SUMMER 2009
(Q2-2009 Data)
Volume 19, Number 3

ewgate’s Municipal Income Portfolio had a strong quarter, rallying 9.4% and now up 23.8% year to date, compared to 4.2% and 9.8%, respectively, for the Lipper General Municipal Income Index.

Market Review. Credit markets have continued to heal, with most sectors recovering to their pre-Lehman collapse metrics. The massive liquidity pumped into the global credit system by most central banks has resulted in low LIBOR and other short term rates. The current steepness of the yield curve clearly reflects some measure of confidence that rates will be rising in the near future. Pessimists, however, point to fears of inflation and a possible collapse in the US dollar as reason for the rise in longer rates.

Municipal bonds have rallied sharply this year, as the Federal Reserve succeeded in pushing down Treasury rates. Munis started the quarter with extreme valuations, with the entire AA municipal curve yielding higher returns than Treasuries at every point along the curve. Even though that relationship started to normalize by quarter’s end, municipal yields are still at historically high levels relative to Treasuries, and well above Treasuries at the long end of the curve.

Concerns about credit quality of municipal bonds have lessened somewhat, similar to corporate bonds. While credit risk remains, the excess yield on municipals continues to reward investors. The largest potential source of stress is California, which is having difficulty meeting its budget obligations. The State of California’s bond rating has been cut several times. The recession is bringing to light structural problems in municipal finance not only in California but in New York, New Jersey and a number of other states. We also believe that when faced with the truly unacceptable reality of defaulting on their debt obligations, governments in those states will be forced to make the difficult, necessary choices. We view significant defaults of municipal bonds issued by taxing authorities as possible, but extremely unlikely.

Portfolio Performance. Municipal bond prices rose across most issuers and maturities. Even California bonds rose despite credit concerns. Discounts on closed-end funds narrowed during the quarter, adding to performance. In addition, many closed-end funds increased their dividends during the quarter. The very low cost of leverage, often under 1%, and the steep yield curve meant increased earnings, and therefore dividends, for many funds. Since most funds generally try to avoid dividend cuts, this quarter’s dividend increases are likely to remain in place for the foreseeable future.

Portfolio Activity. Duration was reduced in the quarter, primarily through an increase in cash. While we feel that true inflation is most likely several years away, the longer end of the yield curve will be vulnerable to profit taking in the short term. We maintained allocations to several state-specific municipal bond funds, including the Blackrock Muniyield California Insured Fund (MCA). After raising its dividend during the quarter, the fund now yields 6.5% and trades at a 14.5% discount. We believe this represents an attractive price for a portfolio of very high quality insured bonds. We also have a substantial position in the Nuveen Dividend Advantage Municipal Fund 3 (NZF) with a 7% yield. More importantly, more than 25% of the bonds held by the fund are backed by the US government, and it has a lower duration (7.7 years) than most funds, allowing us to reduce interest rate risk while maintaining yield.

Outlook. The municipal sector still has ample opportunities as the credit markets attempt to return to a more normal state. If we were in a normal environment, municipals would seem exceptionally attractive. They still are, and will be, as investor confidence returns. Closed-end funds are still priced at attractive levels, but have come in from their extremes. That and future inflation have led us to raise some cash temporarily. We anticipate opportunities to deploy this cash in the near term as credit issues get resolved and investor confidence increases further. The Portfolio’s 5.8% yield still represents value compared to the 4.2% yield on both AA municipals and 15 year Treasury bonds.