MUNI OUTLOOK 4% 3% 2% 1% 0% -1% -2% Figure 1: May Municipal Performance

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1 MUNI OUTLOOK April Main Street Concord MA Flight to Quality efines April Amid continued focus on the accounting issues surrounding AIG and MIA and the report of poor earnings by General Motors (GM), investors sought the stability and security of US debt including municipal bonds. Further stability for the continuation of the municipal rally was provided by a reiteration by the ank of Korea and Japan that each country would continue to hold US debt. uring April, long-term municipals posted price gains in excess of 2.5% and a total rate of return of nearly 3.0%. The performance contrasted the April price deterioration in the US equity markets as shown by the 2.4% decline in the ow Jones Industrial Average. April s tax-exempt performance was similar to that of 2002 when price gains were in excess of %. Since 1990, April has displayed vulnerability with the long-term seasonal bias toward weakness. Historically, May performance is more positively skewed. Figure 1 illustrates the cumulative price gains for the month between 1990 and It is not uncommon for the municipal market to experience explosive advances. For example in 1990, 1995, and 2003, price gains were more than 3.0%. Performance 4% 3% 2% 1% 0% -1% -2% Figure 1: May Municipal Performance Municipal Primary Slows, Secondary Selling Consistently Increases April municipal issuance was reported to be between $27 and $30 by The ond uyer on April 29, representing the lowest monthly issuance total since January. However, as issuance declined, there was little slack in the demand for primary product from crossover accounts-- hedge funds, proprietary desks and tender option bond programs. The new issue market also continued to be dominated by the 5.00% coupon structure. While 5.00% is the popular structure it has contributed to confusion over the definition of current coupon that has been defined as a bond priced near par by the MSR s Glossary of Municipal ond Terms. The result is a bifurcated market condition relected in the long-end of the municipal market by those accounts that benchmark bonds to the high premium pricing to their call as opposed to their price to maturity. The demand among flexible accounts for premium structure has remained unprecedented and the interest from more traditional accounts has been less aggressive. New issues are increasingly being structured for a narrow group of investors. The efforts to transact business in the secondary reflects some of the apathy among traditional accounts as individual investors remain confused by current ambiguity in the US and global economies. Throughout April, the par amount and number of blocks being shown on loomberg s bids wanted steadily increased, peaking in the 3rd week of the month. The number of offerings listed on loomberg and TheMuniCenter also remained high. In addition, as measured by the MSR and posted on TheMuniCenter, the number of daily transactions by both customers and dealers was often below the 30-day average. Federal Reserve and Fundamentals Federal Reserve Governors and regional Presidents were vocal ahead of the May FOMC meeting. The consistent theme was steady growth and moderate inflation. The latter was assisted by oil s price decline below $50/barrel on April 29. The measured pace of rate increases was embraced and fear of an accelerated pace was reduced after March Non-Farm data was 5% below surveys. ond Rally Created Municipal Value The tax-exempt market benefited throughout the month from its attractive standing relative to Treasury and Libor yields. The greatest relative value was in the 2 to 10- year range of the curve, while benchmark 30-year Consensus yields reflected levels that were 100% of Treasury yields. The 30- year Consensus to Libor ratio was 9% at month-end. The latter relationship has Copyright 2005

2 ranged between 88.9% and 94.3% over the past 60 trading days. On April 28, the exceptionally strong market advance, attributed to trading accounts pushing prices for month end, resulted in the municipal/treasury ratio rising above 89.0%, a level not attained since May 18, Figure 2 illustrates the exceptional above average trading activity that occurred on the last regular trading day of the month, with greatest demand between the 6 and 10-year maturities and 16 and 20-year maturities. Percent (%) 8% 6% 4% 2% -2% April 28 "Customer uy" Transactions as a % Above/elow 30-day Average % 0-5yrs 6-10yrs 11-15yrs 16-20yr > 20yrs Maturity Ranges Source: MSR, TheMuniCenter Figure 2: April 28, a market rally at month end, generated above average volume that distorted ratios The greater use of the