Taxable Fixed Income Strategy

During the third quarter, U.S. Treasury yields fell to their lowest levels in over 30 years, as investors both domestically and internationally continued their insatiable appetite for government securities as a way to generate good returns and preserve capital. Still, most investors and market strategists were surprised by the magnitude of interest rate declines throughout all maturity areas. In fact, as reflected below, this move was the single largest quarterly drop since 1989. Furthermore, not since 1939 to 1941 have bond returns been poised to exceed stock returns for three straight years.

While we suspect many investors were properly positioned in advance of this rally, there has been a growing group of skeptics and market critics who remain in disbelief and had been expecting much higher interest rates by now. At Oakwood, we were not at all surprised that interest rates fell dramatically and were well positioned in advance of the rally. Our objective was to match or exceed the duration targets of predetermined bond market benchmarks. Looking ahead, we do not expect a meaningful change in market direction unless key factors, such as a significant drop in oil prices, a rally in stock prices and/or improved corporate profits, occur.

Independent of the overall direction of interest rates, we see several opportunities to further enhance returns in the months ahead. For example, corporate bond performance has not only lagged comparable government performance but it has also seen many individual securities further devastated by weak corporate earnings, deteriorating credit fundamentals and, in some cases, default. As a result, yield spread differentials versus their U.S. Treasury counterparts are at historically wide levels. At this point, almost any sign that may point to a sustained rally in stock prices would easily drive up demand for the corporate sector. This in turn would create a narrowing in yield spreads and higher prices, even if Treasury prices were to suffer somewhat in the process. Just as our current underweighting in corporate bonds augmented total returns versus identified benchmarks during this period of spread widening, an overweighting in corporate bonds at the appropriate time could add nicely to future returns. For now, we will continue to exercise patience and continue to focus on the task of avoiding credit deterioration. In fact, default rates are running at historic highs with investor recoveries at only 36 cents on the dollar, down from almost 50 cents a few years ago.

Another investment opportunity is the selective use of Federal Agency callable type securities, with highly predictable shorter call dates. The use of these securities will augment yields well above comparable one and two year non-callable alternatives. As an example, above market high coupon agencies in the four year maturity area, with one or two years of call protection, are likely candidates for early retirement, even if interest rates were to move much higher, thus creating an opportunity to garner additional performance, regardless of interest rate direction.

We have also identified bonds that are specifically geared for market value protection. One such investment vehicle is floating rate notes. These securities will inherently provide principal protection, as coupon income moves in relation to changes in interest rate direction. Even though it may be premature to predict higher rates, with maximum liquidity in our current portfolios, we could act quickly.

Finally, as pointed out earlier, we have remained fully invested in order to take advantage of declining interest rate trends. Once yields reach a point of investor resistance, we plan to use daily market price fluctuations to our advantage. Specifically, clients may experience additional activity in the active management of portfolio duration, either by generating temporary cash positions or by lengthening or shortening the maturity profile. Our goal is to add incremental return to portfolios while reducing exposure to unforeseen negative market events.

We believe the effective use of these strategies will continue to provide good bond returns in the months ahead. At the same time, we remain focused on preserving capital in portfolios. As a result, fixed income investments should continue to provide investors with an excellent complement to other securities or continue to provide a stand alone option for more conservative investors.