Tax Exempt Fixed Income Strategy

During the quarter, the municipal bond markets kept pace with taxable markets by registering impressive gains. The following graph shows that yield levels fell almost equally throughout all maturity areas.

For this behavior to occur there must be a belief that the Fed has been successful in its efforts to fight inflation and that it will likely start to cut interest rates in 2007. Similar to our taxable portfolios, we were prepared for this tax exempt bond rally. In fact, as the Fed continued on its program of scheduled interest rate increases, we engaged in swaps designed to lengthen short and intermediate holdings, in favor of higher yielding longer holdings. This strategy has been successful.

Looking ahead, we are aware that the present yield levels reflect a significantly weaker economy, declining inflation, and upcoming Fed ease. The markets may not be factoring in the recent decline in energy prices and lower interest rates that show signs of rekindling consumer confidence. Furthermore, the Fed has openly stated that they will remain on inflation watch and stressed a need to monitor upcoming economic and inflation data prior to reversing their restrictive policy.

Therefore, we are altering our current maturity structure which affects the investing of new cash and changes in our overall weighting of longer positions. We will now focus on the intermediate maturity area. It is important to note that the recent decline in yield levels and taxable yield comparisons also impacted 3 to 7 year investments. However, for highly taxed individuals, yields still represent good value owing to the high 5.40% plus after-tax yield and return potential versus inflation.

Along with our goal to reduce longer bond holdings, we are establishing a 15% liquidity reserve by holding cash equivalents and securities that mature within one year. This will provide sufficient flexibility to become more aggressive, as future market conditions are better understood. These changes will bring our overall target duration on portfolios down to around 4.5 years from over 5.25 years.

We feel this desire to become more cautious is appropriate at this time especially because of the quickness and magnitude of the recent rally. The yield pickup from 1 to 20 years is only 73 basis points. We believe there is a good chance the yield curve will return to a more positive slope, as longer yields adjust modestly higher. Therefore, it is our goal to preserve our year-to-date gains which continue to exceed inflation as we look to the end of the year.