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.

February 2011

Fixed Income Market Recap
From a point to point perspective, February appeared to be a rather calm month in the bond market. Yield-to-maturity of the 10-year Treasury Note ended the month 5 basis points higher than where it started and the yield curve was essentially unchanged. However, the intra-month volatility was anything but calm. In the first six trading sessions of February, the yield-to-maturity rose 35 basis points, shaving nearly 3% from the price of the 10-year Treasury Note. Heightened inflation worries and a continued improvement in the broad economy was the catalyst for the selling. However, those worries quickly faded as civil unrest in the Middle East prompted another round of flight to quality buying.

Economic Outlook
The economic data for the month was decidedly strong and reflective of a self-sustaining, accelerating economy. Initially, the employment report signaled otherwise, though. The headline non-farm payroll showed a disappointing gain of only 36,000 jobs for January. However, digging through the details revealed that the severe weather that gripped the Northeast and mid-Western United States distorted the number substantially. The February jobs data confirmed that with a solid increase of 192,000 workers and a drop of the unemployment rate to 8.9%. Clearly, the job market has improved and at this stage of the economic cycle, monthly job growth should be in excess of 150,000 per month.
Less ambiguous results were evident in the inflation indices. The Labor department reported that both the Producer and Consumer Price Index showed greater than expected year-over-year rates of change. With the risk of deflation fading, focus is quickly shifting to inflation, and to what level it may rise. We believe there is a complex dynamic at work that will likely cause inflation to rise faster than investors and economists currently assume. Specifically, the rapid growth in emerging market economies is creating a demand-pull situation in which their consumption of goods is bidding up prices and increasing the cost of goods sold. While the main culprits, China and India, are attempting to cool their economies, their actions have not yet had the desired effect. The second driver of inflation is likely to be housing. Because of the difficulty in measuring housing inflation on a monthly basis, the Bureau of Labor Statistics uses a measure called imputed rent as a proxy. A byproduct of the elevated level of foreclosures is an increasing demand for rental space which, in turn, has put upward pressure on rents. As the housing market improves, that upward pressure is likely to continue, which will contribute to upward pressure on inflation. To put it in perspective, imputed rent represents approximately 1/3 of the overall Consumer Price Index.
To summarize, the unemployment rate is falling, inflation rising, manufacturing is operating at multi-decade highs, the Dollar is weak relative to our main trading partners, and the Federal Reserve is printing money. We expect that the muted discussion surrounding QE2 will soon grow louder, and the Fed will come to been seen as falling behind in the need to drain liquidity. Given this backdrop, we believe that the fund is well positioned to perform in such an environment.

January 2011

Fixed Income Market Recap and Performance Summary
Following the sharp selloff in Treasury bond prices witnessed in November and December, price action in January was relatively sanguine. Looking beyond headline performance, the most notable price action for the month was the (3.5%) loss in 30-year Treasury bonds, and the 2.10% gain in the Merrill Lynch High Yield Master II index. Those returns, paired with 2.25% gain on the S&P 500 for the month reflect the widening belief among investors that economic growth has now become self-sustaining and, in fact, may be accelerating. Recent economic data points to such a possibility. The first glimpse of fourth quarter GDP was significantly stronger than Wall Street economists had been forecasting. When adjusted for inventory growth, the economy expanded at more than a 7% annualized rate for the period. Even more encouraging, the weak growth in inventory for the quarter is likely to be a contributor to future growth as manufacturers restock items that were sold in the fourth quarter. Equally encouraging, the Federal Reserve’s latest lending survey revealed that banks have become more willing to lend, have eased terms, and that loan demand has increased; the most upbeat lending report since prior to the crisis.