intraday trading activity reports of the MSR made the patterns and demand more evident. However, the lack of knowledge of exact par amounts for blocks of $1M or more reduces the ability to discern the intent of the transactions. In addition, the limited number of municipal transactions that occur of $1M+ increases the challenge to evaluate processes for pricing both cash and derivative products. measures the relative value of the ratios on the basis of the standard deviation of the current ratio versus a 60 day period. For example, the 5-year ratio was more Yield than 2 standard deviations below the 60-day mean on March 11, indicating that taxexempts were overvalued vs. Treasuries and Libor, Figure 3. On April 15, the ratio had changed to more than 3 standard deviations above the mean. The dramatic change occurred as 5-year municipal yields rose 1 basis point during the period as compared to a 34 and 29 basis point decline for Treasuries and Libor. etween April 15 and April 29, the undervalued municipals outperformed taxable counterparts. The 5-year municipal yield declined 9 basis points as opposed to the 7 basis point gain for both Treasury and Libor. Municipal & Treasury Yields v. Ratio Standard eviation: 5-Yr Maturity Mar 18-Mar 28-Mar 4-Apr 11-Apr 18-Apr 25-Apr Figure 3: 5-year ratio shifted from ST EV in mid March to +3.2 on April 15, as municipals lagged Spread (%) ST EV Consensus Treasury MA Short Term - 20yr Municipal SWAP Spread January 5, April 20, 2005 (weekly) 50 Jan-05 Jan-19 Feb-02 Feb-16 Mar-02 Mar-16 Mar-30 Apr-13 Figure 4: The MA 7-day rate has increased 100 basis points in the past 2 months ST EV ond Curves Flattening - Inversion? The attention given to the long-end of the yield curve remained predicated on the belief that the Treasury yield curve was on track to invert this summer. Much of this was based on the belief that the Fed will increase the Funds rate to at least 3.50% by August and that the US economy would remain on a modest, non-inflationary pace. The Treasury curve has inverted 2 times in the past 17 years, 1988 and In 1994 the curve came within a few basis points of inverting. In each instance, the flattening Treasury curve coincided with an environment in which the Treasury 10-year yield rose as the 2 to 30-year spread approached or penetrated zero basis points. Since the Treasury curve s peak on August 13, 2003 (366 basis points), the Treasury 10-year yield has declined from 4.57% to 4.22%, yet the slope has narrowed to 94 basis points. The aberrant behavior of the Treasury 10-year yield versus the curve s slope might simply reflect the dearth of fixed-income product in the longer maturities. The taxexempt market was also impacted by the flattening theme. Figure 4 utilizes the MA 7-day floating and 20-year fixed rate levels to illustrate the near 100 basis point adjustment in the curve in April. The derivative curve at 100 basis points could reduce a great deal of return generated from transactions dependent on the curve s slope. The discord in the short-term product was further manifested on April 21 when tax-exempt money market funds posted an average single session rise of 23 basis points. The MA 7-day rate rose from a rate of 1.74% on March 2 to 2.94% on April 20. The flattening dynamic is again illus- Copyright 2005

3 trated for another key area of the interest rate markets, 2 to 10-years. Figure 5 compares municipal, Treasury, MA, and Libor curves, which have flattened in 2005, (41, 53, 31 and 51 basis points respectively). When comparing the current spot maturity yield spreads of the Consensus curve over the past 1 and 3 months, the greatest change has been within the 15-year maturity where the impact from the upward pressure on short-term rates is most pronounced. Spread (%) 2yr- 10yr Spread Relationshiop January 1, April 29, Jan-03 Jan-18 Feb-01 Feb-15 Mar-02 Mar-16 Mar-31 Apr-14 Apr-28 Municipal Treasury MA SWAP Libor SWAP Figure 5: Treasury and Libor swap curves have flattened more than municipal counterparts in 2005 Consensus Curve: TRR & asis Point/ Price Change by Maturity The positive performance of the municipal market was also pronounced inside 15-years. It was in the front half of the tax-exempt curve that the greatest relative value was apparent as many investors grew wary of the dynamics in the longer maturities. Movement down the yield curve was, however, balanced by those who believed the yield curve would continue to flatten. Year-to-date, the greatest total rate of return (TRR) was found beyond 20-years, and in April the absolute gains were in longer maturities. As a result, the best price performance was found in the long maturities where the basis point change translated into a price gain of more than %. The improved performance in the municipal market during April was consistent throughout most of the month. Figure 6 reflects the positive bias as represented by the Consensus Price Index. The Index turned positive on April 1 and sustained the constructive bias to month-end. The Index represents the daily price movement of the 11 to 15-year range of the municipal Consensus yield curve. When the positive bias emerges, (Index, black asis Points Performance (%) Jan-27 Feb-10 Feb-25 Mar-11 Mar-28 Apr-11 Apr-25 Figure 6: Throughout April the Consensus Price Index remained steadfastly positive line, crosses upwards through the shortterm average, blue line), there has historically been a 1.0% to % upward price movement. In Figure 6 the 10-year ratio rose from 8% to more than 89.0% as prices bottomed in March and rallied for the next 5 to 6 weeks. The appearance of value can attract investors who are seeking protection from a possible near-term correction in interest rates. However, at the end of April the upward momentum remained intact. Figure 7 illustrates the greater price performance reflected in the municipal market s offering levels as represented by Thomson s MM yield curve in comparison to the Consensus mid-market curve. enchmark Curve Comparison: April 1 v. April 29, MM-MMA (4/1) MM-MMA (4/29) Figure 7: The 10-year yield spread of less than 5 basis points indicated value in municipals on April 1 Municipal Consensus 11-15yr Performance vs. % to Treasury: 3 Month History 90% 88% 86% 84% 82% 80% 10yr % Ratio 11-15yr Price Performance 11-15yr Moving Average Ratio (%) Historically consistent was the widening of the basis point spread between the two curves during the market s improvement in April - especially in the 10-year maturity. Traders and investors have been rewarded for buying municipals when the 10-year spread difference was less than 5 basis points (as on April 1), and selling them when the difference was 10 basis points, as was the case at the end of April, Figure 7. The predominance of the 5.00% coupon has created a different presentation of the benchmark curves. The Consensus continues to reflect the curve as a current coupon, indicative of bonds with a dollar price between 98 and 102. The purpose is to provide a consistent historical measure. The MM curve appears to represent benchmark yields of bonds priced to the par option, creating a much lower nominal benchmark yield. While the 5.00% premium pricing has become predominant, dictated by the flexible accounts, the shift in presentation can create confusion in historical pricings. The input from the Consensus participants illustrates the range of perspective for benchmark levels. The dynamic of the premium pricing is less of an issue inside 15-years, but it is clear that in the 3 Copyright 2005

4 longer maturities there exists a conflicted state of the market where a small number of participants are focusing on the pricing to the call as the benchmark (which does not reflect yield to maturity). The influence of the current market phenomenon is that the lower yield produced by the pricing to the par call can exert a positive pricing impact on derivative products and the overall market. The emphasis in MM s weighting occurred in late January, and has persisted in Figures 8, 9 & 10 illustrate the distribution of dealer and buyer inputs in the Consensus for the 5, 10 and 25-year maturities on April 29. The persistence of the 5.00% coupon has exerted force on general pricing and benchmark performance indices. Of note is that despite pricing to the call, the MM curve reflected greater market strength than the Consensus, an odd dynamic that might be attributed to the concentrated trading by accounts with more flexibility yr (2010) Municipal 'Aaa' G.O. Consensus Scale ()uyer; ()ealer Figure 8: istribution of Consensus participants distributed evenly around the median (lack ox) yr (2015) Municipal 'Aaa' G.O. Consensus Scale ()uyer; ()ealer Figure 9: istribution in 10-year maturity begins to reflect some more aggressive levels Municipal Issuance & Secondary Supply The ond uyer estimated April issuance between $27 and $30 on April 29. The 4-month total was $128, bringing the 12-month total to $368. Figure 11 compares the 4-month total to the yield of the Consensus 10-year spot. There is a distinct relationship between the decline of the 10-year yield below 0% and the increase of municipal issuance. The 0% was first broached in late It is not coincidental that the low yield environment has also coincided with the absence of an active retail market and a greater degree of price volatility. As April drew to a close, the 30-day visible declined to $6.35, a total less than the seasonal average ( ) of $10 for