MUNICIPAL BOND MARKET UPDATE THIRD QUARTER 2012 potx

Investment Insights Municipal Bond Market Update Third Quarter 2012 Municipal market review The municipal market experienced another quarter of relatively strong performance. During the third quarter of 2012 the Barclays Municipal Bond Index had a total return of 2.32%, bringing the year-to- date performance to 6.06%. The Barclays High Yield Municipal Bond Index produced a positive return of 3.87%, bringing its year-to-date return to 13.89%. This quarter marked the seventh consecutive quarter of positive performance for the municipal market, as measured by the Barclays indices. According to Barclays, high yield and investment grade municipals ranked second and third amongst fixed income asset classes for highest 1-year return. US corporate high yield ranked first. 1 During the quarter revenue bonds outperformed general obligation bonds. Within the investment grade municipal space industrial development revenue/pollution control revenue (IDR/PCR) and hospital bonds were the best performing sectors for both the third quarter and year-to-date periods. Housing and electric bonds were the largest underperformers over both periods. In the high yield municipal space IDR/PCR as well as housing bonds provided the best quarterly performance, while resource recovery and leasing bonds were the largest underperformers. Looking at the year-to-date period the best performing sectors in high yield were IDR/PCR and transportation. The worst performers were resource recovery and leasing. Municipal issuance New issuance for the third quarter was $86.7 billion, bringing year-to-date issuance to $275 billion (Figure 1). The bulk of new issuance continues to come from refunding deals. Over 60% of year-to- date new supply has been from refundings. Year-to-date refundings are up 91% from the same period last year with over 4,600 deals totaling $118 billion coming to market. Much of the seasoned, high yielding bonds continued to be called away from investors, leaving them with no other option but to buy the new, lower yielding issues. We expect that refundings will continue at a strong pace, given interest rate levels. William Black Co-Head of High-Yield Municipals Mark Paris Co-Head of High-Yield Municipals Robert Wimmel Head of Investment Grade Municipals All data as of September 30, 2012 unless otherwise noted. 1 Source: Barclays. Past performance cannot guarantee future results. An investment cannot be made in an index. 2 Figure 1 — Municipal Bond Issuance US Municipal Bond Issuance ($ in billions) 0 100 200 300 400 500 YTD 2012 2011201020092008200720062005200420032002200120001999199819971996 $185 $221 $287 $228 $201 $288 $358 $383 $360 $408 $387 $425 $386 $407 $430 $285 $275 Sources: SIFMA, Bond Buyer. As of September 30, 2012. Municipal credit review We continue to see improvement in the financial situation at the state level. According to the Rockefeller Institute, 2 state tax collections increased by 3.2% in the second quarter of 2012 compared to the same period in 2011. This latest data release marks the tenth consecutive quarter of growth in state tax collections, after a decline for five straight quarters following the recession. A total of 45 states reported gains in overall tax collections, of those eight reported growth in the double digits. While analysis of economic factors suggests that state tax revenues are recovering in step with the improving national economy they are however doing so at a much slower pace. The sluggish growth has been driven by the slow recovery of employment, retail sales and housing prices. Overall, the financial health of states, as indicated by their tax revenues, have fully recovered and are above the pre-recession and peak levels. The situation at the local level is not quite as positive. During the last three years local tax collections have been relatively weak by historical standards. According to the Pew Institute, for the first time since 1980, both property tax revenue and state aid to local governments are declining at the same time. While cities and counties used to be able to count on at least one of those being positive, the current state of a double decline is creating a significant strain on the finances of local governments. 3 Economic data releases at the Federal level have been showing signs of improvement as the Fed announced its plans for Quantitative Easing 3. In September US unemployment fell below 8% for the first time since January 2009. The good news also trickled down to the housing market where data releases continued to show improvement. According to S&P/Case-Shiller, single family housing starts are 43% ahead of last year’s pace, existing and new home sales are also up, the inventory of homes for sale continues to drop and consumer mortgage default rates are reaching new lows. During the quarter default trends on municipal issuers continued their decline from 2011 levels. It is important to note that in addition to a decline in defaults we have also seen a substantial decline in the number of defaults in the pipeline, with fewer first time missed payments by municipal issuers signaling that municipalities have made the necessary adjustments to their financial situations. 