Taxable Fixed Income Strategy

As we enter the second half of 2003, with interest rates at levels not seen since the 1950’s, the overall tenor of the bond market remains quite favorable. As pointed out in the last Oakwood Outlook, during the first 3 months of 2003, we were impressed with the market’s ability to preserve market gains after three consecutive years of declining interest rates and bond price rally. In fact, as shown in the following chart, yield levels on U.S. Treasury securities are still lower throughout all maturity areas. This yield change consistency is indicative of an anemic economy and low inflation.

One of the unresolved issues is whether or not the historic low interest rate levels will be enough to jump-start the economy without rekindling inflation. While we believe it is important to be on the correct side of economic issues and interest rate forecasting, basic portfolio structuring and proper security placement within portfolios are essential to achieving good performance and controlling market risk.

As an example, in view of market uncertainties, we will continue to manage portfolio risk as measured by duration, which is the bond’s price movement to changes in interest rates, within a narrow defined range of the respective benchmark. This decision should provide good relative performance, independent of future interest rate moves and without the risk of either being left behind during periods of market rally or subjecting portfolios to unwelcome losses, in the event that interest rates were to move significantly higher. Furthermore, a more neutral market stance at this time provides discretion to become more or less aggressive, should a significant change in market conditions occur. Currently, we view a significant reversal in current rate levels as counterproductive to the Fed’s efforts to grow the economy. Yet, we are mindful that most market forecasters almost always underestimate the magnitude of cyclical shifts in the economy, interest rates and the market direction. Therefore, prior to initiating a major change in duration targets, we will patiently monitor daily conditions closely in order to identify points of market overreaction.

Meanwhile, in preparation for the second half of the year, security choices and placement are based upon three themes. First, where client permitted, we have up to 50% in corporate securities. We continue to utilize this sector effectively as a way to capture incremental yield with the potential for added return should yield spreads continue to compress to U.S. Treasury alternatives. Second, the use of short maturity callable Federal Agency securities is used to boost yield further, while providing excellent liquidity for potential adjustments in duration targets. Finally, because U.S. Treasury securities are highly sensitive to daily interest rate changes, we will continue to adjust our long Treasury representation in an effort to capture short term moves in the markets.

As stated earlier, we are pleased with the role fixed income securities play in providing investors with a reasonable return above inflation with less risk than many other investment choices. Their benefit should continue even as the economy begins to grow. We believe that the Fed’s stimulative efforts provide an excellent start, although uncertainty lingers as to the extent it will support forecasted growth. Consumer debt levels both on an individual basis and as a percentage of GDP growth remain extremely high. Furthermore, historically low mortgage loans and enticing consumer-borrowing rates may be artificially subsidizing the economy on a short-term basis. This condition provides the argument for still lower interest rates and further bond gains, especially in the long maturity areas where rates are higher.

On the other hand, the U.S. dollar continues to weaken versus other currencies and the price of gold keeps rising, indicating to us that the risks of deflation are low. As a result, we are beginning to initiate a barbell structure in portfolios, whereby we are reducing intermediate 4- to 8-year holdings, in favor of shorter and longer investments. Should the markets begin to sense an end to the declining inflation trend and prepare for a change in monetary policy, this strategy should protect portfolio value, as intermediate yields rise at a faster pace than short and long rates. We believe that this strategy will continue to meet your objectives of preserving capital and receiving decent returns.