Taxable Fixed Income - Strategy
Year to date, the Federal Reserve Bank has lowered its target lending rate four full percentage points to 2.5% in its attempt to avert recession. Unfortunately, despite the massive injection of cash reserves to support the economy, consumer confidence, thought to be the last leg supporting the economy, has now dropped to its lowest level since 1962 – nearly 40 years ago. While this may suggest that the Fed’s efforts are not working, historic evidence shows a lagging effect in spending patterns versus interest rate adjustments.
This may be especially true this time, in light of the recent terrorist attacks that have severely shaken consumer confidence and potentially delayed the recovery. However, we are confident that consumers will eventually return to take advantage of low interest rates and the favorable cost of goods due to tame inflation. Regardless, we can expect additional interest rate moves by the Fed, until life comes back into the economy.
Eventually, this aggressive monetary policy may turn into a negative for bond investors, especially in long dated issues. During this past quarter, we saw the largest interest rate decline in short-term bonds since 1989. Since year-end, 3 month U.S. Treasury bill yields have dropped 3.6 percentage points to a yield of 2.25%. Furthermore, two-year Treasury yields have fallen over 2 percentage points to a yield of 2.75%.
With short rates currently at record lows, many investors may be tempted to redirect money into longer bonds in order to chase higher yields. However, there is growing evidence that the relentless Fed easing is limiting gains in these longer securities. In fact, year to date, ten year yields are only 30 basis points lower while 30 year yields are actually higher. As discussed in the January 2000 Oakwood outlook, a period when the Fed was raising interest rates to slow the economy, repeated tightening placed a lid on how high long rates could go before the end to the last tightening move. Today, the opposite should be true. The stalling out of the long bond rally may be evidence that the repeated Fed ease is becoming a concern to bond investors who worry about its impact on inflation.
We acknowledge this concern and even plan to modify portfolio structures to include shorter 4 to 8 year investments. Our studies show that this area offers the best return versus risk characteristics. However, we will be undertaking such moves in a deliberate manner while the economy remains weak with few signs of improvement and inflation is not currently a problem.
We continue to like Federal Agency issuers. This sector provides excellent liquidity and yield with little chance of further regulation from Congress during these troubled times. The corporate bond market has been hit hard since the attacks, resulting in wider yield spreads throughout most sectors. As an example, during September, Government securities generated gains of over 1% while broad based corporates dropped approximately 1%. We will use this weakness in corporates as an opportunity to add to our existing positions. The high quality Canadian Provinces are among our favorite picks and should be especially attractive to investors seeking a relatively safe haven during these volatile times. Specifically, we like Ontario and Quebec owing to strong fundamentals, improving credit ratings and low financing needs. We continue to like companies that are well diversified to include General Electric and Citicorp. However, we remain mindful that during the last recession of 1991, overall quality levels were higher than they are today. This concern, along with the uncertainties surrounding the timing of the recovery, steer us in the direction of caution.
On balance, we see an environment for further gains in the bond market. If conditions change, we will implement strategies to protect market value and shift our security choices in favor of higher coupon flow and yield enhancement versus appreciation.