this time of year, Figure 12. $ Figure 10: The longer maturities show a number of participants influenced by par call premium pricing There is an increased perception that the large issuance totals in February and March can be attributed to an urgency felt by issuers to capture what was perceived as the last opportunity to lock-in low long-term rates. espite the decline Municipal ond Issuance: $180 $128 $150 $120 $90 $60 $30 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Issuance 4-mo 10yr Municipal Yield Figure 11: Municipal 10-year yields below 0% have sustained 4-month issuance above $120 pace 4 25yr (2030) Municipal 'Aaa' G.O. Consensus *arrow reflects total as of 4/05 ()uyer; ()ealer Munil Yield (%) at month-end, April s calendar was generally above average, led by the state of California and New York City G.O. sales of $779M and $850M. In the secondary there were two interesting trends. The first was the large increase in the bid wanted par amount during periods of the municipal market s strength. y the last week of April, the 6-day bid wanted sum exceeded the prior peak which occurred in February, Figure 13. Trading accounts have learned that liquidity in the municipal market is at its best when prices are rallying and that value (i.e. demand) is created by the lagging of the municipal market relative to Treasury and Libor. Second, there was a definitive increase in the number of offerings in April shown via loomberg and TheMuniCenter. Copyright 2005

5 Seasonal Price Trends - Reinvestment As mentioned, the Consensus Price Index reflected a positive price trend throughout April. The performance was contrary to the seasonal adversity historically associated with the month. Figure 14 illustrates the upward sloping actual price trend in April versus the negatively sloped seasonal line. It should be noted that April has experienced positive monthly performance in the past, i.e and Since 2002, when the municipal market began to reflect more of a trading market behavior with other fixed-income sectors, the month of April has been positively biased in 2 of the last 3 years. Similar to the strong performance in 2005, the April 2002 municipal advance coincided with a sharp decline in US equities. While long municipal bonds posted gains in excess of %, the ow dropped %. In 2003, the ow rallied along with municipals. However, the ow was 2% lower than it was in both 2003 and in In 2002 and 2003, the uncharacteristic spring rally served as a catalyst for 2nd qtr. municipal issuance to increase 4% more than the 1st qtr. The increase in issuance, (assisted by low yields), has occurred in May as issuers (1pt.=1%) ($ millions)) 12,000 10,000 8,000 6,000 4,000 Seasonal vs. Actual Municipal 30-day Visible Supply Seasonal Average Visible Actual ,000 10,000 8,000 6,000 4,000 Figure 12: At the end of April the forward calendar fell below the seasonal average ( ) Index (1pt=1%) Consensus Price Index 21-25yr vs. id Wanted Par 6-ay Sum Feb 17-Feb 8-Mar 24-Mar 13-Apr 21to25yrMuni Figure 13: The improvement in the municipal market coincided with increased W activity Figure 14: April performance contrary to seasonal patterns - May to July historically positively biased Seasonal vs. Actual Municipal Cash Index Apr 21-Apr 9-May 30-May 19-Jun 10-Jul 30-Jul 19-Aug 9-Sep 29-Sep are aware of the large municipal reinvestment over the next 3 months, specifically in June and July. These three months represent a total reinvestment estimated to be between $96 and Seasonal Muni. Cash Actual 2005 Figure 15: 10-year municipal taxable equivalent yield is 150 basis point more than Treasuries Municipal Consensus Yield (Actual vs. Tax-Equivalent Yield) v. Treasury Yield yr 2yr 5yr 10yr 30yr Municipal Consensus Yield Tax-Equivalent (35.5% Tax Rate) Treasury Yield (1pt.=1%) id Wanted 6-day ($ millions) W Par ($M) $120. June s total, which might exceed $50, has historically had an influence in May (prior to the Memorial ay weekend) in addition to contributing to the upward seasonal price patterns from mid-may to mid-august, Figure 14. In addition, an estimated $113 of corporate debt will mature in the next 3 months and given the uncertainty in company earnings, some of the reinvestment might turn toward municipals. The after-tax argument continues to benefit municipal investments. Figure 15 compares the taxable equivalent yield of municipals to Treasuries along the yield curve. In the 10-year maturity, the municipal tax-advantage is 150 basis points, compared to the 100 basis points represented by the investment-grade corporate to Treasury spread. Further, the lackluster performance of equities in the past year might direct more reinvestment to municipals. 75 Main Street Concord MA Copyright 2005