A Word From The Advisor
Preparing for a Bond Rally
A vast amount of news about the stock market reaches our ears on a daily basis. Sometimes it is good news about the economy or a company which causes a rally, and sometimes it is bad news about rising oil prices or a company missing earnings, causing a subsequent decline in market levels. Recently, it seems that we are also being inundated by news of the negative effects that rising interest rates will have on our daily lives. These concerns include fears that mortgage rates will skyrocket, monthly payments will rise, and housing values will drop. In addition, investors are being led to believe that investing in bonds is a losing proposition with little or no likely return potential.
Just as a successful real estate expert knows how to manage the mortgage market in order to capitalize on changes in interest rates and housing values, a successful fixed income manager knows how to position client portfolios in response to changes in market conditions. For example, in a period of declining interest rates just two years ago, investors were pleased that their fixed income investments were generating attractive returns and providing stability against the volatility in the stock portion of their portfolios. What might not have been apparent to these same investors, however, was that the same dynamic of lowering interest rates that created market value gains in their fixed income investments was pushing yields down to historic low levels, deeming them unattractive.
History shows that as interest rates decline, many investors become reluctant to invest in lower yielding bonds. Instead, they begin searching for higher yield at the expense of risk. This is particularly true for those investors who depend on fixed income as a means to generate needed income to live on. However, those few extra basis points in yield come with a trade off – the inability to unwind the position quickly and to be poised to take advantage of more attractive opportunities created by a changing environment.
That propensity to seek higher yield may seem reasonable until a period of rising interest rates, similar to the environment which we have been experiencing since June 30, 2004, causes investors to become trapped with their investment choices. Following the adage “It’s best to own the best house on the street when the market turns down”, a smart real estate investor knows to upgrade the quality of his real estate investments in order to preserve valuable capital and gain flexibility for future opportunities. At Oakwood, we use the same reasoning to build and manage client bond portfolios. Unlike those investors who searched for higher yield by lowering their quality standards or accepting complex bond structures during this period of rising rates, we were willing to accept a lower yield and focused on preservation of capital and future flexibility. The success of this strategy is shown by our ability to retain precious market value during this fifteen-month period of eleven consecutive interest rate hikes. In addition, because we own only highly liquid investments, we maintain investment flexibility, in advance of better market conditions. Unlike the passive buy and hold investor, we view changes in market conditions as an opportunity to improve returns. This more active management strategy allows us to react quickly as interest rates begin to peak and to shift our attention to capital appreciation.
Over two hundred years of experience in numerous economic cycles back up Oakwood’s senior decision making team. The discussion of all current economic events at Investment Policy Committee meetings and the often differing viewpoints add a depth of insight and strengthen the fixed income team’s ability to identify risk factors and return opportunities that are not apparent to less experienced managers. Oakwood’s fixed income managers know that liquidity and flexibility are crucial in order to advantageously position client portfolios in this dynamic market. Oakwood provides a highly disciplined quantitative approach to fixed income management that is necessary to evaluate individual security provisions, control portfolio risk in all interest rate market environments, address future changes in taxes and policies, all of which ultimately leads to properly structured portfolios based on risk versus return expectations.
Well-defined investment processes are what distinguish Oakwood’s strategies from our competitors. The ability to adhere to our investment disciplines and avoid the risky temptation to chase yields is what provides Oakwood clients with the reassurance that the objectives of the strategies will be met with the right balance between risk and reward.
