Taxable Bond Commentary
Managing Through Cycles

With one quarter remaining, 2009 is shaping up as a year of positive bond returns in a low inflation environment. This extends the long time frame in which high-quality taxable bond investors have received consistent portfolio growth along with asset protection. In fact, not since 1994 has the benchmark Merrill Lynch 1 to 10-year Corporate/Government Composite posted a negative yearly return.

As you may know, yield levels on most taxable asset classes are low, with the exception of “junk” or high-yield bonds. To increase the potential for return, we continually examine trends in the economic cycle to assist in investment decisions. The graph illustrates how the economy grows until the cycle reaches its “peak,” or maximum point of growth; at which time it then tires, or is forced down by Federal Reserve actions, to a “bottom” or low point in the cycle.

Riding the cycle for client advantage

To take advantage of market dynamics, we upgrade our security choices, often to Treasuries, as the economy approaches its peak. This is designed to protect assets against an expected decline in company fundamentals that cause corporate bonds to underperform as yields move higher.

Then, as the economy begins to contract under the weight of a tighter monetary policy and a need for companies to restructure operations, we await the economic bottoming out. This provides us with an opportunity to lower our Treasury quality standards and increase our corporate bond holdings. As stated earlier, our goal is to add to return over and above the general level of interest rates.

Monitoring and tracking tools

Now, it’s almost impossible to predict the exact moment when economic contraction will give way to expansion. However, in trying to do so, we track key factors that most influence the markets and the economy. One such indicator is the price of energy. Approximately one year ago, a barrel of oil reached $147, which resulted in a significant hindrance to economic growth. Today, oil is around $70 a barrel and the economy appears ready to grow. We note that if oil were to move substantially higher or lower, it could have a significant impact on the direction of the economic cycle.

Other critical factors we monitor include inflation reporting, monetary policy, stock market trends and the level of corporate yield spreads. For example, corporate yield spreads, a sign of economic well being, have contracted to the point that companies can now access capital markets at a favorable rate. This environment provides companies with a valuable tool to refinance outstanding debt and/or to expand operations. As bond holders, we also receive a return benefit.

Most key factors now point to economic growth. We therefore maintain our overweighting in corporate bonds. The key to success is our ability to react quickly to the “drivers of change,” rather than trying to predict outcomes. It is our nature at Oakwood to proceed with caution. Yes, retail sales and housing are beginning to show signs of life and the worst in unemployment seems near. But much of the improvement may result from Government spending and tax subsidies. Nonetheless, we stand ready to alter our structure quickly. This may involve a return to the safety of Treasuries, if we abandon hopes of an economic recovery and a bottom in the cycle.