Tax Exempt Fixed Income - Strategy

During the first six months of 2001, municipal bonds posted their best returns in the shorter versus longer maturity areas. As an example, yield levels on 2-year tax-free bonds declined approximately one percent while yields on 20-year bonds remain close to year-end levels. However, in spite of this disparity, most maturities posted positive results and continue to play an important role in preserving capital and reducing market risk. As a result, we remain bullish on tax-free bonds and expect the demand for these securities to remain quite strong. Currently, we like the 5 to 12 year maturity areas, where we capture yields of 3.65 to 4.75%. This equates to a taxable equivalent of 6% to 8%. However, investor demand for long-duration paper may continue to be apathetic, because of the risks associated with aggressive Fed easing and recent signs that the stock markets and economy are rebounding. We may have to wait for long rates to finish adjusting to the perceived risks before we extend our maturity profile. Until then, we believe the best value on a risk adjusted basis favors the intermediate part of the yield curve.

The percentage of newly issued municipal bonds insured by companies such as MBIA or AMBAC soared during June to almost $15 billion, despite a weak economy. This is especially true in California where power concerns remain a major issue. In fact, since January, the State has shelled out over $7.4 billion from its general fund to pay for power. There is a mounting need to issue up to $13 billion in new securities in order to purchase future power on behalf of its two largest utility companies and to reimburse the State’s cash strapped general fund which now stands at less than $1 billion.

The situation in California has resulted in a quality downgrade of the State’s bonds by Standard and Poors and Moody’s to A+ and Aa3, respectively, from AA- and Aa2. This has further led to a performance shortfall of California issues versus other general market names. However, well in advance of California’s power problems and the potential ripple effect on the State’s economy as a whole, we sold non-insured California specific bonds, and bought out of state credits. This resulted in a yield pickup to clients, even after adjusting for the payment of state taxes. In addition, the strategy preserved market value as California’s energy problems unfolded and also enhanced liquidity, which is vital as we begin to return to investments within the State of California. In fact, even though the State is not yet out of the woods, which is why S&P still has a “negative” outlook, we have been able to selectively switch back to local California issues for a net benefit to our clients. In doing so, we are demanding very high quality and/or credit enhancement on all purchases.

Our overall outlook on municipal bonds remains positive, owing to several factors. First, we see strong demand from individual investors seeking an alternative to very low money market yields. Second, as the Federal Reserve continues to lower interest rates, municipalities will move to refund the older higher coupon debt, which in turn will improve their balance sheets and quality rating. In fact, Standard and Poor’s recently upgraded over 600 securities, many of which are tied to government appropriations. These upgrades will improve the ability to finance schools, municipal buildings and roads at a lower borrowing cost. As an investor, this should assure a supply of high quality bonds for investment consideration. And most importantly, relative to inflation, municipal bonds should continue to provide investors with a lower risk opportunity to garner reasonable returns, on a tax-adjusted basis.