Dear Clients, Associates and Friends,The sales of Bear Stearns and Merrill Lynch, the bankruptcy of Lehman Brothers and the government takeover of Federal National Mortgage Association (FNMA), Federal Home Loan Mortgage Corp. (FHLMC) and AIG in addition to other disruptions in the financial markets have created extreme investor nervousness and uncertainty. Equity and most other securities prices have declined sharply in this environment. In contrast, investors have diverted assets into safe harbor Treasury securities causing yields along the yield curve to decline dramatically.
In contrast to the Treasury market, yields on high quality municipal securities have risen modestly during this period causing prime tax-exempt yields to exceed Treasury rates throughout the yield curve. As you may recall, this relationship existed last February when the municipal insurers came under pressure due to their exposure to mortgage backed securities and the majority of auction rate programs failed. The ratio of ten year prime municipal to Treasury yields rose to 115% at that time. The ratio has returned to levels above 100% in response to the current market disruption. The municipal market is therefore extremely attractive on a relative basis.
Of more importance at this time is the safety of the municipal market. As we have often pointed out, our approach to credit selection is to invest only in high quality, liquid, general obligation and essential service revenue bonds in client accounts. These types of securities have been extremely sound investments over the years and only Treasuries have historically been more secure. Our approach to credit selection serves our clients well in times such as these.
Further, our sell discipline requires that a security be sold as soon as it is practical to do so if it is downgraded to the BBB level by Moody’s, S&P and Fitch. This provides a safety mechanism that prevents serious price declines should an unforeseen credit problem arise.
While we feel comfortable with the bonds held, we feel during this time of uncertainty that it is prudent to move cash holdings in client accounts from tax-exempt or municipal custodial sweep vehicles to Treasury or U.S. Government money market funds. Municipal money market funds tend to hold large components of variable rate demand notes (VRNs) that are long maturity securities with one or seven day put features. VRNs provide money market funds with daily liquidity to accommodate withdrawals when they occur. Letters of credit and liquidity agreements from commercial banks and some insurance companies support the puts. Municipal money market funds are likely to remain sound, but there could be some securities that are impacted should a bank that is providing credit or liquidity support experience pressure. Therefore, we feel that it is appropriate to opt for the most conservative short term vehicles available.
Yields on taxable and tax-exempt sweep vehicles are both very low (1.5% or less) so little income will be lost by making this switch. Taxes will have to be paid on the income generated by the government sweep funds, but we feel that this is a small price to pay given the increased security of the government market.
For the first eight months of the year our long term composite has returned a positive 2.41% and our short term composite is up 2.33%. If rates remain where they are for the remainder of this month, the long term product should have about a break even total return for September while the short term product will again provide a positive return.
Please let us know if you have any questions. We appreciate your confidence.
Sincerely,
Craig W. Henderson
PresidentThomas L. Mallman, CFA
Senior Managing Director