2 Source: State Revenue Report: “Sales Tax Revenues Show Slowest Growth in the Last Two Years” October 25, 2012 3 Source: Pew Center on States, June 2012 Investment Insights: Municipal Bond Market Update 3 Municipal bond mutual fund flows One of the continued themes of 2012 is the strong inflows into municipal bond mutual funds. Year-to-date through the end of the third quarter municipal mutual funds have experienced net inflows of over $43 billion, with over $15 billion coming in during the third quarter (Figure 2). Intermediate funds led the charge during the quarter, bringing in over $4 billion dollars. High yield municipal funds came in second with net inflows of nearly $3.3 billion, followed by state funds with net inflows of $2.5 billion and national long municipal funds which brought in nearly $1.9 billion. The last week of September 2012 marked the 44th week of positive inflows into municipal funds, a stark contrast from the same period last year when net flows for the category stood at negative $21.5 billion. The municipal market has also seen an increase in non-traditional municipal investors like banks and non-US buyers. If the investment from banks continues at the current pace, they will be on target to replace insurance companies as the third largest buyer of municipal securities. The strong demand for tax-exempt income coupled with a large number of refunding deals has created a supply/demand imbalance that should be supportive of municipal bond prices over the near term. Figure 2 — Municipal Bond Fund Flows Remain Positive $ in millions -15,000 -12,000 -9,000 -6,000 -3,000 0 3,000 6,000 9,000 9/12 8/12 7/12 6/12 5/12 4/12 3/12 2/12 1/12 12/11 11/11 10/11 9/11 8/11 7/11 6/11 5/11 4/11 3/11 2/11 1/11 -12,530 -4,369 -2,576 -3,843 -5 868 67 -894 1,734 2,024 3,053 4,830 6,574 3,776 2,435 5,024 3,812 5,511 5,606 4,015 6,467 Source: Morningstar, as of September 30, 2012 4 Where are the opportunities? Intermediate term municipal bond funds Intermediate term municipal bond funds are well positioned on the historically steep municipal yield curve. This may provide an attractive risk/reward trade off as well as price appreciation through the effects of roll down. (Figure 3) Figure 3 — Intermediate Term Municipal Bonds May Experience Price Appreciation as They Get Closer to Maturity “AAA” General Obligation Yield Curve 0.0 0.5 1.0 1.5 2.0 2.5 3.0 302928272625242322212019181716151413121110987654321 Yield (%) Years to Maturity As a bond rolls down the curve, toward maturity, it approaches the steepest part of the curve, where the market demands lower yields (e.g. 22 basis points (bps) roll down from 5 to 6 years and 26 bps from 6 to 7 years). Therefore a bond paying a constant coupon greater than what the market is currently pricing in will see its price increase. Rolling down the yield curve may lead to price appreciation Shorter bonds typically yield less than longer bonds — as you hold a bond its market value rises (to a point) as it rolls down the curve. 2.84 2.85 1.06 2.11 0.62 0.80 Source: Thomson Municipal Market Data (MMD) as of September 30, 2012 Past performance cannot guarantee future results A basis point is the movement of interest rates or yields expressed in hundredths of a point. One basis point is equal to 1/100th of 1%. Risk/reward trade off •The municipal yield curve is at historically steep levels. Historically, intermediate municipal bond funds focusing on the middle part of the curve tend to offer competitive yields with considerably less volatility than long municipal funds. •Bonds with 15 years to maturity picked up over 70% of the long bond yield with 50% of the maturity. •Intermediate municipal bond funds have been less volatile than long municipal bond funds due to yield curve positioning — the further you move down the curve, the lower the duration. Therefore, intermediate municipal bond funds have typically outperformed long municipal bond funds in inflationary periods due to their reduced sensitivity to interest rate movements. Roll down •Intermediate municipal bond funds have been typically more sensitive to the effects of roll down. •Shorter bonds have typically yielded less than longer bonds, but when held, the bond’s market price tends to rise (to a point) as it rolls down the steepest portion of the curve. •We believe that municipal bonds with maturities inside of 15 years are the most sensitive to the attractive price appreciation from rolling down the curve. With the Fed stating their intent on keeping rates low until 2014, the roll-down effect tends to be a benefit to the performance of municipal bonds in the intermediate part of the curve over this period. Single state municipal bond funds •Single state municipal bond funds invest in bonds issued by a specific state and its local governments. •The income from these funds is generally exempt from federal and state taxes in the issuing state. •Investors in single state municipal bond funds in the state of their residence may benefit from double tax exemption on their income. •Single state funds have been especially attractive in states such as California and New York, where capital gains taxes are some of the highest in the nation (Figure 4). Ratings allocations are based upon ratings assigned by Standard & Poor’s. A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other debts. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest); ratings are subject to change without notice. Not Rated indicates the debtor was not rated and should not be interpreted as indicating low quality. For more information on Standard and Poor’s rating methodology, please visit standardandpoors.com and select “Understanding Ratings” under Rating Resources on the home page. Investment Insights: Municipal Bond Market Update 5 Figure 4 — States With Highest Rates for Individual Capital Gains Tax 2012 law Top Fed rate: 15% 2013 law w/extension of 2001/2003 tax cuts Top Fed rate: 15% 2013 law as scheduled (tax cuts expire) Top Fed rate: 20% Hawaii 22.2% 26.0% 31.6% California 21.7% 25.5% 31.2% Oregon 21.4% 25.2% 31.0% Vermont 20.8% 24.6% 30.4% Washington, DC 20.8% 24.6% 30.4% New Jersey 20.8% 24.6% 30.4% New York 20.7% 24.5% 30.3% Maine 20.5% 24.3% 30.1% Minnesota 20.1% 23.9% 29.7% Iowa 20.1% 23.9% 29.4% Source: State government websites; Internal Revenue Service; and Ernst & Young LLP calculations, March 2012. Municipal outlook We believe municipal funds will continue to offer attractive opportunities for the following reasons: •Headline risk continues to impact the municipal market. The macroeconomic forces at work in the global economy that continue to spread volatility and general uncertainty can potentially create opportunities in the municipal market. •Given that it is an election year, we expect political, headline and event risk to remain elevated. We recognize that difficult budget and policy decisions are needed and as a result we are avoiding investments that are highly dependent on federal aid. •Credit concerns, which dominated the municipal market last year, have diminished as state and local governments have taken the necessary steps to get their finances in order. Municipalities continue to work to improve their tax revenues and pension funding status, the two biggest factors impacting general obligation debt. We believe that going forward municipalities will be selective in the types of new project they enter. We expect to see the low default rate exhibited so far in 2012 to continue in next year. •We believe that municipalities will avoid raising taxes to pay for bond sales and will be selective on the types of new bonds issued. We expect that the focus going forward will be on projects offering debt refinancing, infrastructure repairing and energy cost savings. Tax advantages of municipal bonds 4 •Municipals bonds offer investors tax exempt income, meaning the interest income payments from municipal funds is exempt from federal income taxes and may also be exempt from state income taxes. •In some circumstances, investors may also be exempt from local taxes. •With expectations of continued low rates, municipal funds may offer investors the opportunity to benefit from monthly tax exempt income at attractive yields. Invesco’s municipal capabilities In this environment, we continue to emphasize the importance of bottom-up fundamental credit analysis. At Invesco, we have a staff of 31 municipal investment professionals with an average of over 21 years of experience continuously monitoring our portfolios. Our staff includes 9 portfolio managers and 17 municipal credit analysts dedicated to reviewing and rating each and every credit we hold. Team members are located in 5 locations around the US, allowing flexibility for due diligence and site visits. 4 Income exempt from regular federal income tax may be subject to US federal alternative minimum tax as well as state and local taxes. 6 [THIS PAGE INTENTIONALLY LEFT BLANK] Investment Insights: Municipal Bond Market Update 7 [THIS PAGE INTENTIONALLY LEFT BLANK] About risk Municipal securities are subject to the risk that litigation, legislation or other political events, local business or economic conditions or the bankruptcy of the issuer could have a significant effect on an issuer’s ability to make payments of principal and/or interest. Municipal securities can be significantly affected by political changes as well as uncertainties in the municipal market related to taxation, legislative changes or the rights of municipal security holders. Because many securities are issued to finance similar projects, especially those relating to education, health care, transportation and utilities, conditions in those sectors can affect the overall municipal market. In addition, changes in the financial condition of an individual municipal insurer can affect the overall municipal market. Credit risk is the risk of loss on an investment due to the deterioration of an issuer’s financial health. Such a deterioration of financial health may result in a reduction of the credit rating of the issuer’s securities and may lead to the issuer’s inability to honor its contractual obligations, including making timely payment of interest and principal. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. Lower rated securities may be more susceptible to real or perceived adverse economic and competitive industry conditions, and the secondary markets in which lower rated securities are traded may be less liquid than higher grade securities. Fixed-income products are subject to risk, including, but not limited to, the effects of changing interest rates. There is no assurance that any investment or strategy will achieve its investment objective. Not all strategies are available to all investors. Contact your financial adviser for more details. The opinions expressed are those of the portfolio managers, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. The Barclays Municipal Bond Index is an unmanaged index considered representative of the tax-exempt bond market. The Barclays High Yield Municipal Bond Index is an unmanaged index consisting of noninvestment-grade, unrated or below Ba1 bonds. An investment cannot be made directly in an index. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices. ©2012 Morningstar, Inc. All rights reserved. The information contained herein is proprietary to Morningstar and/or its content providers. It may not be copied or distributed and is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. invesco.com/us MUNIMKT-INSI-1 11/12 Invesco Distributors, Inc. 16547 . Investment Insights Municipal Bond Market Update Third Quarter 2012 Municipal market review The municipal market experienced another quarter of relatively. Two Years” October 25, 2012 3 Source: Pew Center on States, June 2012 Investment Insights: Municipal Bond Market Update 3 Municipal bond mutual fund flows One