Taxable Fixed Income Strategy

As expected, the Fed raised its overnight lending rate be-tween banks by another 25 basis points to 5.25%. This latest move reflects the ongoing equal 25 basis point rate increases at each of the 17 previous meetings. In an accompanying statement, the Federal Open Market Committee “judges that some inflation risks remain,” and states “the extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth as implied by incoming information.” While on the surface this statement could be interpreted as a negative to bond investors, a closer view of the Treasury curve reaction since the first rate hike in June 2004, shows a level of confidence on the part of investors.

Clearly, the repeated rise in the Fed Funds rate has had a direct impact on shorter maturity yields as evidenced by a 200 basis points increase in 3-year Treasury yields. However, an investor seeking a safe haven by investing heavily in this maturity area found little protection. By contrast, to the surprise of most market experts during this same period, there was a remarkable amount of stability in longer maturity areas. Oakwood correctly saw the opportunity in this area, and took advantage of it for client portfolios. In fact, the yield level on 30-year Treasuries actually fell by 21 basis points. This suggests that, at least to this point, investors view inflation as a short-term condition and endorse the Fed’s efforts.

We are pleased with the year-to-date investment results in client portfolios and the significant cash flows that our bond investments have provided. While it has been difficult to entirely avoid the effects of interest rate tightening, our decision to combine very short investments with longer investments, best known as a barbell structure, has provided market protection. By next year, we expect the Fed to begin cutting rates. In fact, well in advance of any Fed action, a change in market sentiment should ignite a bond rally.

Because a reverse in the interest rate cycle is difficult to time, we will unwind our barbell strategy in incremental steps. Yield levels in the long end of the maturity curve have not ratcheted up to the same extent as intermediate maturities. Hence, we see more opportunity for yields to fall in the 2 to 5 year maturity areas. We recognize the fine line between unacceptable inflationary trends and the dampening effect of a slowing economy on its future path. However, if inflation gains inertia, it will be difficult for the Fed to stop and reverse its direction, even with a slowing economy. To illustrate this point, we again show an historic yield curve comparison, this time using a shorter time frame.

As shown, in the face of relentless Fed monetary tightening, yield levels throughout all areas have recently moved noticeably higher because of new inflation concerns. This occurred despite a housing slowdown, deceleration in consumer spending, rising energy costs and substantial hikes in adjustable loans. As a further slowdown in the economy accelerates, we expect the upward trend in interest rates to stop. This will provide us with an opportunity to extend short maturities and lock in the higher income levels and allow for future growth potential. To augment the yield portion caused by a flat yield curve, we continue to find additional yield in Federal Agency mortgaged-backed securities and high quality corporate bonds that have a demonstrated build up in free cash flow. Although free cash flow does not directly correspond to a higher coupon for corporate bonds, it does provide corporations with the flexibility to decide how to invest or distribute this cash.

In our view, inflation concerns remain too high, although as the economy shows more signs of slowing in the second half of 2006, fixed income investors should be rewarded. Meanwhile, we remain steadfast in our mission to protect capital and mindful that even with all of its resources and experience, the Fed is not prepared to claim victory on inflation at this time. This may be why the Fed has remained diligent in the face of pundit criticism that they are over-reacting to only a small increase in inflation.