Tax Exempt Fixed Income Strategy
Municipal Bonds Weather the Storm

In the year’s first quarter, tax-free municipal bonds gener-ated mixed results depending on maturity. Two-year mu-nicipals returned around +1.90%; 10-year munis returned +0.47%; and 20-year munis returned a negative -3.50%.

Oakwood client returns were positive, ranging from +0.40% to around +1.80% depending on client preference or restriction. In view of the weak economy and declining revenue growth to municipalities, we are pleased by these results.

We are experiencing the worst housing slump in 16 years. This problem is severe in states like California, where mandated spending increases are met with slowing revenues. With its $16 billion deficit, California is not alone however. A full half of U.S. states, including New York and New Jersey, are projecting budget deficits this year and Florida’s credit was recently downgraded.

Troubled Insurers

Market prices on even the safest municipal investments have faltered, regardless of the municipal issuer’s ability to meet debt obligations. Almost half of the outstanding municipal debt has an insurance support as a protection against default. Unfortunately, along with insuring municipal bonds, insurance carriers also guarantee mortgage-related debt. As housing defaults rise, many insurers are falling short of the required minimum capital. Even though the historic occurrence of tax-free-bond default has been rare (below 1%), this has triggered drops in credit ratings. Investors are naturally worried, and this helps to account for the sector’s short-term underperformance.

Munis Relative to Treasuries & Corporates

It’s surprising how well the value of most municipal bonds has held up—a testament to the sector’s rare default experience and to ongoing strong demand. Tax-exempt bonds typically move in the same direction as taxable Treasury yields, although not at the same pace. The weak economy and problems surrounding sub-prime mortgage defaults has prompted the Federal Reserve to quickly and dramatically lower short-term interest rates. Considered to be the safest fixed-income investment, Treasuries respond rapidly to changes in the economy, inflation and Fed policy. Municipal and corporate bonds, by contrast, take into account credit quality, liquidity, and supply/demand characteristics and thus may not respond as rapidly.

We see current market conditions as an opportunity for municipal bonds. We have reached a point when municipals, like high-quality corporate bonds, are very attractive relative to Treasuries. In fact, the yield level on many tax-free bonds is now higher than Treasuries. As the housing crisis and the economy begin to stabilize, we expect municipals to easily outperform Treasuries. However, we must be very careful in our selection. We have consequently upgraded our quality preference to focus on Government-collateralized investments and issues that have a minimum underlying quality rating of AA. We also continue to avoid state-level California debt until the budget shortfall is addressed in a meaningful manner.

To take advantage of the recent attractive yield levels, we’re adding 13 to 15 year maturities to portfolios. A tax-free yield of 4.40% equates to a taxable equivalent of more than 6.75%. By comparison, high-quality taxable corporate bonds are yielding around 5.75%, while Treasuries yield only 4.00%.

Demand will Remain as will Role of Insurers

As the November election approaches, it’s unlikely that tax rates on the wealthy will fall and therefore demand for tax-free municipal bonds should remain strong. We’re confident that the municipal insurer problems will be resolved. There are a number of adoptable proposals on the table: bank infusions of capital, government involvement, or a split up and sale of assets by quality. For now it’s likely that despite the enviable high-quality nature of municipal bonds, many issuers will continue to augment their debt with insurance. For investors unfamiliar with the specifics of each municipality, this insurance provides quality reassurance.

Until issues surrounding the economy, housing and insurance carriers are resolved, we will continue to invest in only the strongest municipalities. We remain patient and careful prior to making investment decisions. Now more than ever, trading skill and due diligence are essential to capital preservation and the expectation of favorable investment performance.