Tax Exempt Fixed Income Strategy

In an otherwise difficult interest rate climate, municipal bonds provide a somewhat bright spot. In fact, our recent decision to selectively extend shorter maturity positions into the 10 to 17 year maturity area has helped to stabilize market values. As an example, a 15-year municipal bond generated enough income to overcome a modest market decline. This occurred as the demand for longer securities remain strong, especially in the face of two additional rate increases by the Fed since the beginning of 2006. The following graph shows yield changes in municipal versus taxable securities since year-end 2005.

Although both taxable and tax-free yields have moved higher, the magnitude of increase is less for municipals, especially in longer maturity areas.

A review of Oakwood client fixed income portfolios essentially reflects flat returns for the first quarter. Nonetheless, client portfolios enjoyed good cash flows from interest payments on their bonds, and we are pleased with our ability to retain market value during this difficult environment. In fact, we feel the municipal bond sector continues to provide an inherent degree of market protection, for the following reasons:

• Based on quality, while municipals have more risk than government securities, the historical default rate is less than 1.0%. This provides comfort to investors even under the weight of ongoing Fed actions.
  
  
• The demand for municipals is driven by a tax advantage to those investors in higher tax brackets. Unlike taxable bonds, where demand can be distorted by foreign buying, a shift away from US securities would be less onerous to this market sector.
  
  
• Taxable equivalent yield levels on municipals are favorable versus taxable alternatives even after adjusting for inflation. As an example, investors can capture a 4% tax-free yield by investing in a 10-year bond. For higher taxed individuals, this equates to over 6% on a taxable equivalent basis, well above both a comparable high quality corporate bond yield of around 5.65%, and of core inflation at around 2%.

Overall, the quality level in municipalities is improving as the economy remains strong. However, we still prefer to scrutinize each investment choice as a protection against a slowing economy. Our fixed income investment process is dynamic, and is a process in which we continually strategize. As such, we have postponed our goal to extend portfolio durations from 5.0 to 5.5 years. And as previously mentioned, on a limited basis we will continue to seek value in the 10 to 17 year maturity area. For California clients, we continue to invest in local level municipalities and avoid purchases on a State level, even with some financial improvement at the State level. This avoidance will not change until policymakers focus more on expense reduction than on a tax revenue bailout from the bustling economy.

While this remains a difficult period for bond investors, we believe we are nearing a time when markets will become more stable. The higher yields have adjusted to market concerns and now provide an acceptable yield over inflation. As pointed out earlier, municipal investments provide a way to squeeze out more after tax-income. As the Fed nears completion of its mission to curtail the threat of inflation, the higher level of yields should provide investors with growth opportunities and a solid flow of tax-free income for years to come.