BOND MARKET PERSPECTIVES Major News and Themes Driving Fixed Income Markets

August 2012 Bond Market Perspectives | Week of August 27, 2012

LPL Research Marketing 75 State Street Highlights Boston, MA 02108 800-775-4575 We view 's sale of municipal credit derivatives simply as the closing out of a [email protected] profitable trade, and not a true concern for broad-based municipal credit quality. www.lpl.com Washington, not credit related issues, may pose the greatest near-term risk for investors.

Municipal Misconceptions

Renowned investor Warren Buffett recently made headlines when his firm Berkshire Hathaway disclosed selling $8 billion worth of municipal derivatives contracts during the second quarter of this year. The news lingered in financial markets and over the weekend of August 25-26, 2012. It was cited by a widely-followed financial news source as a misleading intro to a story on state credit quality. Several media sources have construed the sale as yet another sign of deteriorating state credit quality. We caution against reading into stories suggesting a sharp deterioration in municipal credit quality.

We simply view the Berkshire Hathaway sale for what it is-the closing out of a profitable trade. We believe Berkshire would have likely sold the entire position, rather than just half, if there was true concern for broad-based municipal credit quality. If Berkshire did have a negative view of the municipal bond market, it could have easily placed a bearish bet but did not. Buffett and Berkshire Hathaway declined to comment to reporters on the motive for the trade but we believe Berkshire simply found a more attractive investment on a go-forward basis.

The cost to insure against municipal default has declined since the financial crisis when Berkshire Hathaway initiated the trades. Since peaking at 3.5%, the cost to insure a basket of municipal bonds against default has declined by roughly half and a 0.5% decline in the premium over the first quarter of 2012 may have been the catalyst for the sale [Figure 1]. Lower Credit Default Swaps (CDS) mean a lower premium, and therefore less profit, to insure against default.

Berkshire's sale may be similar to Berkshire's municipal bond unit, Berkshire Hathaway Assurance Corp (BHAC), ceasing to insure new municipal bond issuance. The downfall of several municipal bond insurers in 2008 and beyond created an opportunity for well capitalized firms like Berkshire willing to step up and provide insurance in the marketplace. Strong demand for insured municipal debt, during a time of heightened credit fears, meant muni bond insurers could charge more for their services. As the market moved on from insurance the cost to obtain insurance declined, making it less profitable for insurers like BHAC.

Federal Reserve (Fed) Researchers Take a Shot

This August the New York Fed, through its Liberty Street Economics blog, released its own study of municipal defaults indicating that municipal defaults are greater than what was implied by long-term default studies conducted by Moody's and Standard and Poor's rating agencies. The Fed study claimed that defaults were much greater than reported by Moody's or S&P since both failed to account for non-rated bonds, but this is hardly news. Non-rated, more speculative bonds have historically been the biggest source of defaults in the municipal market and that remains true today. Of the approximately $13 billion in municipal defaults over the last three years, roughly $10 billion originated from non-rated issuers, according to Municipal Market Advisors (MMA) and Municipal Securities Rulemaking Board (MSRB) data.

In general, the news on municipal bond defaults continues to improve. Through the end of July 2012, $820 million in municipal bonds have defaulted year-to-date, versus $1.34 billion over the same period in 2011 according to MMA and MSRB data. The fact that defaults are on pace to decline for the fourth consecutive year is an impressive achievement for municipal issuers and speaks to the priority of debt payments and resilience of the municipal bond market. The municipal market largely ignored recent news headlines and outperformed Treasuries so far this August as indicated by improving valuations relative to Treasuries [Figure 2]. A lower yield ratio implies a higher valuation due to lower yield relative to Treasuries. Conversely, a higher yield ratio implies a lower valuation due to a higher yield relative to Treasuries.

Washington, Not Pensions, Is the Greatest Near-term Risk

Budgets and related pension funding will be a challenge for many municipal bond issuers for years to come. However, investors can navigate around such issues as there are many sectors in the municipal bond market, backed by dedicated revenue streams, that are unaffected by budget or pension issues. We view budget and pension issues as more negative for economic growth than a major default risk would be.

We believe the greatest near-term risk for municipals may come from Washington and potential tax legislation, not budgets or pension-related issues. Both presidential candidates have different ideas for tax rates. President Obama seeks to raise tax rates, which by itself would increase the attractiveness of tax-exempt municipals, but may also seek to cap the tax-exemption for top earners. Governor Romney, on the other hand, may seek to lower tax rates, which would reduce the value of the municipal tax exemption. The potential tax implications, if any, could take several forms and the uncertainty could weigh on the municipal bond market. On a positive note, top-rated municipal yields exceed comparable Treasury yields (as Figure 2illustrates) indicating an attractive valuation and suggesting the market is partially braced for tax uncertainty.

Sale of Insurance via Credit Default Swaps (CDS)

Berkshire's municipal derivatives exposure consisted of the sale of insurance via municipal credit default swaps (CDS), which essentially charge a percentage to insure a principal amount against default. Berkshire captured the premium in exchange for offering to pay against default. As a hypothetical example, a 5-year CDS spread of 3% means it costs $30,000 annually to insure $1,000,000 worth of municipal bonds against default over a 5-year horizon. The premium can rise or fall over the life of the CDS depending on numerous factors, including market perceptions of default expectations and credit quality.

IMPORTANT DISCLOSURES

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.

A Credit Default Swap (CDS) is designed to transfer the credit exposure of fixed income products between parties. The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.

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.

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.

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.

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

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.

Credit Quality is one of the principal criteria for judging the investment quality of a bond or bond mutual fund. As the term implies, credit quality informs investors of a bond or bond portfolio's credit worthiness, or risk of default.

Default Rate is the interest rate charged to a borrower when payments on a revolving line of credit are overdue. This higher rate is applied to outstanding balances in arrears in addition to the regular interest charges for the debt.

Non-rated bonds have not been issued a rating by bond rating agencies such as Standard and Poors and Moodys. Bonds that have not been rated by an agency are usually considered to be junk bonds or fall below investment grade.

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

Derivatives involve additional risks including interest rate risk, credit risk, the risk of improper valuation and the risk of non-correlation to the relevant instruments they are designed to hedge or to closely track.

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 indices are unmanaged and cannot be invested into directly.

LPL Research is a Registered Representative with and Securities are offered through LPL Financial, member FINRA/SIPC. Insurance products offered through LPL Financial or its licensed affiliates.

Marketing is not a registered Broker/Dealer and is not affiliated with LPL Financial

Not FDIC/NCUA Insured Not Bank/Credit Union Guaranteed May Lose Value Not Insured by any Federal Government Agency Not a Bank Deposit

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