Tax Exempt Fixed Income Strategy

During the first half of 2005, there was a seemingly endless discussion on the future direction of monetary policy and interest rates. Some have even concluded that bonds do not offer a good investment opportunity for investors. However, a review of the bond market returns for the first half of 2005, especially after adjusting for risk, does not concur with this viewpoint.

As mentioned earlier, investment returns on widely recognized indices such as the S&P 500 Index, the Dow Jones Industrial Average and the NASDAQ Composite are all negative year-to-date through June 30, 2005. Municipal bonds have produced modest positive returns for the same time period. However, on a taxable equivalent basis, the return difference between municipal bonds and the equity indices shows a greater margin of difference. Additionally, on a risk-adjusted basis, we believe that Oakwood clients achieved this positive return with lower risk.

This point is not meant to mitigate the role that the stock market plays. In fact, in contrast to the lower return potential of bonds, the stock market offers investors the ability to generate higher returns over time. After factoring in numerous market uncertainties, a risk management approach using asset allocation can be important to wealth building. Therefore, we believe municipal bonds will continue to play a vital role, for highly taxed investors who seek tax-free income generation, good after-tax total returns and protection of purchasing power. As you are aware, the Fed recently raised its Federal Funds target rate for the ninth time, to 3.25%. It is likely that they will continue to raise this rate at a “measured pace” until inflation is no longer believed to be a concern. When combined with the relentless rise in energy prices, it becomes difficult for both equity and fixed income investors to predict market direction with conviction. Regardless, tax-free yields ranging from 2.75% to 4.25% provide an attractive 4.2% to 6.5% taxable equivalent yield.

At the same time, we emphasize the importance of a strong underlying credit ranking, even if the bond has insurance backing. Recently, there have been numerous examples of municipality downgrades due to poor fiscal management and budgetary imbalances, to include the City of San Diego, California, which was recently downgraded to BBB+ from A. This pattern of deteriorating creditworthiness hurts liquidity and results in market loss. Oakwood client holdings have been completely unaffected by this trend in downgrades.

As shown below, there has been a notable flattening in the yield curve as long rates have moved in the opposite direction of short rates.

It is important to point out, however, that on a taxable equivalent basis, tax-free bonds are considerably more attractive than similar maturity Treasury or corporate securities. As an example, a 15-year tax free California bond at a yield of 4% equates to a 6% yield for individuals in the highest tax brackets. This is why we will continue to focus on investing in this area.

Simultaneously, we are initiating a program that involves the selling of very short municipal bonds to be extended into the 4 to 6 year maturity area. However, we now see value in higher coupon callable type bonds, as municipals are trading at 82% of equivalent taxable treasuries. In addition, they offer generous yield versus a non-callable counterpart, with little risk of extending to their longer stated maturity.

While we continue to seek out attractive investment areas, the municipal market is facing several challenges. The first challenge is “rate shock.” To overcome this, we are focusing our attention on quantitative risk/reward security placement. This provides maximum tax-free income, without subjecting portfolios to high levels of market risk. The second challenge is how to invest as the Fed continues on its program of fighting inflation. Oddly, we see this as an easier challenge. Only two years ago, a 4-year municipal bond was yielding 1.75%. Today, this same investment offers a tax-free yield approaching 3%, or on a taxable equivalent, 4.6%. This provides Oakwood with the continued confidence that with today’s yields, a municipal bond strategy can generate good returns and can provide a risk adjusted complement to other investment choices.