Taxable Fixed Income Strategy

In the previous edition of the Oakwood Outlook, we outlined several conditions that could lead to a favorable bond market for the second half of the year. Essential to our forecast was an attentive Federal Reserve (Fed) policy with a particular focus on inflation. Fed policy success is critical to sustained economic growth and continued low interest rates. Shown in the following chart is a comparison of yield levels at the end of September versus June, the date marking the first of three 25-basis point rate increases:

Contrary to most market forecasts, each rate increase was followed by a bond rally, not higher interest rates. Bond market fundamentals have been bolstered by strong foreign demand for Treasury securities and investor concerns that the economy may be losing momentum. Historically, tracking the yield of the 10-year Treasury note provides a useful tool to forecast the direction of economic and inflation trends. After reaching a peak yield of 4.85% in June, the downward move of this benchmark points to slower growth ahead and moderating inflation trends, two positives for the bond market. On September 30, the 10-year yield stands at 4.12%, a yield decline of 73 basis points.

As we near the presidential election, investors can expect the Fed to be low key and passive, unless there is a noticeable deterioration in international events, economic fundamentals or inflation trends. With the absence of extraneous factors, the Fed’s long-term goal continues to be to raise rates in “measured moves” in order to achieve a neutral Fed Funds target rate versus inflation. Currently, this rate stands at 1.75%, with annual core inflation of around 2.00%. The 25 basis point differential suggests a continuation of monetary “ease” or accommodation. In the past, the favoring of this type of policy for long periods of time has led to rapid growth accompanied by higher inflation. The latter fear is being displaced by evidence that the economic cycle has peaked. Despite this, we feel the bond rally will end if the Fed continues to tolerate this rate imbalance or if oil prices begin to descend. If this occurs, we feel investors will again refocus their attention on economic growth and inflation.

For the balance of the year, we are ready to initiate further steps to protect against the possibility of higher interest rates. As an example, during the year, we utilized callable type securities to augment yield, not an easy task in this very low rate environment. By eliminating this exposure, we will protect the holdings against the risk of maturity extension and further price erosion. Also, investing in higher coupon securities provides generous cash flow to client accounts along with a measure of market protection. We intend to continue this strategy as ongoing coupon payments are reinvested.

Finally, our judicious use of corporate bonds has enhanced yield and performance in client accounts. However, we remain mindful that any earnings disappointments can easily alter quality expectations and hinder future performance. Because economic growth has been somewhat sporadic and uneven within corporate sectors, we are concerned that the success of one company could come at the expense of its competition. The automobile and drug sectors are examples of this. Consequently, as each portfolio holding reaches our return goals, we may begin to reduce our overall corporate exposure, in favor of government-type securities.

During the next quarter, we should begin to see a resolution to many issues on the minds of investors. On one hand, natural disasters such as those experienced in Florida and surrounding states will initially subtract from upcoming GDP reports. However, the rebuilding process should create approximately 20,000 jobs that otherwise would not exist. Many of these jobs will be in construction, retailing, insurance and a variety of services. In the past, economic benefits from rebuilding outweighed the initial damage. As we experience these benefits, continue to make progress in Iraq and finalize Election Day results, the future for the economy should be clearer and the bond markets should stabilize. The critical unknown is the future of oil prices and the corresponding impact on the economy and bond markets. For now, caution is advised.