SUMMER 2010
(Q2-2010 Data)
Volume 20, Number 3

ewgate’s Municipal Income Portfolio rose 2.3% during the second quarter and is up 6.7% year to date, compared to 1.7% and 3.3% for the Lipper Municipal Fund Index.

Market Review. The bond market remains buoyant despite low interest rates. Though the global economy is improving, data releases in May and June suggest a tepid, rather than the desirable “V-shaped” recovery that is more common post-recession. Interest rate increases are off for the foreseeable future. The market’s increasing pessimism on the economy can be seen in both the flattening of the Treasury yield curve and wider spreads for corporate bonds.

The reaction in the municipal market has been muted. The muni curve did not flatten nearly to the same extent as the Treasury curve. There is a large spread between general obligation bonds (backed by taxing authorities) and revenue bonds, repaid by revenue from specific projects often tied to real estate development projects.

The municipal market lagged Treasuries as investors prefer the absolute safety of the US government. There are a handful of significant “headline” municipal bankruptcies looming, such as Harrisburg, PA, that defaulted on bonds issued to build an energy producing trash incinerator and now seems destined for bankruptcy despite strong resistance from local officials. Some states have taken drastic actions to conserve capital, for example, California temporarily reducing workers’ pay to minimum wage and Illinois leaving bills unpaid.

Actual defaults and bankruptcies by municipalities declined in the first half of 2010. According to the Distressed Debt Securities Newsletter, there have been $1.5 billion in defaults in the first six months of the year, compared to $4.5 billion in the first half of 2009. Our view is that political issues are at the root of the problem with municipal debt, not fundamental economic ones. Long term debt issues are difficult, but not intractable (for the most part). Local politicians seem to accept the idea that defaults on bonds would likely have severe long term repercussions. California has a law requiring repayment of bonds before all other expenditures after education. In California, workers and their pension and benefit plans are junior creditors to debt holders.

Portfolio Activity. Low absolute yields on municipal debt and stability in the financing environment for leveraged closed-end funds have caused a further narrowing of discounts in the Portfolio. Even single state funds, that typically have wider discounts due to less diversification and a smaller investor base, are expensive. We sold the Blackrock Muniyield NY Fund as its discount narrowed, but retain funds like the Blackrock Muniyield California Insured Fund (MCA) with a 6.1% yield and a 7.6% discount. We continue to use select ETFs to manage both duration and credit quality in the Portfolio.

Outlook. The outlook for municipal bonds appears highly positive. Yields relative to Treasuries are attractive; inflation fears remain muted. It now seems that tax rates may rise before interest rates do, making tax exempt bonds that much more attractive. While there are real concerns with respect to credit, we are confident that most issuers are addressing both short and longer term funding issues. Newgate’s Portfolio provides exposure to thousands of issues, not just the couple dozen in a typical laddered investment portfolio. This diversification is always an advantage, but may become more important should there be deterioration in the credit environment. The Portfolio’s 5.3% tax free yield is well positioned for investors looking to balance income and risk in this low rate environment.