Portfolio Positioning and Economic Outlook
Given the backdrop of positive growth and the relative value of the various fixed income sub-asset classes, we have positioned the portfolio to reflect an increasing likelihood of a rate rise, the increased rate sensitivity of the Barclay’s Aggregate Index, and the wholesale cheapening of the Municipal bond market. At month-end, the duration of the Aggregate index stood at 5.07 years, the most rate-sensitive the index has been in over 20 years. In simplistic terms, a duration of 5.07 years implies that a 100 basis increase in interest rates would result in a 5.07% loss in value. Rather than replicate that increasingly risky profile, we’ve taken steps to position the portfolio to profit as rates rise. To accomplish that, we’ve reduced duration to less than half of the index and have further mitigated risk sensitivity by positioning floating rate notes. As interest rates rise, the floating rate note coupon adjusts upward, making such a security a valuable tool at this stage of the economic cycle. Moreover, as we have discussed on previous occasions, the interest rate options market currently offers a cost effective opportunity to profit from a rise in short maturity interest rates. With that, we’ve increased our exposure during the month to approximately 40 basis points of total fund value.

We suspect that in the not too distant future, criticism over the ongoing easing of monetary policy by the Federal Reserve will intensify, and ultimately evolve into a discussion of how and when policy will be reversed. Moreover, given the extraordinary measures taken to reflate the economy, we expect that the Fed will not pursue Greenspan-style incrementalist policy as a tool to drain liquidity. Instead, we expect that extraordinary tactics will be necessary to undo the extraordinary reflation measures that have been put in place over the last two years. Finally, as recently discussed, we’ve been selectively positioning municipal bonds and preferred equity notes. While the “baby and the bathwater” selling witnessed in November and December has subsided, we continue to find compelling opportunities in which to invest.

Opportunity in Municipal Bonds

Investors continued their exit from municipal bond funds throughout December and the first two weeks of January. Concurrent with heightened credit fears in the Municipal market, higher long term US Treasury rates, and an expected supply shift from long term taxable municipal bond issuance to long term tax exempt issuance led to indiscriminate selling among traditional tax exempt investors. Mutual fund outflows averaged more than $2.0 billion per week from the middle of November to the middle of January and have now approached $30 billion for the period according to ICI. Over the past two weeks, the municipal market has stabilized as lower new issuance supply, January 1st coupon and principal repayments and mutual fund outflows appear to have reached equilibrium. We believe that the market has over-corrected and see this back-up in the yield to maturity as an opportunity to adjust the portfolio.

From a total return perspective, the broad municipal market index (Barclay’s Municipal Index) has under-performed the Barclay’s Aggregate index over the last 3 months, falling 5.6% compared to a 1.7% decline in the Aggregate index. The US Treasury component of the Aggregate Index fell 2.9% during the same 3 month period. It is worthwhile noting that the Barclay’s Municipal Index has an average maturity of 13 years, compared to 7 years for the Aggregate Index and 6.6 years for the US Treasury Component of the Aggregate Index. Table 1 details the returns of the Municipal Index by maturity and compares those returns to similar on-the-run US Treasury securities. When compared in this fashion, it is evident, that while the fixed income markets had a difficult 3 month period, the intermediate sector of the municipal bond market actually out-performed comparable US Treasury Notes. Long maturity municipal bonds under-performed the long end of the US Treasury market by approximately 0.50%.

In our November commentary, we highlighted four drivers of the weakness in the municipal market, as follows:

• Low absolute rates, in general, and the selloff in US Treasury Bonds following the Federal Reserve‘s announcement of further quantitative easing
• Uncertainty surrounding Income tax rates and subsidy extensions
• Contagion of sovereign credit fears and incomplete media coverage of municipal credit worthiness
• Mutual fund outflows forcing heavy selling into a period of large new issue supply

We recognized in November that this under-performance of the municipal bond sector was creating an opportunity to invest at seemingly attractively levels, however, we remained cautious and resisted the temptation to extend duration meaningfully in light of the still artificially low levels of interest rates. Instead, we focused investments on shorter maturity issues, with an overweight to A-rated securities issued by essential service providers.

The confluence of these factors continued to weigh on the market in December and January – widening credit spreads and steepening the municipal yield curve. The yield to maturity on AAA rated 20 year bonds increased an additional 75bps to reach a 4.68%, while the yield to maturity on 30 year AAA rated paper rose approximately 60bps further to 4.90%. Chart 1 depicts a long term view of the yield to maturity on AA rated State General Obligation Bonds maturing in 20 years. The AA yield to maturity has averaged 6.0% since 1962. Interest rates were considerably higher during the hyperinflation period of the early 1980’s. While we believe that inflation will pick up to more moderate levels, we do not yet believe we are in for a period of mid to high single digit inflation. We believe that this additional 60 to 75bps of yield in the long end now presents an opportunity to begin building a position of longer term municipal paper.

