Tim McGregor, Director of Municipal Fixed Income Portfolio Management at Northern Trust Provides Our Latest Thoughts on the Unusual Volatility in Municipal Bonds.

November 23, 2010

The week of November 15 was very volatile for traditional tax-exempt bond markets. The comments below address the why, the effects, and our outlook for the Municipal market:

Volatility and its effect on pricing
Volatility in the tax-exempt bond market has been and, in our opinion, will continue to run much higher than historical levels. The risk tolerance of the broker dealer community appears to us to be down over pre-crisis (2008) levels. We expect that imbalances between supply and demand and/or buyers and sellers will be greater without the broker dealer community acting as a risk buffer. They don't carry high inventories anymore, they don't stock deals that don't sell anymore, and they don't prepare for high seasonal demand anymore. This means day to day secondary trading may have greater pricing swings. Issues have recently been priced to move, and prices have therefore been rising and falling faster due to seasonal technicals. Additionally, most broker /dealers now are on the same calendar year ends - not staggered somewhat like before (some had October and November year ends, now most have December year-end periods).

Recent supply effects
The fourth quarter has historically been the heaviest in terms of traditional supply ($10-12 billion per week in the fourth quarter vs. $2-4 billion per week during the summer months). The market seems to have prepared for this with a trend towards higher rates (needed to clear all the supply) starting in October.

However, in addition to seasonal supply, during the week of November 15, also witnessed forced selling from select high yield muni mutual funds and levered investors in response to the widespread downgrades of Municipal Tobacco Settlement Trusts. These particular bonds were under severe price / liquidity pressure, so much of the selling was executed in the better credits / more liquid names. Our Active Investment Grade Tax Exempt Team currently does not own any tobacco bonds nor do we use leverage, but we still felt the effects of that week’s sell-off. As net asset values (NAVs) across the municipal mutual fund market dropped, fear set in and fund redemptions picked up dramatically. For the week, just over $3 billion was withdrawn from municipal bond mutual funds – the largest weekly withdrawal amount in 20 years, according to our analysis. Also worth noting was the additional price pressures associated with California's large note deal ($10 billion in size). There was some profit taking in the general market as sellers looked to re-invest in this deal. The one-year California note cleared the market at a 1.75 percent yield.

These events adversely impacted the muni bond market through the middle of the week of November 15, but conditions improved as higher nominal rates began to spark demand from both traditional and crossover buyers (no need for tax exemption). Tax-exempt rates were not only above US Treasuries on a pretax basis, but muni rates exceeded many corporate bond yields as well. The muni market rebounded that Thursday and Friday. Our portfolios generally lost ground early in the week of November 15, but in most cases recovered some lost ground by week’s end.

We expect the negative headlines around municipal credit to continue, and are positioning our portfolios in higher quality issuers. It’s been somewhat ironic to us that lower rated (BBB and A) bonds have been outperforming higher rated (AAA and AA) bonds by such a large margin this year. The trend we saw was partially reversed. We like high quality unlimited tax general obligation bonds, essential service revenue bonds, and pre-refunded municipal bonds (now backed by US Treasury obligations). We continue to avoid bonds backed by project specific revenues, leases and annual appropriations - sectors of the bond market that rely on discretionary funding or legislative acts to appropriate annual debt service requirements.

Tax-free rates have reached higher/attractive nominal levels. Ten year high grade bonds reached 3 to 3 1/2 percent while longer maturities (20yr+) climbed to 4 1/2 to 5 1/2 percent on Friday, November 19, offering long term value, in our opinion. The yield curve is historically steep today, so investors are being compensated for extending the maturity of their purchases. Volatility will continue, but we see the potential for long term value in today's municipal bond market.

Past performance is no guarantee of future results

Risk Considerations

Bond Risk: Bond funds will tend to experience smaller fluctuations in value than stock funds. However, investors in any bond fund should anticipate fluctuations in price, especially for longer-term issues and in environments of rising interest rates.

Tax-Free/AMT Risk: Tax-exempt funds' income may be subject to certain state and local taxes and, depending on your tax status, the federal alternative minimum tax.

Regional Investment Risk: The geographical concentration of portfolio holdings in a fund may involve increased risk.

Diversification alone does not guarantee a profit nor protect against a loss.

The information in this report has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. Opinions expressed are current as of the date appearing in this material only and are subject to change without notice. This report is provided for informational purposes only and does not constitute investment advice or a recommendation of any security or product described herein.

There are risks involved in investing including possible loss of principal. There is no guarantee that the investment objectives of any fund or strategy will be met. Risk controls and models do not promise any level of performance or guarantee against loss of principal.

Before investing you should carefully consider the fund’s investment objectives, risks, charges and expenses. This and other information is in the prospectus and summary prospectus, which may be obtained by calling 877-867-1259. Please read the prospectus and summary prospectus carefully before you invest.

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