Confidential
Vanguard Municipal Market OutlookPhiladelphia FPA
May 17, 2011
Mike KobsSenior Portfolio ManagerMuni Bond Group
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• General Overview of the Municipal Market
• Review of Current Market Conditions
• Vanguard’s position on default risk and public pension underfunding
• Municipal Bond Market Outlook
• Q&A
Municipal Bond Market Presentation
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• Issuers are typically state and local governments and not-for-profit entities
• Most municipal debt provides a tax-advantage for investors
• Borrowing cost advantage for issuers
• Relatively high credit quality
• Large number of independent issuers/credits
• Municipal securities are exempt from registration with the SEC
Unique Characteristics of theU.S. Municipal Securities Market
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• “General Obligation” Notes and Bonds–Backed by the full faith and credit of a state or local
government–All sources of revenue, unless specifically limited, will
be used to pay debt service on the bonds
• “Revenue” Notes and Bonds– Issued to finance specific revenue-generating projects
or utility systems–Secured solely by the revenues from the financed
project or system
How are U.S. Municipal Borrowings Secured?
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• $2.925 Trillion outstanding
• 50,000+ Issuers
• 1.18 million cusips
How big is the Municipal Bond Market?
Source: MSRB 2010 FactBook
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Core Inflation Momentum FactorsMunicipal Bond Market- Credit Quality and Sectors
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Municipal Bond Market- New Issuance Supply
Source: The Bond Buyer
2002
2004
2006
2008
2010
0
100
200
300
400
500
Issuance ($Billion)
Issuance ($Bil-lion)
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Other8%
Broker/Dealers1%
Commercial Banks
8%
P&C Insurance14%
Mutual Funds15%MM Funds
18%
Households36%
Municipal Bond Market- Holders of Municipal Debt
Source: Federal Reserve Board, Flow of Fund Accounts
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Core Inflation Momentum FactorsMunicipal rates have risen from historical low levelsJan-00
Jul-00
Jan-01
Jul-01
Jan-02
Jul-02
Jan-03
Jul-03
Jan-04
Jul-04
Jan-05
Jul-05
Jan-06
Jul-06
Jan-07
Jul-07
Jan-08
Jul-08
Jan-09
Jul-09
Jan-10
Jul-10
Jan-11
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
AAA Municipal Yield Levels
7-Day 5-Year 25-Year
Perc
ent
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Core Inflation Momentum FactorsCredit Quality Spreads
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Core Inflation Momentum FactorsMunicipals look attractive versus high quality alternatives
10-Year Comparison
5/6/2011
Muni Corporate
QualityCredit Spread AAA (MMD) Yield Tax Eq Yield*
Credit Spread UST Yield Vs Corp Vs Tsy
AAA 17 2.74 2.91 4.48 29 3.18 3.47 1.01 1.30
AA 56 2.74 3.30 5.08 99 3.18 4.17 0.91 1.90
A 154 2.74 4.28 6.58 131 3.18 4.49 2.09 3.40
BBB 211 2.74 4.85 7.46 170 3.18 4.88 2.58 4.28
*35% Federal Tax Bracket
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Core Inflation Momentum FactorsHistorical Municipal Default Statistics
Moody's (1)
S&P (2)
Fitch (3)
0.00% 0.20% 0.40% 0.60% 0.80% 1.00% 1.20% 1.40% 1.60%
CorporateMunicipal
.89% [238 defaults (1999-2009)]
.04% [10 defaults (1999-2009)]
1.54% [1,604 defaults (1986-2008)]
.02% [10 defaults (1986-2008)]
1.57% [1,707 defaults (1970-2009)]
.01% [54 defaults (1970-2009)]
1. Moody’s Investors Services, U.S. Municipal Bond Defaults and Recoversies, 1970-2009 (February 2010); Moody’s Investors Service Corporate Default ad Recovery Rates, 1920-2009 (February 2010). Percentags based upon average one year default rate.
2. Standard & Poors, 2009 Global Corporate Default Study and Ratings Transitions (March 17,2010); Standard & Poor’s; U.S. Municipal Ratings Transitions and Defaults, 1976-2009 (March 17,2010); Standard & Poor’s; U.S.
3. Fitch Ratings Inc. U.S. Public Finance Transition and Default Study (1999-2009), March 25,2010; Fitch Ratings Global Corporate Finance 2009 Transition and Default Study.
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• Over the Counter Market
• 100’s of dealers
• 1.2% of securities outstanding trade daily on average, most of these trades are in denominations of less than $100,000 par value
• Evaluations are done daily by two pricing services: Thompson/JJ Kenny and IDC Muller
• Pricing convention is on a Yield to Worst basis
Municipal Market Trading Conventions
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• Steep Yield Curve
• Cheap relative to Treasuries
• Wider Credit Spreads
• Headline Risk
• Regulatory Rhetoric
Current Market Conditions
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Steep Yield Curve
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
Municipal Yield Curve3/31/2011 "AAA" MMD Curve
Years to Maturity
Yield
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Cheap relative to Treasuries
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 201165%
75%
85%
95%
105%
115%
125%
135%
145%
155%
165%
Ratio of 10-Yr Muni to 10-Yr Tr(1990-Present, Monthly)
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Core Inflation Momentum FactorsState and Local Government Challenges
• Pensions – the biggest long term challenge due to constitutional and statutory protections (estimates up to $3 trillion unfunded liability depending on discount rates selected)
• OPEB – huge promise to retirees with estimates up to $700 billion unfunded liability, generally pay-as-you-go; can be altered by legislature
• Medicaid – on the way to becoming largest line item in state budgets
• Education – continuing to be squeezed, particularly with the loss of ARRA funding
• Debt – much discussion of default, but debt burden remains within historical norms
> 18 ConfidentialSource: Rockefeller Institute
> 19 ConfidentialSource: Rockefeller Institute
> 20 ConfidentialSource: Rockefeller Institute
> 21 ConfidentialSource: Rockefeller Institute
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Core Inflation Momentum FactorsMunicipal interest cost is manageable
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Core Inflation Momentum FactorsUnfunded Actuarial Liabilities from Pensions and OPEBs
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Core Inflation Momentum FactorsDebt levels have risen but are within historical norms
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Core Inflation Momentum FactorsMunicipal Market Outlook
• Yield Curve – Flattening as Fed Tightens
• Credit Spreads – Wider than historical averages, differentiation in credit
• Headline Risk – As the budget process moves forward, difficult decisions about cutting services and raising revenues will be played out in the press
• Legislation Risk – Many initiatives to replace the tax-exemption in Munis will play out in the media and generate volatility depending on what form gains traction
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Core Inflation Momentum FactorsQ&A
• What concerns your clients about the Municipal Market?
