As far as armor goes, I've set it as clothing, and moved the armor class to a shield ability on the NPC. This seems to work around armor damage.
Now I'm wondering about weapon damage...
I'm thinking along the lines of giving the items a high health level, and maybe adding a "Begin OnUnequip, remove item, add item" type deal to ensure they always have healthy swords.
Anyone know if that will work? I'm trying to avoid having any dependencies besides stock oblivion, so I'd like to avoid OBSE, etc.
-Andy