potential for additional rate hikes beyond that level.

As pointed out in previous editions of the Oakwood Outlook, we feel that it is important to differentiate “future inflation expectations” from “current inflation reporting” as the key to understanding monetary policy and, more importantly, to projecting changes in market expectations. For example, clearly, to date, inflation has remained under control. A widely watched current inflation report, the Commerce Department’s personal consumption expenditures (PCE) core index, rose only 2.1% on an annualized basis, during the last quarter. Given this benign reading, why are bond investors concerned? For one thing, central bankers have said they would be comfortable with a 1.0 to 2.0% inflation level. While this initial 2.1% level is only modestly above their range, the report was later revised upward to 2.4%. This revision can focus the attention of the Fed to the fact that future inflation expectations may soon trend even higher.

Adding to concerns is the state of the economy. As you are aware, the economy remains quite strong despite the headwinds of higher energy and commodity prices and higher interest rates. Despite earlier evidence that employment growth may be slowing, new data suggests that the economy is expanding at a 4.7% pace in the first quarter. This is consistent with factories running at 81% of capacity, matching a five-year high, in December. The Fed may be concerned that the level of growth will further drain the pool of available workers who will then demand higher wages. This, combined with the run-up in commodities prices, hints that inflation trends may indeed move higher. Therefore, we feel it is important for the economy to slow as a prerequisite to an end in rate hikes.

Not all of the news is negative for bond investors. The following graph demonstrates confidence that the Fed will be successful in its efforts to curb this inflation threat.

Since the start of the interest rate tightening in June 2004, the Fed’s targeted fund rate has increased 350 basis points, to 4.75%. Concurrently, the yield spread separation between Fed Funds and 30-year Treasury bond yields has declined to zero. This means that long bond yields rose only modestly in the face of relentless Fed tightening. If inflation were indeed systemic and not a short-term issue, long bond yields would increase well beyond current levels, despite strong demand from overseas investors.

We believe this persistent Fed policy will ultimately reward bond investors. This is not to suggest that it’s time to turn completely bullish in the fixed income market. Our goal remains to preserve capital and position ourselves for an upcoming bond rally. Therefore, we continue to maintain a modified barbell structure in client portfolios. As an example, because yields levels in the shorter maturity areas match the yields in the 4 to 7 year maturity area, we hold a large weighting in shorter securities. This strategy produces similar coupon cash flow while providing valuable protection against further Fed rate hikes. In addition, we hold a market weighting of securities in the longer 7 to 10 year area. This is in response to the previous graph which suggests a degree of market stability and growth potential. Our preference is for corporate bond holdings with strong quality trends. Examples include:

• HSBC Holdings, one of the largest banking and financial services organizations in the world;
  
  
• J.P. Morgan, a global financial services firm, under the direction of well respected CEO Jamie Diamond;
  
  
• Black and Decker, a global manufacturer and marketer of power tools and accessories, hardware and home improvement products, and technology-based fastening systems; and,
  
  
• Lockheed Martin Corporation, which researches, designs, develops, manufactures, integrates, operates and sustains advanced technology systems, products and services, and whose corporate bond holdings have recently been upgraded.

We expect Chairman Bernanke to err on the side of caution in order to establish credibility. The decision to raise interest rates at the latest meeting marks the first attempt by Chairman Bernanke to shape monetary policy. We view a continuity of monetary policy as an essential ingredient to a continued strong economy and low inflation. Therefore, we remain committed to preserving capital and look forward to a better bond market ahead. We believe fixed income will soon reward investors for their patience and to even consider abandoning the bond market with 15 rate hikes behind us is a huge mistake.