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Muni Outlook: A Year of the Coupon

February 2013

Sheila Amoroso of Franklin Templeton Investments believes that after a bumpy few years, the municipal bond market could very likely offer relatively steady income in 2013
Municipal bond investors were relieved and rewarded in 2012. Yields fell as fundamental conditions strengthened, and earlier fears of widespread defaults proved unfounded. Healthy fundamentals are likely to persist this year, says Sheila Amoroso, senior vice president and co-director of the Franklin Templeton Municipal Bond Department. But with yields so low, she encourages muni bond owners to be content to collect income--the main reason for holding munis in the first place--and not to expect further prodigious price appreciation. Prices have gone up dramatically, she observes. I find it hard to believe that were going to get the same kinds of increases again this year. I believe 2013 will be the year of the coupon. A favorable supply/demand balance that helped the muni market to repair itself, she says, accounts for some of the strength in 2012. Just as many issues were retired as brought into the market, and cash flows were strong; so there was not enough supply to meet demand. That was one of the big drivers of munis outperforming Treasuries. The yield on the 10-year Treasury note fell last year to 1.78% from 1.89%, according to the Federal Reserve Bank of St. Louis, less than the decline in municipal bond yields. Other factors that Amoroso credits with compressing spreads include a steady rebound in state and local-government revenues and a flattening of the muni yield curve, with rates coming down more on longer-dated paper. Spreads over Treasuries narrowed despite a bout of selling late in the year, Amoroso notes, as investors reacted to uncertainty over tax rates and to whether there would be a cap put on the tax exemption for municipal bonds. The result, she recalls, was two weeks that were pretty sloppy for the market, and she acknowledges that the prospect of munis becoming a casualty of tax policy initiatives could remain a concern in 2013. Its hard to say at this point if politicians are going to learn how to work together and develop solutions to the problem of the nations wide fiscal deficits, Amoroso says. She doubts, however, that the exemption for munis will be reduced. Doing so would not be effective, in her view, because it would bring in comparatively little revenue and would hinder the ability of state and local governments to finance public services. One negative influence on sentiment that has largely dissipated heading into 2013 is concern about defaults. The panic created about two years ago, when high-profile analysts warned of a serious default risk in municipal bonds, turned out to be a false alarm, Amoroso says. Meanwhile, she continues to see a favorable supply/demand balance as the year begins, with minimal issuance. But she warns that its hard to predict what cash flows are going to look like. Thats something that state and local authorities know all about, Amoroso notes, but the slow but steady economic recovery and the stabilization of the housing market--and therefore the stream of property tax revenues on which governments depend--have helped to buoy munis. States have closed over $500 billion in budget gaps since 2009, she says, although she concedes that authorities have had difficulty coming to grips with their significant pension obligations.

Befitting her forecast of moderating returns, Amoroso recommends a balanced approach to allocation within munis. Franklin Templetons portfolios hold revenue bonds and general-obligation bonds in roughly a 2-to-1 ratio, she says--broadly in line with the muni universe. And she has no significant preference for one sector over another. She does profess a bias toward higher-quality issues and toward bonds with longer maturities within each time horizon--closer to 10 years than to eight years in intermediate-term portfolios and 25 years or more rather than 15 years in long-term portfolios. Amoroso emphasizes that in any case munis are an asset class in which security selection is usually best done issue by issue rather than category by category. Its a complicated market that requires a lot of legwork to get right, she says, but she reminds investors-- especially after the strong year that just ended--that munis are typically included in broad portfolios to fulfill a simple role: to provide income. Clients need to stay diversified, not pick highs and lows in markets, she says. They need both income and growth in their portfolios because they never can tell which one is going to outperform in any given year.

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Shelia Amorosos comments and opinions do not provide a complete analysis of every material fact regarding any region, or market, and are for informational purposes only. Because market and economic conditions are subject to change, her comments, opinions, analyses, and holdings are only valid as of the date of the interview and may change without notice. Her opinions are intended to provide insight as to how she analyzes securities and her commentary is not intended as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. Please consult your own professional adviser before investing. Data from third party sources may have been used in Sheila Amorosos comments and neither Sheila Amoroso nor Franklin Templeton Investments has independently verified, validated or audited such data. We do not guarantee its accuracy. 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