Insights. Municipal. in this issue JANUARY The BMO Tax-Free Income Team. Portfolio Managers. Credit Analysts

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1 JANUARY 2013 Municipal Insights The BMO Tax-Free Income Team Portfolio Managers John D. Boritzke, CFA Joseph J. Czechowicz Craig J. Mauermann Duane A. McAllister, CFA Erik R. Schleicher Credit Analysts A.G. Anglum Michael R. Janik, CFA Catherine M. Krawitz, CFA Andrew W. Tillman in this issue 2 } What a Year! Despite the Finish Despite a sharp correction in December, overall, 2012 was a very good year for municipal investors. Tax-related selling at year-end caused a sharp rise in intermediate and long-term yields, reversing the risk-on theme that was pervasive all year. Surprisingly, short and intermediate yields are back to year-ago levels. Long-term rates are still well below where they started the year and may have little additional room to run. 3 } 2013 Outlook Even with the year-end deal to avert, or postpone, the full impact of the fiscal cliff, there are many unanswered questions as we enter The primary concern is what changes, if any, there will be on how taxexempt interest is treated going forward. That said, there is much we do know that allows us to be cautiously optimistic on the municipal market in We list what we do know, with some degree of certainty, and how each impacts our market. We particularly like the roll offered from the intermediate segment of the yield curve. 5 } Strategy 6 } Data for the Journey Asset Management BMO Funds Retirement Services Trust and Custody Services

2 What a Year! Despite the Finish 2012 was a rewarding year for municipal investors, particularly those who were willing to accept additional risk. Although interest rates rose both early and late in the year, the broad trend was toward lower yields for most of the year, particularly among longer maturities. In fact, by late November, yields had reached the lowest levels in nearly 50 years. Those who stretched for yield by extending duration, lowering credit quality, or moving into riskier sectors of the market were rewarded. They outperformed investors who played it more conservatively in each of these risk categories. The strong and consistent inflows to tax-free mutual funds throughout the year suggested not only a comfort with the municipal market in general, but a willingness to stretch for yield into longer-term and high-yield funds. December, however, marked quite a reversal of this risk-on theme. Last month, risk was turned off as the market came under its most intense selling pressure since December And, for the first time in over a year, the market experienced back-to-back weeks of outflows from tax-free funds. Last month s price correction was most severe on longer maturities, as 5-, 10- and 30-year yields rose 17, 25 and 36 basis points (bps), respectively. While some seasonal weakness at year-end was expected, the catalysts for this year s selling pressure were unique. Much of the selling was due to anticipated changes in capital gains and estate tax rates. The fiscal cliff debate was also a factor. At one point, it seemed that both political parties had agreed to cap the tax exemption of municipal interest at 28%, regardless of the top marginal income tax rate. Those concerns faded as it became evident there would be no grand bargain deal before year-end, and the selling pressure eased. Two full years without a meaningful pullback breeds complacency in any market and municipal investors had perhaps become too comfortable with positive returns each month. In fact, on a risk-adjusted basis (i.e. factoring in volatility) the municipal market has been the best-performing asset class over the last two years, according to a Bloomberg and Bank of America/Merrill Lynch analysis. What December s adjustment provided the market once again was an appreciation for risk, an important reminder with yields near record lows. Even with the December correction, the Barclays Municipal Index was still up 6.78% for all of 2012 and the Barclays 1 10 Year Municipal Blend Index returned 3.56%. And, thanks to the year-end sell-off, yields on short and intermediate maturities are now back near where they started the year (see Figure 1). That is not the case for longer-term yields, however, which beyond 20 years are still more than 70 bps below year-ago levels. Figure 1 Yield Curve Analysis 4% 3% Municipal Market Data AAA Rated Yield Curve as of 12/30/2011 as of 12/31/2012 As painful as this correction may have been for some, particularly bond dealers with too much inventory, from our perspective the back-up in rates at year-end was both welcome and overdue. YIELD 2% 1% 0% 1 Year 5 Years 10 Years 15 Years 20 Years 25 Years 30 Years YEARS TO MATURITY Source: InvestorTools Perform BMO Global asset management } 2

