2009 in Review

Municipal bonds had the greatest price appreciation since 2000, with the Bond Buyer 20 Index (which tracks 20-year general obligation yields) falling to the lowest yields since 1967. We started the year at 5.24 percent and on October 1st, the index dropped to 3.94 percent (the Index ended the year at 4.25 percent). January of 2009 represented the strongest month of price appreciation for the asset class in recorded history.

2010 Outlook

Specifically, there is no clear source of demand for U.S. labor emerging that will fill the void created by the recent/current recession. The U.S. labor force ended 2009 where it was in 1999, meanwhile the population grew by approximately eight percent. Related to the employment environment, and in the context of reduced access to credit, the prospects for rapidly increasing consumer demand are unlikely. Finally, both the commercial and residential real estate markets remain in a tenuous position. Mortgage delinquencies (not including foreclosures) are approaching 10 percent. We expect that Fed purchases of mortgage-backed securities will extend beyond the current March expiration in an effort to support prices in the residential market (the New York Fed estimates that Fed purchases have reduced mortgage rates by 150 basis points). In the end, the overwhelming supply of Treasuries should more than offset the subdued economic activity in the U.S.

The good news for municipal bond holders is that the supply of new-issue traditional tax-free (or tax-advantaged) municipal bonds will decline in 2010 at approximately the same time the value of tax-free income is expected to increase. In 2009, the Build America Bond program was started where in lieu of bondholders getting tax-free income, a subsidy equal to 35 percent of the interest expense was paid by the U.S. Government directly to the municipality. In the past, taxable municipals accounted for approximately seven percent of the total municipal bond market. In 2009 (the program began in April), taxable municipals represented nearly 20 percent of the market. In 2010, taxable municipals could total 30 percent of total municipal issuance. Tax-free income could become dearer as the “Bush” tax cuts are set to expire in 2011 and by some measures the U.S. is currently at relatively low historic tax rates.

The bad news for the municipal bond market is that the creditworthiness of many municipalities is on the decline. As states push $193 billion of combined budget deficits to local municipalities, more municipalities will experience challenging times in 2010 and 2011.

In spite of the sometimes opaque nature and lack of timeliness of financial information provided by municipalities, the scarcity issue and value of tax-free income should allow municipal bond holders to enjoy modest returns in 2010.

In 2010 we will be focusing on adding quality “A” rated issues to enhance yields in client portfolios. Rather than being compensated for credit risk, we see it as enhancing yield for a modest reduction in liquidity. In the context of the average quality of our client portfolios and cash flow dispersion, we feel this is a prudent tool to enhance returns.

Another strategy we expect to employ is accepting call risk (or optionality) to enhance returns. Specifically, we are seeking high coupon bonds with a call date that is three to six years away and a maturity date that is less than 10 years away. The goal is to push reinvestment risk out beyond what we feel has a decent chance to be a low interest rate environment without taking on too much interest rate risk.

A final note has to do with what we perceive to be a shrinking liquidity environment in the secondary municipal bond market, attributable to the reduced number of firms in the bond underwriting and trading business. This change is potentially bad if you are forced to sell positions or if you hope to make portfolio tilts and total return trades. As a buyer, if you don’t mind seeing the remaining dealers make above average profits on modest risks, you can enhance yields buy acting as a source of liquidly/buyer in the secondary market.

We are in the process of stratifying similar data to look at the liquidity characteristics of various states, project types, issuer ratings and transaction size. Based on some initial observations, we believe there is significant value in secondary market purchases of “A” rated bonds, essential purpose revenue bonds and bonds that have a degree of optionality/callability.