Taxable Fixed Income Strategy

September 18, 2007, marked the first time in over 3 years that the Fed altered its monetary policy stance, favoring lower interest rates and economic growth. In an accompanying statement, they cited concerns that rising defaults in sub prime loans are likely to have an adverse effect on other areas of the economy and the prospects for sustained economic growth. Naysayers of this policy change cite concerns that the Fed’s rate cut will backfire and cause inflation to go higher and lead to a rise in Treasury yields. In fact, the first reaction to the Fed’s rate decision was quite negative, with long Treasury bond prices plunging 5%. However, weakness in recent economic data was supportive of this decision and bond prices are now moving steadily higher again, thus yields are falling.

While there are a number of unsettling aspects that might prove negative to inflation, including stubbornly high commodity prices, the rapidly falling dollar and near record gold prices, actual inflation numbers are well behaved. In fact, the Fed’s well watched Personal Consumption (PCE) Price Deflator fell below 2%, on a year over year basis.

Our view remains one of cautious optimism. While we agree that the Fed needed to lower interest rates and may need further cuts in the months ahead, we are monitoring employment data as a key variable to future changes in monetary policy and interest rates. For now, the recent weakness in employment data, coupled with the distressed housing market, should allay concerns about overstimulating the economy and a rekindling of inflation.

As part of our management strategy, we recently increased our exposure to the corporate bond market, bringing us back to a neutral weighting versus respective benchmarks. The cheapening of yield spreads across virtually all sectors provides better valuations than have been available for some time. As an example, four months ago, Aaa rated General Electric Capital Corp was yielding only +58 basis points more than a comparable 5-year Treasury. Currently, the yield advantage is over +90 basis points. Another widely held security, Target Corporation, is presently yielding +100 basis points over comparable Treasuries. Even though we have a limited exposure to the financial sector, we may further reduce our exposure, in favor of industrial type companies. We are especially interested in those companies that have a strong presence in overseas economies. As our research progresses, we will keep you posted of our choices.

Finally, we will restrict investments in Federal Agency securities. We do not feel that Congress should use the Government sponsored Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation to bail out bad decisions in the mortgage industry. We do agree that they should continue to mandate sound lending practices and maintain high quality standards in their loan portfolios.

Another consideration leading to our decision to limit the use of Federal Agencies in client accounts is the potential impact on earnings from reduced housing activity. As a protection, we will restrict new purchases to maturities of less than 4 years.

As seen below, the shape of the Treasury yield curve has changed significantly during the quarter.

The most significant change shows up in the shorter maturity area, where yield declines approach 1%, or 100 basis points. This is the result of weakness in employment, housing activity and a directional change in monetary policy to pro-growth. It is interesting that long bond yields have also declined, although to a lesser degree, implying investors are confident that, over the long-term, inflation will remain under control. Now that short-term yields have declined more than long-term yields, the 2-year versus the 10-year yield spread has steepened to 65 basis points. This will provide banks and mortgage lenders some relief in their ability to borrow at a lower short-term rate, in order to fund longer term commitments.

Unfortunately, consumers have seen little relief in their ability to borrow at a lower rate. This may be a vital factor to the future direction of the economy. Recently, we used this steeper slope in yield spreads as an opportunity to extend 10-year positions, in favor of the U.S. Treasury 8.125% due August 2018, for generous yield gains. As time passes, this security should outperform as it reaches yield parity with its 10-year counterpart.

It is our goal to remain fully invested and as previously stated, monitor upcoming employment data for signs that the economy is rebounding too strongly. If this occurs, we stand ready to reduce longer positions and utilize cash as a buffer to potentially higher interest rates. However, if our long-term forecast is correct, interest rates may need to move much lower to salvage the housing market and the economy. In the past, economic and market “bubbles” included a collapse of the Japanese stock market, huge declines in technology stocks and commodity price deflation. Situations like these are not usually resolved overnight. It is unlikely that our current housing problems will be an exception. Even with additional help from the Fed and a further decline in interest rates the impact to the economy may be felt for some time.