Municipal credit spreads, while tighter than 2008 crises levels, remain wide reflecting reduced appetite for lower rated credits and in many instances reflect an attractive entry point. See Chart 2. Similar to credit spreads the municipal yield curve has steepened to a very attractive level (See Chart 3). We measure the steepness of the yield curve as the difference between the yield to maturity on the 30 year and the 2 year AAA municipal bond. Chart 3 shows that the 2s-30 year curve is at its steepest point since 1993. The difference is nearly 4.10% – almost twice its historical average. Given these factors, we have been adding to longer maturity bonds rated between AA and BBB. Specifically, we are concentrating our purchases in bonds maturing in 20 years. Chart 4 shows the current AAA rated municipal yield curve, the current on-the-run US Treasury yield curve and the taxable equivalent municipal curve.

In selecting the maturity to invest, we are taking a pragmatic approach to positioning on the yield curve. The municipal yield curve historically offers only about 10 bps more yield for a 30 year bond than a 20 year bond. With that in mind, we have been targeting municipal bonds with maturities around 20 years, thus we earn about 95% of the 30 year yield but with 10 years less time to maturity.

December 2010

Fixed Income Market Recap

Despite ongoing open-market Government bond purchases by the Federal Reserve, investment grade bond prices declined in December. The most intense selling pressure occurring in the first half of the month, as the market continued to be buffeted by the selling pressure that commenced in November. The principal driver was a much better than expected holiday selling season and the positive spillover effect that surprise had on the broader economy. As was the case last month, the sharp selloff in the overall bond market was the overriding negative contributor to performance. The rise in interest rates was offset marginally by a slight tightening in credit spreads and an exceptionally strong performance in the High Yield bond market. Despite the sharp rise in interest rates associated with longer maturity bonds, interest rates for securities of less than one-year actually fell for the month.

Economic Overview
The unexpected improvement in domestic economic activity that materialized in November continued to drive rates higher. Coincident with the mid-term election, consumers began to appear more confident and willing to consume. Additional contribution to the acceleration in economic activity came from the manufacturing sector, which has recovered to pre-recession levels, and the stock market which finished the year less than a basis point from the two-year high. The irony is that interest rates hit a bottom just as the Fed outlined the details of its planned buyback of public securities. When viewed from the intramonth low yield in November to the intramonth high yield in December, interest rates on 5-, 10-, and 30- Treasury securities were all approximately 100 basis points higher.
However, the improvement in economic activity did little to calm either the troubled European government bond market or the domestic municipal bond market. On December 31st, the yield-to-maturity on 10-year government bonds of Greece, Ireland, Spain and Italy were all at, or near multi-year highs, as investors continue to believe that some form of default or restructuring is inevitable. Similarly, investors in the municipal bond market continued to reduce their exposure to the sector, resulting in a 194 basis point loss in the Barclays Municipal bond index. With municipal bonds now yielding more than 100% of U.S. Treasury notes, we believe municipal bonds offer an attractive value play and will be selectively be buying them for our taxable and tax-exempt clients.

Looking forward, we expect volatility to be heightened and, with that, the opportunity to add value to the portfolio through active trading. Moreover, we believe that as the economy continues to expand, rhetoric from the Federal Reserve will begin to refocus from monetary stimulus to how they intend to sop up the massive amount of liquidity they’ve added in the last two years. Expecting that it will prove more problematic than they’ve acknowledged, we will continue to significantly underweight the government sector, overweight corporate notes, maintain a weighted average duration well below benchmark, and employ interest rate hedges.

