Taxable Fixed Income Strategy

Bond investors have endured the eleventh consecutive in-crease of the target Federal Funds rate which began on June 30, 2004. This pace of rate increases suggests that inflation remains at the higher end of the Fed’s tolerance, and if so, one or two additional rate hikes by year end cannot be ruled out.

However, there is a risk that the Fed becomes overly obsessed with fighting inflation and causes the economy to slip into recession. In fact, many market experts believe the potential economic drain from recent natural disasters, accompanied by a decline in consumer confidence and a slowdown in home sales, are ample evidence that the Fed should stop the rate increases. A recession could trigger deflation, as overseas trading partners are forced to flood the United States with low priced goods in the face of slowing demand.

We suspect that we are approaching a time when overvalued housing will cause a meaningful drag on the economy and the Fed will stop raising short term rates. This should provide a benefit to short and intermediate maturity investments as the continuous decline in market principal is no longer a drain on the cash flows from coupon payments. The following chart shows the significant rise in short term yields over the last sixteen months.

Our general level of optimism that the interest rate hikes will come to an end should not imply that we are shifting our market bias to a more aggressive posture. In fact, as long as inflation and economic forecasts remain clouded, we will continue to avoid making large market bets, either by overweighting non-government sectors or by significantly altering duration targets versus respective benchmarks. However, in preparation for a more favorable market environment, we are enhancing liquidity in client portfolios, favoring longer maturity securities with more price sensitivity, currently in the 7 year maturity area. This involves a systematic reduction in overvalued corporate positions and the targeting of specific short maturity holdings, as we swap these securities candidates into high quality liquid investments.

At the present time, we do not feel that investors are properly compensated to tolerate a quality downgrade or to invest in complex bond structures. These strategies are best implemented when yield levels are more generous, or when quality trends begin to improve from the depths of recession.

Our primary goal is to maintain maximum portfolio flexibility, in advance of the end of Fed tightening. We believe bond investors will soon be rewarded for their patience. To date, we feel the diligence exercised on the part of the Fed has been the prescribed medicine needed to assure that inflation remains contained. This is an essential ingredient to an improved future bond market. Although bond returns have not been generous recently, we feel that our strategy of protecting capital has been invaluable to client portfolios, in the face of relentless Fed tightening. Fed Chairman Greenspan has repeatedly forewarned us of the dangers associated with “low risk premiums”, which include overvalued housing, speculative security choices and low yielding long Treasury bonds. Recognizing this, our overriding focus is to isolate potential market risks and properly evaluate security choices, based on return expectations and capital preservation, which are consistent with our clients’ goals and sensitivities.