Taxable Fixed Income Strategy
The first half of 2002 ended with solid fixed income gains for Oakwood clients. Once again, bonds played a vital role in the preservation of capital and the controlling of risk in conjunction with other asset classes. At the latest Federal Reserve Open Market Committee (“FOMC”) meeting, Fed authorities decided to hold the targeted Fed Funds rate at 1.75%, which may remain for the balance of the year. Presently, the yield differential between Fed funds and the ten year U.S. Treasury bond is 310 basis points. Based on historic relationships, yield levels on the 10-year Treasury appear somewhat wide, leaving room for compression, should bonds continue to rally. While this implies a favorable outlook for bonds going forward, we are now focused more on the potential risks facing the markets.
To date, stronger than expected economic data, widespread weakness in the dollar and increases in commodity prices are being overshadowed by Middle-East tensions, declining stock prices and a notable lack of investor confidence. However, even one of these factors, such as a continued decline in the U.S. dollar, could eventually fuel higher consumer prices once importers are forced to raise prices in order to maintain acceptable profit margins. In addition, the CRB inflation index (a broad measure of commodity prices) now stands at 209, up from a low reading of 187 earlier this year. While the reading remains well within an acceptable tolerance, it could mark a bottom in the inflation cycle. The bond market often reacts in anticipation of an actual event.
Furthermore, a calming in Middle-East tensions, a subsequent drop in oil prices and improving corporate earnings could be catalysts to bolster stock market confidence. This could spark a rally in stocks and a call for Fed interest rate tightening. To date, investors are also fleeing the stock market in favor of the presumed comfort and safety of fixed income securities. Unfortunately, many corporate bond investors have not shared in this protection, as rating services continue to ratchet down the quality rankings of once sound companies to junk or default status.
At Oakwood, we have avoided the fixed income securities of those corporations which have generated significant losses to investors. In fact, we remain very selective and continue to emphasize corporate bond choices in the short to intermediate maturity areas. However, as an added layer of protection, we stand ready to sell all existing corporate bond positions, in favor of U.S. Treasuries or Federal Agencies, if we perceive even a small negative market event. Examples of this trend include a reduction in both General Electric and IBM bonds for now. We look forward to a time when we will again overweight corporate bond positions and embark on a program to lengthen existing holdings for yield gains. However, we will remain patient pending validation of a prolonged positive economic trend and then only after the stock market has improved.
As pointed out earlier, the early detection and monitoring of potential problems facing the markets may trigger additional changes to our current strategy. However, for now the basic elements driving lower interest rates, primarily low inflation and economic uncertainty, remain intact. With the avalanche of pessimism facing the stock market, we will remain fully invested with target durations close to their respective benchmarks. We continue to believe there are many opportunities ahead for bond investors.