November 2010

Fixed Income Market Recap
November could be characterized as a month in which old news, thought to be resolved and impotent, reemerged to the detriment of the capital markets. With attention focused on the Federal Reserve and its well broadcast plan to reduce rates through a second round of quantitative easing (QE2), investors had positioned their portfolios for a continued fall in rates. When the anticipated rate decline failed to materialize, traders were quick to shed holdings of Treasury notes, pushing interest rates more than 40 basis points higher mid-month trough-to-peak. Exacerbating the rate rise was an unexpected, but welcome improvement in domestic economic activity. Just as the Fed’s public handwringing spooked investors into pushing the 5-year treasury yield down to nearly 1% during the month, improvement in employment, retail sales, and manufacturing served to reverse that trend, launching the 5-year note yield 50 basis points higher on an intra-month basis.

Economic Overview
While investors were caught off guard by the unexpected volatility in Treasury notes, even greater volatility was evident in the Municipal bond market. A reemergence of state and local debtor solvency concerns gained steam throughout the month, culminating during the week of the 14th, during which investors staged a stampede out of the sector. Over the course of that week, $4.2 billion redeemed from municipal mutual funds; the single heaviest week of redemptions ever. Several high-profile, long maturity municipal bond funds were down between five and ten percent for the month.

Concurrent with heightened fears in the Muni market, investors again began to worry that the weaker peripheral countries of the Euro were at risk of default. Investors were cheered earlier this year with the bailout of Greece and what appeared to be a “more-than-sufficient” stabilization fund. However, as economic activity remained depressed throughout Europe, investors began to again worry that the weaker, peripheral countries were at risk of default. Such worry spiraled into reality with Ireland, as borrowers became unwilling to lend to the sovereign, ultimately forcing an EU bailout similar to what was extended to Greece. As was the case with the Greek bailout, a relief rally ensued and at the time of this writing, the as-yet-unrescued nations of Portugal, Spain, and Italy are enjoying a reprieve from default concerns. However, just as Ireland required a Greek-style bailout, we wouldn’t rule out a requirement of similar support for the three remaining peripherals.

As we head in to the final month of 2010, we continue to believe that the economy will continue to improve, and that fixed income investors have overpriced government and government-related debt. As such, we will continue to significantly underweight the government sector, overweight corporate notes, maintain a weighted average duration well below benchmark, and employ interest rate hedges.

October 2010

Fixed Income Market Recap
Dominating attention through the month was the Federal Reserve with the Fed and Wall Street trading-desks attempting to out-game each other. Clearly, the Fed has not handled the idea and implementation of QE2 very well. When the concept was first floated, interest rates fell as the Fed had certainly hoped. Then, concluding that the easing was fully “priced-in”, traders sold bonds and pushed rates back up to the pre-announcement level. The Fed countered by hinting that QE2 would be bigger than first suggested. Rates tumbled and the cycle repeated itself. In our opinion, QE2 is a flawed strategy. The back and forth on interest rates and the public debate among Fed governors and presidents only serve to confuse and alarm consumers. Nonetheless, the Fed has committed and it’s their move. In 2001, the yield on the 30-year bond fell 40 basis points in two days on the news of the elimination of the security as a funding vehicle. With the interest rate spread between the 10-year and 30-year Treasury’s close to a record wide, a strategy of focusing purchases on the very long end of the yield curve could have a similar effect and force the entire term-structure lower. At least temporarily. Back in 2001, the 30-year rate rose back to the pre-announcement level one month later.

Economic Overview
Buried amidst the monetary policy rhetoric, recent economic activity has showed some sign of improvement. Specifically, Retail Sales grew at a faster rate than was expected. Similarly, recent news on housing sales and new home inventory hinted that the worst may be behind us. However, the employment picture has yet to signal that job creation is imminent. While employment is a lagging indicator, the naggingly high unemployment rate is likely to continue to be an impediment to acceleration in economic growth. With the holiday selling season rapidly approaching, it will be telling to see if consumer spending will hold up. If it does, the possibility exists that it could be enough to ignite a virtuous circle with enough momentum to make a meaningful dent in the unemployment rate. If such an outcome were to materialize, talk would quickly shift from quantitative easing to the mountain of excess reserves sitting in the banking system.

Anticipating continued heightened volatility and mindful of the potential for extreme moves in the capital markets, we continue to maintain a defensive posture in the portfolio and have implemented long option positions to mitigate the impact of an extreme outcome.