Taxable Fixed Income Strategy
Could the Economy Possible be More Complex?

In recent Oakwood Outlooks, we explained the beneficial role we expected “yield” to play in 2008 investment returns, and we began to add yield to the portfolios by purchasing corporate bonds. Our goal was a targeted 45-50% corporate-bond allocation, a significant increase over last year’s target of 20-25%. This marked departure from our 2007 strategy, when we focused on “price action” as a means of capturing return, proved to be successful, as weak economic conditions propelled a bond rally and forced the Federal Reserve to lower short-term interest rates. The chart depicts the dramatic shift in monetary policy.

Fed sacrifices inflation & the dollar for the credit market
We believe that the Fed has been overly aggressive in lowering its funds rate to 2%. This ratcheting down of short rates has in fact been counterproductive to the need for lower home mortgage rates and has been very detrimental to the US dollar, as shown in the following chart. This brings inflation to the epicenter of consumer and interest-rate anxiety. At its June 25th meeting, Fed policy makers (fortunately) decided to hold interest rates steady. While we support market observers urging the Fed to raise rates, it’s difficult to envision such a hike for the balance of the year given the financial system’s ongoing strains, and with no clear sign that the economy can regain its footing soon. To halt the negative effects of inflation, we do urge that the Fed intervene strongly, in conjunction with other international trading partners, in support of the dollar.

Massaging the economy’s opposing forces
We believe the Fed is correct in its view that inflation will wane in the coming months. Even though we may not technically be in a recession, history shows that recessions kill inflation. As rising commodity prices push up the cost of producing goods, it becomes increasingly difficult for corporations to pass on increases to consumers at the retail level. We also note the sharp decline in housing values as a major deflationary force on the system. The negative effect on wealth may have a significant impact on future consumer spending. As stated in the last Oakwood Outlook, any meaningful improvement in housing requires fixed term mortgage rates to fall to 5.50%. For this to occur, 10-year Treasury yields may first need to fall from a recent peak of 4.25% to around 3.50%. We believe this is likely to occur.

Of Corporates & Agencies
We continue to seek attractive corporate bond candidates, however difficult the task given the earnings slowdown. We’re pleased by the additions we made to our holdings in 2008: Berkshire Hathaway, Monsanto, Halliburton, Union Pacific, McDonalds, and Province of Ontario Canada. Absent from this list are banks/finance companies, which we monitor daily. Prior to purchasing banks/finance companies, however, housing must regain traction, commodity prices must retreat, and oil prices must fall – all pre-conditions for growth of earnings and the economy.

There’s a desire to use Federal Agencies in portfolios. They are currently under Congressional scrutiny and are likely to experience further regulation – a policy designed to protect against future missteps. On the other hand, politicians must be sensitive to an Agency’s obligation to shareholders to produce a fair return on capital. We’ve begun to invest in Federal Farm Credit Bank and Federal Home Loan Bank. Both possess strong management and a manageable mortgage exposure. We’re moving slowly and, as yield spreads stabilize, other Agency issuers are currently under review.

We’ll pass on the looking glass
Rather than speculate on possible outcomes in the current difficult environment, we prefer to let the market’s directional changes dictate the appropriate strategy. We continue to structure portfolios based on quantitative techniques and risk/reward probabilities. This includes the selection of new corporate holdings based on yield benefit and the potential for spread contraction. It also means taking advantage of short-term price movements to alter portfolio durations between neutral to modestly aggressive. Our overriding goal is to avoid weak-quality bonds and to avoid chasing yield at the expense of principal preservation.

At times market outcomes seem obvious to us. But market conditions can change rapidly. While we do have strong viewpoints, we remain quite cautious and prepared to alter portfolio structures quickly, especially if inflation ramps up. While the year’s first half saw modestly positive returns, bonds continue to offer an excellent method of capital preservation as well as an alternative to riskier investment vehicles.