Taxable Fixed Income Strategy

The future direction of Federal Reserve monetary policy appears to be the dominant issue facing the fixed income markets, as both market forecasters and investors try to predict the end to the Fed rate increases. Many point to a moderation in inflation pressures and conflicting economic data as reasons for the Fed to soon end its tightening. In fact, several Fed Open Market Committee (FOMC) policy makers, including Dallas Federal Bank President Richard Fisher, suggest that the central bank is in “the final innings” of its interest rate increase. Furthermore, the historic low level of long-term interest rates indicates that inflation is contained and the Fed should be nearing the end of tightening.

While this may prove to be correct, at Oakwood, we don’t necessarily see an urgency to stopping the string of the nine consecutive 25-basis point interest rate increases that began in June 2004. The economy, in spite of escalating oil prices, continues to grow at a solid pace with the latest reporting of GDP growth at 3.8%. The unemployment rate stands at 5.0%, its lowest level since September 2001, and weekly jobless claims continue to trend lower. Furthermore, policy-making is much more transparent than it was several years ago and has taken a lot of the risk-premium out of the market. This allows the Fed to conduct monetary policy without creating unwarranted gyrations in bond prices, consumer confidence and economic expectations. As shown, this factor alone may explain the pattern of declining long maturity US Treasury yields, in the face of repeated Fed rate tightening.

Unfortunately, this unexpected drop in long term rates is causing a problem for the Fed, as home prices have been escalating at an unsustainable pace and consumers tap equity in their homes for spending. As discussed earlier, the US is not currently a “savings” country. Recent reports indicate that over $200 billion of funds that could be invested into a hard asset or saved (actions the Fed would prefer to see) has not been utilized in this productive way. At some point, this alarming trend may be the catalyst for a drop in home values or even a recession.

Meanwhile, we will continue to focus on attractive areas of the yield curve as a way to capture valuable return. In fact, in spite of significantly higher short-term interest rates, Oakwood clients enjoyed positive returns during the first half of 2005, throughout short, intermediate and longer investment strategies. And, despite all the worries about higher bond yields, our full maturity investment strategy was able to produce even higher positive returns. We continue to favor higher yielding discount callable Federal Agencies in the 2 to 3 year maturity area. In addition, we plan to add a five-year zero-coupon Treasury holding. Benefits of zero-coupon holdings include market values that compound over time and the avoidance of a possible untimely reinvestment of coupon cash flows.

Recently, we have reversed our under-weighting in intermediate 4 to 10-year maturity areas, by shortening longer Treasury positions and extending very short holdings. As shown below, this decision is designed to improve yield and return potential in advance of market demand, as investors see the value of this maturity area. Because we don’t know the ultimate extent of Fed tightening, we remain duration neutral versus respective performance benchmarks.

Finally, as a protection against the risks of negative financial news events, we reduced our corporate exposure and have made selective sales of corporate bond holdings which include Morgan Stanley and Valero Energy. Conversely, we continue to hold corporate positions with recent quality upgrades such as Occidental Petroleum, BankAmerica and Lockheed Martin, and positions that are pending an upgrade such as Black and Decker and Kinder Morgan.

Fed Chairman Alan Greenspan has repeatedly made clear that his approach to monetary policy aims to move against risks that may undermine the Fed’s main objective of full employment and low inflation. We are certain that as the chairman nears retirement, which is expected early next year, that he will be slow to end the inflation fighting effort. We continue to like the fundamentals in the bond market. Because we have reached a favorable balance of economic growth and inflation, interest rates could trend lower and even compress versus lower yielding European and Asian countries. However, we are monitoring the price movement in oil on a continual basis for signs of a directional change. A precipitous drop in energy could prompt excessive growth in the economy and plant the seeds of inflation. Given the absence of this event, there is a decent chance that the Fed will begin to lower rates in 2006.