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Anthony Valeri, CFAMarket Strategist LPL Financial

L P L F IN A NCI A L RESE A RCH

Bond Market PerspectivesFebruary 26, 2013

Waiting for the Spring

HighlightsA traditionally difficult March, along with ongoing secondary market pressure, may continue to challenge municipal bonds in coming weeks.

Sequestration poses a greater risk to economic growth rather than the municipal bonds.

We still find municipal bonds attractive on a long-term basis, but investors may have to wait for Spring before strength returns.

Municipal bonds have struggled in February following a good start to 2013. Price declines have translated to modest losses for investors in February, but on a positive note, year-to-date municipals still hold a performance advantage to their taxable counterparts (both through February 22, 2013), according to Barclays Index data.

The tough slog for municipal bonds may continue in March, leaving investors to await Spring for a rebound. March traditionally is the worst month for tax-exempt bond investors, as average performance has been slightly negative during the month [Figure 1].

1 March Has Traditionally Been a Difficult Month for Municipal Bonds

Source: Barclays Index data, LPL Financial 12/31/12

Average monthly index returns 1990 – 2012.

The Barclays Municipal Bond Index is a market capitalization-weighted index of investment-grade municipal bonds with maturities of at least one year. All indices are unmanaged and include reinvested dividends. One cannot invest directly in an index. Past performance is no guarantee of future results.

Oct DecApr Jun AugFeb NovSepJulMayMarJan

1.00%

0.75%

0.50%

0.25%

0.00%

-0.25%

Average Monthly Total Return: Barclays Municipal Bond Index

Tax-exempt bond market performance has historically been worst in March for several reasons.

� Tax payments. The approach of April 15 is the primary reason why the municipal market has suffered in March. Since municipal bonds

Tax payments, limited reinvestment, and broader bond market weakness have

historically caused poor tax-exempt bond market performance in March.

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are typically owned by higher net worth, higher tax-bracket investors, municipal bonds are often subject to heavier selling in March as investors raise cash to pay taxes on capital gains from other investments.

� Limited reinvestment. March has typically been one of the lightest months in terms of maturing bonds, leaving investors fewer proceeds to reinvest into the municipal bond market. In sum, the combination of tax season along with limited reinvestment demand creates a short-term supply-demand challenge for the municipal market.

� Broader bond market weakness. Taxable bond performance, on average, is weakest in March as well. While municipal and taxable bond prices do not always move in sync, taxable bond weakness can often impact municipal bonds.

Over the coming weeks, there appear to be no catalysts to spark a significant turnaround. New issuance picks up this week (February 25, 2013) to approximately $8 billion. Although roughly in line with the weekly average of the past 12 months, the increase follows a week of mixed demand for new issues in addition to existing market weakness. Furthermore, bond dealers have become less aggressive for fear of taking losses on existing holdings. The value of bonds available for sale in the market increased steadily in recent weeks; we see this as a sign bond dealers are looking to unload inventory [Figure 2]. The last time the value of bonds for sale reached this level was early December, just before the mid-December pullback.

Additionally, municipal valuations have not cheapened substantially to draw in additional buyers. Municipal-to-Treasury yield ratios have increased but remain at the low end of recent ranges [Figure 3]. A yield ratio above 100%, which means top-rated municipal bonds yield more than Treasuries, may be required to spur demand amidst higher supply and a difficult March.

Secondary market supply, higher valuations, and general bond market weakness contributed to municipal bond declines in February. On a positive note, recent taxable bond market strength, should it persist, may lend support to municipal bonds. Italian election results highlighted the lingering political risks associated with European debt problems and spurred the strongest single-day Treasury rally in three months on Monday, February 25, 2013.

Tax Policy and Sequestration

While political risks have resurfaced in Europe, tax policy uncertainty and looming sequestration spending cuts were not behind recent municipal market weakness. We continue to believe the prospect of a 28% cap to the tax exemption of municipal bond interest income remains a low probability event, and the recent increase in top tax rates was a modest positive for municipal investors. Should a 28% cap ultimately be implemented, we believe it will be a manageable risk, but much depends on yields and overall valuations at that time. Any change in tax treatment is likely to be a result of broader tax reform, which is unlikely before the end of 2013, if then.

Recent taxable bond market strength, should it persist, may

lend support to municipal bonds.

2 A Steady Increase in Secondary Market Supply Has Weighed on Municipal Bonds

Source: Bloomberg, LPL Financial 02/25/13

Par value is a dollar amount that is assigned to a security when representing the value contributed for each share in cash or goods.

Feb‘13

Aug‘12

Oct‘12

Dec‘12

Jun‘12

Apr‘12

Feb‘12

$15

$13

$11

$9

$7

$5

Total Par Value Offered (5-Day Moving Average)$ Billions

3 Municipal-to-Treasury Yield Ratios Do Not Point to Increasing Demand

Source: Bloomberg, MMA, LPL Financial 02/25/13

Yield ratio is a comparison of the expected yield of one bond to the expected yield of another.

Jan‘13

Sep‘12

Nov‘12

May‘12

Jul‘12

Jan‘12

Mar‘12

140%

130%

120%

110%

100%

90%

80%

Municipal-to-Treasury Yield Ratio

30-Year 10-Year

Municipals Less Expensive

Municipals More Expensive

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Build America Bonds and Sequestration

Sequestration may impact Build America Bond (BAB) issuers since payments from the federal government to BAB issuers, to offset the higher taxable interest cost, may be reduced. However, since BABs issuers are large, fiscally sound entities, they are generally more than capable of adjusting to a modest 6 – 7% reduction in subsidy payments. A change in subsidy may open the door to extraordinary bond redemptions, but the vast majority of BABs contain protective measures for bondholders where bonds would have to be redeemed at above market prices, making such redemptions uneconomical for issuers. Only a very small percentage of BABs contain provisions to be redeemed at par value, which would subject investors to losses. Such provisions are a possible risk for individual bond holders, but we do not see them as broad enough to pose a risk to holders of BABs via mutual funds or exchanged-traded funds (ETFs). Year-to-date BAB weakness is due to the general rise in high-quality bond yields and not sequestration fears. We view sequestration as a greater risk to economic growth, since it will divert funds from state and local governments, rather than the BAB market.

On a longer term basis, we continue to find municipal bonds an attractive high-quality bond option. Although valuations, as shown in Figure 3, are more expensive on a short-term basis, they remain attractive on a longer term basis. Prior to 2003 and the full implementation of the Bush tax cuts, 10- and 30-year yield municipal-to-Treasury yield ratios averaged 81% and 88%, respectively, well below current levels. Even if municipal valuations do not regain those prior levels, we still believe municipal bond yields do not fully reflect the impact of higher tax rates on taxable bonds. Short-term challenges may persist through the remainder of winter, but for 2013 we continue to find municipal bonds one of the more compelling high-quality bond alternatives in a low-yield world. n

We continue to find municipal bonds one of the more compelling high-quality

bond alternatives in a low-yield world.

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This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Yield is the income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment’s cost, its current market value or its face value.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Bonds given an investment grade rating indicate a relatively low risk of default.

The issuance of Build America Bonds (BAB) began in April of 2009. They were authorized by the ARRA economic stimulus of 2009 and can be issued for qualifying infrastructure projects. They are taxable municipal bonds and are considered a category of bonds.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Intermediate bonds are characterized by a maturity that is set to occur in the next three to 10 years.

Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax free, but other state and local taxes may apply.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

Investing in mutual funds and exchange-traded funds involves risks, including possible loss of principal.

An investment in exchange-traded funds (ETFs), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks: not diversified, the risks of price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking error.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.