Taxable Fixed Income Strategy

At the end of the last quarter, we noted the difficulty in predicting the future direction of interest rates. For the bond market overall, the second quarter of 2004 was the worst in 10 years, with the Lehman Aggregate bond index down 2.4%, almost exactly offsetting the first quarter’s gain. Changes in the economy, inflation and world events can heighten price volatility and easily alter return expectations in bonds. As a result, we shifted away from lower yielding, more price-sensitive Treasuries, to an over-weighting in higher yielding corporate bonds. The strategy proved to be a benefit for client portfolios, as yield and spread contraction has helped to preserve market value during this unstable period.

Furthermore, we noted that concerns over inflation favored some maturity shortening. During the quarter, there was evidence that corporations were beginning to raise prices, which can be a sign of inflation. This development weighed in on the Federal Reserve’s decision to halt the string of monetary easing that began four years ago. However, despite a 25-basis point hike at its latest policy meeting, Fed Chairman Alan Greenspan repeated that inflation is “not a serious concern” and reiterated that future rate changes are likely to be “measured” over the quarters ahead.

We agree that the recent Fed action was justified and believe that they will be diligent in their efforts to contain inflation, which must be done to maintain a long period of economic expansion. As a result, we are changing our current structure by adding to Treasury positions, primarily in the 3 to 5 year maturity area. However, we will continue to maintain an overall emphasis on higher coupon securities and remain duration-neutral to identified benchmarks. To accomplish this, we are reducing our over-weighted position in select corporate holdings, at attractive price levels. This return to more price-sensitive security choices should not imply that we feel further interest rates increases will not occur. Instead, our strategy is based on expectations of the occurrence of a notable increase in new corporate bond issuance with attractive yield levels and historic evidence that current corporate bond issuance lags the rate of GDP growth.

We must remain mindful, that even with the Fed’s access to endless data, it conducts monetary policy on a best effort basis in an ever-changing environment of unknowns. While it may appear obvious that additional tightening is likely, we believe that current yield levels throughout the maturity curve are in balance with current economic conditions and inflation evidence. As the Fed steers its way through these factors, they remain attentive to the benefits that a strong economy has on government needs, deficit management and job growth.

Since the Fed is expected to broadcast changes in monetary policy well in advance, our forecast calls for a subdued bond market this summer. This means that interest rates should trade in a narrower range than the past year. Just as the Fed used the words “measured moves” in its recent policy statement, we are likely to manage changes in the portfolio in a “measured way”. However, we expect to actively buy and sell a predetermined Treasury holding, concurrent with short-term market fluctuations. This strategy is designed to enhance portfolio returns within a somewhat cautious framework. Given the current situation, we anticipate waiting until the fourth quarter to become more aggressive. By then, the Fed should have a clearer view of inflationary forces.