Tax Exempt Fixed Income Strategy

We expect the problems related to sub prime lending to have a negative effect on the economy and many municipalities for some time. As you know, there has been a barrage of new mortgage originations, based on below market teaser rates and absent the requirement of an appropriate down payment. This type of financing technique has helped to propel an unprecedented boom in housing and the economy. To sustain this phenomenon, interest rates would need to remain at abnormally low levels, or household income would need to grow at a comparable rate to the increase in mortgage costs that accompanies a rise in variable rates. In reality, throughout many areas of the country, household income has not kept pace with rising home prices and rising mortgage rates, thereby forecasting an end to the housing boom.

Unfortunately, now that mortgage rates have adjusted, a large number of these initial teaser rates are readjusting beyond the affordability of many home owners. This situation can effectively reduce the market value of all homes, as repossessions and the glut of unsold homes mount. There appears to be no quick fix to this problem, even though the Federal Reserve recently lowered its benchmark Federal Funds lending rate by 50 basis points to 4.75%. Adding to the dilemma, mortgage lenders are now being forced to apply stricter standards prior to mortgage approvals. These include mandatory down payments and more stringent affordability requirements.

Meanwhile, moderating home values and accelerating foreclosures could be damaging for many local level municipalities, who are largely dependent on the collection of property taxes, in order to maintain services to the community. At Oakwood, we meet this challenge by only investing in well-managed towns or cities that exercise sound management practices and are able to operate with a dependable income base. This is essential to the servicing of its debt structure, which is vital to our clients. In addition, we continue to seek out tax-free bonds based on essential services such as water or sewers, surcharges attached to voter approved propositions or other reliable user fees to support bond payments. Historically, the backing of these types of securities has been somewhat immune to changes in the economy.

A difficulty facing State level municipalities is the potential impact that housing deflation has on consumer confidence and a state’s ability to garner revenue through the collection of sales taxes. We believe that some states, including California, have adopted reckless spending programs with expectations that sales tax revenues would continue at a record pace. With clear signs that the economy is beginning to slow, it is likely that tax revenues will also slow. In Massachusetts alone, experts suggest it must spend at least $2.2 billion to improve structurally deficient bridges. According to a recent report, they are falling into disrepair faster than they can be fixed. The State needs to spend an additional $19 billion over the next 20 years, just to maintain its transportation infrastructure. Unfortunately, a slowing economy will not help this situation. As a result, we are restricting the use of State level obligations, especially in California, unless they are backed by Government collateral or are insured, and have a maturity within 5 years. As stated repeatedly in previous Outlooks, we have always required a minimum underlying quality rating of A2 with added insurance enhancement, for an overall rating of Aaa. For an uninsured investment to receive our approval, the security must maintain a minimum Aa quality rating.

Despite the challenges that lay ahead, we feel municipal yield levels are attractive and reflect many of these concerns. If our interest rate forecast is correct, yields may need to fall much further, in order to rekindle GDP growth back to 3 to 4%. This, combined with actions already taken by the Federal Reserve, should begin to stabilize both the economy and housing. With tax-free versus taxable yield ratios in the 81% to 89% range, we are adding to positions in the 5 to 10 year maturity areas. We remain mindful that the Federal Reserve will adjust its policy in response to upcoming data. We also stand ready to adjust our forecast and portfolio positioning, in response to changes in the economy, taxing policies and inflation data. For now, we will remain fully invested with a duration target of 5.2. This should be conservative enough to protect us against unforeseen events, yet suitable for market appreciation resulting from an expected decline in yields.