Taxable Fixed Income Strategy
Spirals are Reversible

The lowering of the Fed funds rate to 2.25% on March 18th marked the Federal Reserve’s sixth consecutive cut since the rate peaked at 5.25% in August 2007. While additional cuts cannot be ruled out, the Fed’s aggressive actions are making investors wary of inflation. On the other hand, battered credit markets and the illiquidity of many investment vehicles are a clear threat to economic growth. This self-feeding economic downturn is becoming entrenched—with erosion in financial conditions reinforcing predictions of recession.

The chart depicts the Fed’s attempt to assist our faltering economy with its decisive monetary policy easing.

The heart of the U.S. economic problem is housing. The collapse of the sub-prime mortgage market has led to $208 billion in write downs or credit losses since the start of 2007. This is causing home values and consumer confidence to spiral downward to the point of pushing the likes of Bear Stearns to the brink of bankruptcy. Not since the 1973 oil embargo have consumers been so pessimistic about the economy.

Strong Positioning Helps Portfolios

Despite these problems, Oakwood clients nonetheless experienced steady improvement in the value of their fixed-income assets. Last year, anticipating these problems, we significantly reduced our exposure to financials and allowed many of our federal agency holdings to mature or be called prematurely. With the proceeds we overweighted U.S. Treasury securities. This action was taken as a protective measure to deteriorating credit conditions and to benefit from declining interest rates.

In the year’s first quarter, we reversed that decision. We began swapping select Treasuries to mostly non-financial corporate bonds, e.g., McDonalds, General Electric, John Deere, and Berkshire Hathaway. We have also recently renewed our interest in both the Federal Home Bank and Federal Farm Credit Bank. We believe the mortgage credit freeze is forcing politicians to scrutinize the mortgage origination process and potentially redefine the Fed’s role in conducting monetary policy. For example, along with the Fed’s ability to conduct policy through open market operations, lowering of short-term rates or the availability of reserves in the system, the Fed must also convince investors of its readiness to support Government-sponsored agencies (e.g., Federal National Mortgage Association, Federal Home Loan Mortgage Corporation) in times of crisis. By contrast, we continue to avoid mortgage-backed securities. The clear identity of collateral, market place support, liquidity, credit support and investor confusion all contributed to this decision.

Affordable Mortgages to Give Positive Traction

The bottom line is that the U.S. public needs access to mortgages at affordable rates. Even with its aggressive monetary policy actions, the Fed has been unable to achieve this goal thus far. Rather than pass the lower borrowing costs along to consumers, we see banks tightening lending standards and applying the savings to rebuild their balance sheets. The evidence is that recent differentials between 10-year Treasury yields and fixed mortgage rates is 2.75%, one of the widest gaps since 1986.

It’s possible that until the Federal Reserve stops the aggressive easing, the problem will linger. There’s little incentive for banks to originate new mortgages by paying higher interest rates to attract deposits. Furthermore, the endless flood of Fed liquidity is rekindling inflation fears. This in turn raises 10-year Treasury yields and keeps fixed mortgage rates higher than they would otherwise be. We feel that homebuyers will re-emerge if fixed-rate, 30-year mortgages drop to around 5.50%, and if buyers qualify. According to the U.S. Census Bureau, nearly 18 million homes stood empty in the first quarter.

Looking Ahead

Our current duration target on portfolios is modestly aggressive to the respective benchmarks. We still like U.S. Treasuries in the 11 to 13 year maturity area. The present yield gain is +40 to +50 basis points versus 10-year alternatives.

The balance of the year should prove rewarding to fixed-income investors. While last year investors saw large gains in Treasury prices, this year the added yield in high quality corporate and agency bonds should benefit returns. We continue to closely monitor economic conditions and corporate earnings for signs that may alter our current outlook.