SPRING 2010
(Q1-2010 Data)
Volume 20, Number 2

ewgate’s Municipal Income Portfolio rose 4.4% during the first quarter, compared to a 1.5% gain for the Lipper Municipal Fund Index.

Market Review. “Is this a recovery, or just the next phase of the crisis?” That is the implicit question running through the global markets. Near zero interest rates, quantitative easing (central bank purchases of its own government’s bonds, a fancy way of saying “printing money”) and fiscal stimulus appear to have put the global economy on the right path. But is the economy strong enough to survive the withdrawal of government stimulus? Or are we now set for a hyper-inflationary environment due to excess liquidity? No one knows for certain, but the truth usually lies between the extremes.

What we do know is that fear drove money into government bonds, especially US Treasuries. Now with bond yields low, and the need for real return and confidence increasing, long dated Treasury securities seem like the worst of a series of uncertain options.

During the quarter, spreads on municipal bonds relative to Treasuries narrowed, making municipals increasingly attractive. This was especially true on the short end of the curve. By March 31, AA rated municipal bonds shorter than 2 years in maturity had higher yields than Treasuries. The same was true for bonds with maturities greater than 20 years.

Municipalities have been taking advantage of lower interest rates by issuing new bonds, either to refinance existing debt or fund new projects. Over $105 billion of municipal bonds were issued in the first quarter of 2010, compared with $88 billion last year. Much of this issuance has come from the Build America Bonds program, where municipalities issue bonds with taxable coupons, but the Federal government subsidizes the issuers themselves. Taxable investors get a tax equivalent yield comparable to that of traditional municipal bonds, but issuers get a low cost of funding due to the subsidy. One positive effect of the program is that foreign investors, who normally would not participate in the asset class at all, purchased over $60 billion dollars worth in 2009.

Credit quality remains the largest source of concern in the municipal market. Stories abound of cash strapped cities and states wrestling with budget shortfalls. However, it seems that most (though not all) stressed issuers of general obligation bonds are at a political, not an economic, crossroads. When it comes to credit quality, the situation is improving marginally. Data suggest that state tax collections for the first quarter rose unexpectedly, though they are well below 2008 levels. States still need to repair their finances, but the situation is less urgent than it was months ago.

A factor affecting the market for municipal closed-end funds has been their ability to find new vehicles for leverage. The failure of the Auction Rate Preferred (ARP) market caused concern that closed-end funds were no longer a viable investment vehicle. While the refinancing of funds from ARPs to alternative structures is a process that will take some time, it does appear that the market is accepting these new structures. There are now even ETFs that purchase these new structures, increasing the liquidity in the short end of the market.

Portfolio Activity. Inherent value in the municipal bond market encouraged investors to buy closed-end funds. Fund discounts narrowed; some funds, especially leveraged funds, began to trade at premiums. We increased allocations to unleveraged funds to reduce risk and duration. ETFs also play a role in this strategy. There is still value in state-specific funds like the Blackrock Muniyield California Insured Fund (MCA) with a 6.1% yield and a 9.8% discount.

Outlook. Municipal bonds are at attractive levels relative to Treasuries. They also represent a logical“first step” for investors looking to increase yield in their portfolios. The expectation of rising tax rates not only shores up credit quality for borrowers, but makes tax exempt income more valuable to investors. As interest rates rise, diversification and duration management will be vital for success. An actively managed portfolio of closed-end funds seeks to provide both.