Taxable Fixed Income - Strategy
Our review of fixed income results for the first half of 2001 showed that taxable securities posted positive returns throughout most quality levels and maturity areas. Specifically, shorter maturity U. S. Treasury issues received a benefit from a series of six Federal Reserve interest rate cuts, while intermediate to long corporate bonds garnered their inherently higher income flow and modest appreciation, as the difference between their yield and that of Treasuries narrowed. In fact, as shown in the following chart only intermediate and long Treasury yields rose during this period. Fortunately, after factoring in coupon flow, the modest principal erosion was offset on all but a few issues.
From an historic perspective, during initial periods of aggressive Fed easing, longer maturity Treasuries have come under pressure, as investors become concerned that an easy monetary policy will lead to higher inflation. In fact, during the first half of this year, there was additional pressure from higher energy costs, increasing wage demands, which were accompanied by a drop in corporate productivity gains. Simply put, a very long era of declining inflation trends was clearly at risk.
However, we see the underperformance of longer Treasuries leading to a steepening in the yield curve as an opportunity to lock in an attractive yield, especially in the 15 to 20 year maturity area where yields are approaching 6%.
Our favorable forecast stems from several factors. First, on June 27th, Federal Reserve policy makers again voted to drop the targeted Fed Funds rate by only 25 basis points to 3.75%. This was half the amount of the five previous cuts and represented a disappointment to those investors wanting to see more decisive action. We feel this last modest effort was prudent, implying restraint on the part of the Fed and should be encouraging to inflation hawks. In addition, the Fed issued an accompanying statement denoting that the current risks are weighted toward more economic weakness. This should be viewed as a sign that the Fed does not feel they have gone too far in their efforts to stimulate the faltering economy. Second, we now see signs that oil prices may have peaked or at least have stabilized. This will have a positive effect on the costs to produce and transport goods. Finally, the Commodities Research Bureau index (CRB), a widely accepted inflation barometer, recently dropped to 204, well off its peak reading of 230 and significantly below the 210 level, the point below which one would be entitled to be positive on the trend in inflation.
All of the above factors should lead to a more stable interest rate environment as we approach the year end expecting a modest flattening in the yield curve. However, near term bond prices could be under pressure, especially if the stock markets rally. As inflation concerns dissipate, we believe investors will begin to favor longer investments. The enormous cash that has been building up in money market funds should in part begin to seek higher yield levels. Individuals are beginning to experience rate shock owing to a seemingly never-ending drop in money market rates. We also expect investors to continue to favor those companies with a stable or improving balance sheet as these organizations attract investors who are seeking more return.
This means that Oakwood clients can expect the overall duration and average maturity for fixed income portfolios to be as follows: a duration of 2.2 years with an average maturity of 2.5 years on shorter Governments-only portfolios, a duration of 3.5 years with an average maturity of 4.5 years on intermediate investment grade portfolios and a duration of 5.6 years with an average maturity of 9.0 years on full maturity portfolios. Because of the uncertainty of the near term direction of the markets, we will take advantage of the volatility to augment returns by extending or shortening portfolio durations accordingly. We will remain focused on security quality, as we add to our list of approved corporate issuers. In fact, we are pleased that our previous investment choices maintained their quality rating and participated in the first half of the year’s performance. Recent additions to our list of approved corporate issues now includes Kimberly Clark Corporation and Washington Mutual as a complement to our previous positions in such names as General Electric and Citigroup.
We continue to believe that fixed income will play a vital role in balancing a client’s risk tolerance with return expectations. We remain mindful that as interest rates move to seven year lows, a careful scrutiny of new investment opportunities should achieve our overriding goal to preserve market value and provide a reasonable return above inflation. We will continue our diligent study and vigilant observation and analysis of interest rate patterns which will, in large part, determine the entry and exit points for both short and long term trading decisions. Finally, we will continue to analyze changes in the yield curve to seek out additional yield with a minimal impact on overall maturity structure.
