1st Quarter 2011 Municipal Bond Highlights

1st Quarter 2011 Municipal Bond Highlights

• Short maturity yields are low
• Long end yields have corrected
• Yield curve is historically steep
• Credit spreads are attractive

Municipal bonds suffered a decline in price after an apocalyptic prognostication from layman during the 4th quarter of 2010. Suggestions that the municipal market faced defaults in excess of $100 billion resulted in a wholesale exodus from the sector. As we mentioned in our last municipal market piece in January, this flight from the sector resulted in a good buying opportunity. As the headlines subsided during 2011, municipal bonds managed to outperform US Treasuries for the 1st quarter.

The yield to maturity on AAA rated bonds in 5 years was essentially unchanged, while the yield to maturity on both 2 year and 30 year AAA municipal bonds fell during the quarter. In contrast to the investment grade corporate market, municipal credit spreads did move wider during the period with AA rated 10 year spreads reaching 27bps from 20bps and 20 year BBB rated spreads pushing out to 170bps from 150bps. The widening in spreads reflected continued selling of lower rated credits as mutual fund liquidations persisted throughout the period.

Overall, the Barclay’s Municipal Bond index (average maturity of 13.5 years) returned 0.51% for the quarter compared to 0.42% for the Aggregate Bond index. The five- and ten-year Municipal index (more comparable to the Aggregate Index) returned 0.61% and 0.76%, respectively.

The selling pressure, a result of heightened headline risk and fear of rising interest rates, coincided with a sharp decline in municipal new issue supply. Borrowers, who issued a lot of bonds in the fourth quarter of 2010 (ahead of expiring BAB program), stayed on the sidelines during the first quarter of 2011. Fiscal deficits, curtailed infrastructure programs and unease in the market place forced issuers to delay or postpone bond offerings. As the quarter progressed, the decline in new supply helped to support bond prices, despite an improving economy and a divided Federal Reserve.

With fears of higher long term rates, market participants appear to be focusing buying in the 1 to 5 year maturity range, in an effort to earn a small amount of income without taking too much interest rate risk. The buying is focused on AA and AAA rated paper, leaving little liquidity for longer dated, lower rated credits.

We view this as an opportunity to make further enhancements to an intermediate municipal portfolio. Given our views on a strengthening economy and an overly aggressive monetary policy stance, we view interest rates, particularly on the short end, to be too low. State and local revenues continued to increase during the fourth quarter of 2010 as reported by the US Census Bureau.

Revenues have been estimated to have increased further during the 1st quarter of 2011, helping to repair the damaged caused by the recession. The over exaggerated spike in municipal defaults, pontificated by non-market participants in 2010 has yet to materialize.

With this in mind we have been adding to lower rated investment grade municipal bonds, in an effort to increase income as an improving economy helps rebuild municipal budgets from the revenue side. The progress, although with still much further to go, on the expenditure side is also encouraging.

Given our views that short term interest rates are too low, we have been incrementally implementing a barbell maturity structure, buying 20 year maturities and floating rate notes, while selling short and intermediate maturities. We continue to maintain a shorter duration position than the 5 year Barclay’s Municipal Index.

March 2011

Fixed Income Market Recap
Given the ongoing positive fundamentals evident throughout the first quarter, we continue to believe that bond market valuations are out of equilibrium given this stage of the economic cycle, and we continue to position the portfolio accordingly.

While we expected that the Federal Reserve would have been more proactive in normalizing interest rates, from a performance perspective we’ve been able to keep pace with the Barclays Aggregate Bond Index by actively trading and positioning the portfolio.

Economic Outlook
In positioning the Fund for the next stage of the interest rate cycle, we’ve anticipated that sequencing would play a big role in how Chairman Bernanke would move from stabilizing the U.S. economy to draining the massive amounts of excess liquidity from the banking system. Frustrating many, the Chairman has been glacial in effecting that change. As we expected, Q1 economic growth continued to demonstrate surprising strength, with the most pleasant surprise being the fall of the unemployment rate a full 1.0% in the last five months. Moreover, monthly job growth has continued to accelerate with monthly job gains registering approximately 200,000 in the last two months. That job growth paired with a rising stock market, a sharp rally in commodity prices, a renewed weakening in the trade-weighted dollar, and what’s arguably become a self-sustaining economy, have investors questioning why the Federal Reserve continues to aggressively ease monetary policy.

With the improvement in economic growth, an intensifying debate is taking place within the Federal Reserve itself. From the Board of Governors, Chairman Bernanke continues to lead the easy money charge, backed by easy money activist Janet Yellen, and the seemingly voiceless Governors Duke, Tarullo, and Raskin. Two of the seven governor seats remain vacant. In pragmatic terms, we question the viability of a board of two economists and three lawyers to effectively forecast and manage the U.S. economy. Lining up on the opposite side of the boardroom are the Twelve Federal Reserve Regional Bank presidents. Five of those Presidents are voting members on the Federal Open Market Committee, and quite vocal as to where they would like to see monetary policy. Of that group, one of the most vocal is Dr. James Bullard, President of the St. Louis Federal Reserve. A heavy-weight economist on equal stature with Chairman Bernanke and fully of the mind that the Fed’s continued monetary stimulus is a serious policy mistake. Equally vocal is Richard Fisher, former vice-Chairman of Kissinger McLarty Associates, and President of the Federal Reserve Bank of Dallas. Mr. Fisher has publicly stated that the Fed should neutralize their easy money policy immediately.

Our expectation has been that solid economic growth would spur debate about the sensibility of continued monetary stimulus. In turn, that debate would turn to open and aggressive criticism of the Fed, which is where the matter currently stands. However, we expect that the criticism will soon become louder and more aggressive, with the credibility of the Federal Reserve soon being called into question. Especially since the European Central Bank has just raised interest rates despite a significantly less balanced growth trajectory and significantly worse fiscal condition than the United States.

With that said, all eyes will be on Fed at the conclusion of the April 27th FOMC meeting. In late March, the Fed announced that the chairman would conclude four of the eight annual FOMC meetings with a press conference, complete with a Question and Answer session. The first press conference is scheduled for later this month. Given the recent ECB rate hike, speculation is rife that the Chairman will use this opportunity to articulate a change in policy. Certainly such a venue would allow him to clearly articulate what he intends to do once quantitative easing ends in June.

Despite all of the noise surrounding the Federal Reserve, we are of the opinion that the economy has already become self-sustaining and that, with the approach of warmer weather, may come even greater growth. Moreover, we expect that the second quarter surprise will be an uptick in home sales and home prices. With such a backdrop, a rise in the Fed Funds may come as soon as the third quarter.