3 2013 Outlook Even with the President and Congress reaching a mini-deal in the final hours of 2012 to avert, or postpone, the full impact of the fiscal cliff there are perhaps more questions than answers as we look to the new year. The primary question for the municipal market is whether there will be policy changes regarding the exemption of municipal interest. Many possible changes have been discussed, some more draconian than others, but investors should know that this will be part of a larger tax-reform and spending debate throughout Already the Republican party seems intent on using the looming federal debt ceiling limit as leverage to force the issue of spending cuts. This is likely to create anxiety and volatility in the municipal market. It s important, however, to focus on what we do know, at least with some degree of certainty, as we begin the new year. Here are a few of the items that impact our positioning across the strategies: n Tax rates for all workers will rise in 2013, but particularly for high income earners. The deal reached on New Year s Day will raise the top marginal income tax rate to 39.6% from 35.0% for individuals earning more than $400,000 ($450,000 for joint filers). The tax rates on capital gains, dividends, and estates will also rise. Payroll taxes rise 2.0% on all workers, back to the 6.2% rate. And, included in the Affordable Care Act bill, a 3.8% surtax will apply to investment income on individuals earning over $250,000, except for municipal interest. All of these tax increases make tax-exempt interest more valuable in 2013 than it was in n The Federal Reserve (Fed) is very likely to continue to hold short-term rates near zero throughout Rarely has Fed policy been so clear at the start of a new year. The Federal Open Market Committee (FOMC) has been as transparent as possible with their new guidelines to maintain an extraordinarily easy monetary policy until the unemployment rate falls to at least 6.5% and expected inflation is above 2.5%, neither of which are likely to occur in n With the Fed on hold, the yield curve should remain steep, enhancing the roll opportunity. Although the long end of the yield curve has flattened, the short to intermediate segment of the curve is back to year-ago levels. The slope of the curve provides an important means to enhance returns by rolling down the intermediate maturity segment. As bonds age from one year to the next along a steep curve, they appreciate in value, enhancing the total return of a bond portfolio or fund. n A steep yield curve has historically led to market inflows. As long as investors are rewarded for extending from cash into higher yielding short or intermediate maturities they tend to do so for the extra yield. This should help minimize outflows, if not bring more money into the municipal market in BMO Global asset management } 3

4 Current Strategy Duration: Neutral in Ultra Short, Short and Intermediate strategies. Modestly short in the long-term strategy. Curve: Intermediate focus, regardless of the investment strategy. For Ultra Short and Short strategies, a barbell structure. Intermediate and Long strategies, a bulleted structure. Credit: Remain overweight, but less so than in Focus on A rating category. Sector: Maintain a revenue sector bias, but as housing improves, selectively add general obligation exposure. Geographic: Emphasize cyclical rebounding states (e.g., CA, AZ, FL) and strong energy production regions. Underweight or avoid state credits in pension problems (e.g., PR, IL, CT, KY) Outlook (continued) n New tax-exempt supply is unlikely to fully offset what is rolling off, creating a solid supply/demand picture. Total supply expectations for 2013 are similar to 2012 levels (approximately $375B). If so, then the amount of debt issued will likely be less than what is called or matures, creating a natural level of demand even without new flows. n Broadly speaking, municipal credits are on the mend. One-half of the states are reporting that tax revenues are now above pre-recession levels, or soon will be. Also, reserve fund balances are growing once again in many states. At the local level, housing prices have stabilized or are on the rise, particularly in some of the hardest hit areas. Significant work remains to be done regarding long-term pension and other post-employment benefit liabilities, but 29 states have already made modifications to reduce their liabilities. n States have stepped up their monitoring of local governments. Many states already have plans in place to assist local governments if they need help. More are putting plans in place to provide oversight and assistance if needed, or are considering various ways to do so. The days of a hands-off state government when local municipalities need help are fading. So, despite the many uncertainties that exist, what we do know allows us to be cautiously optimistic on the municipal market as we enter While we think the risk-on trade has largely run its course, we don t yet see the catalysts in place for a risk-off trade either. Policy changes in Washington or economic conditions could change this over the next several months, but that s not the case currently. Outlined above are our best views in each of the risk categories across our range of tax-free strategies for January. We plan to closely monitor and alter strategies as political, economic, and municipal specific information changes and will report on those changes in future monthly publications, as appropriate. BMO Global asset management } 4

5 Data for the Journey Valuation AAA Yields Change Year Current 1 Mo 3 Mo 1 Yr % 0.01% 0.01% -0.05% % 0.17% 0.19% -0.04% % 0.25% 0.02% -0.11% % 0.36% -0.02% -0.72% Cross-Market Values Current Year Muni/Treasury Muni/Corporate 2 124% 83% 5 112% 81% 10 98% 81% 30 96% 82% Yield Curve Source: InvestorTools Perform Source: InvestorTools Perform and Bloomberg Slope Changes Change Current 1 Mo 3 Mo 1 Yr Wkly 2 s 0.12% 0.03% 0.05% -0.03% 2 5 s 0.56% 0.17% 0.19% -0.04% 2 10 s 1.41% 0.24% 0.01% -0.06% 2 30 s 2.52% 0.35% -0.03% -0.67% Performance By Duration Year 1 Mo 3 Mo 1 Yr % 0.43% 2.99% % 0.72% 6.84% % 0.85% 8.86% % 0.62% 15.78% Credit Source: InvestorTools Perform Current Rating Spreads Current Year AAA A AAA BBB % 0.82% % 1.43% % 1.51% % 1.31% Source: InvestorTools Perform Source: Barclays Point Performance By Quality Rating 1 Mo 3 Mo 1 Yr AAA -0.99% 0.40% 4.52% AA -1.12% 0.63% 6.23% A -1.43% 0.94% 8.16% BBB -1.76% 0.59% 9.80% Source: Barclays Point BMO Tax-Free Suite Fund Name BMO Tax-Free Money Market Fund BMO Ultra Short Tax-Free Fund BMO Short Tax-Free Fund BMO Intermediate Tax-Free Fund Ticker (Y Shares/I Shares) MTFXX / MFIXX MUYSX / MUISX MTFYX / MTFIX MITFX / MIITX BMO Global asset management } 5

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