TBP Conference 2012 Municipal Market Overview

The Municipal Market in 2012

Dont believe everything you read (or hear). Whats going on in California and is it a precursor for the rest of the country? (A Case Study)

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Copyright 2012 by Gurtin Fixed Income Management, LLC Chicago | San Diego

The Municipal Market in 2012: Thesis

Municipal debt has many self proclaimed experts.

Our View: there are few seasoned and skilled professionals trained in true fundamental municipal credit analysis.

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Copyright 2012 by Gurtin Fixed Income Management, LLC Chicago | San Diego

The Municipal Market in 2012: Summary

Dont Believe Everything You Read (Or Hear) 1) Individuals are the largest holders of outstanding municipal debt 2) Individuals are insecure about municipal credit, mostly because few people fundamentally understand municipal credit analysis 3) Generally, individuals confuse sustainable income for total return 4) There is a dearth of properly trained municipal credit analysts and an overreliance on ratings agencies as arbiters of credit risk assessment Many analysts incorrectly attempt to apply corporate fundamental analysis to municipal obligors

Conclusion: The lack of understanding and knowledge of municipal credit quality creates confusion, misperception, and volatility.

No part of this presentation may be copied, reproduced, stored in a retrieval system, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the written permission of Gurtin Fixed Income Management, LLC. This presentation is incomplete without the accompanying oral commentary and discussion.

Copyright 2012 by Gurtin Fixed Income Management, LLC Chicago | San Diego

The Municipal Market in 2012: Summary

Whats Going on in California?
(A case study on why you should never believe everything you read or hear)

1) Widely reported credit stress, some of which is real 2) Concerns are warranted, but are overblown by lack of market knowledge and ratings agencies unwillingness to focus on forward looking research 3) Somewhat a precursor for national trend, but manageable This creates opportunity for seasoned professionals with strong research

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Copyright 2012 by Gurtin Fixed Income Management, LLC Chicago | San Diego

Dont Believe Everything You Read (Or Hear)

Households directly and indirectly hold roughly 74% of outstanding municipal debt.
Owners of Municipal Debt
2% 5%

Households Mutual Funds

3% 9%

Individuals buy and hold many bonds directly Many bonds are purchased and held with little to no credit analysis Insecurity stems from a lack of credit analysis

7%

49%

Property/Casualty Insurance Co. Money Market Funds Commercial Banks Life Insurance Co. Closed-End Funds

9%

16%

Other

Source: Federal Reserve Board, June 2012

No part of this confidential presentation may be copied, reproduced, stored in a retrieval system, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the written permission of Gurtin Fixed Income Management, LLC. This presentation is incomplete without the accompanying oral commentary and discussion.

Copyright 2012 by Gurtin Fixed Income Management, LLC Chicago | San Diego

Dont Believe Everything You Read (Or Hear)

Market confusion and bond holder insecurity regarding credit quality is due to not only a general lack of sophisticated buyers, but years of insurance dominance in the market until the 2008 credit crisis:
MUNICIPAL DEBT ($ BILLIONS)
500 400 300 200 100 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 YTD

Insured

Issued

Insurance in the municipal market is akin to giving a person an umbrella when its sunny, and taking it away when it rains.

No part of this confidential presentation may be copied, reproduced, stored in a retrieval system, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the written permission of Gurtin Fixed Income Management, LLC. This presentation is incomplete without the accompanying oral commentary and discussion.

Copyright 2012 by Gurtin Fixed Income Management, LLC Chicago | San Diego

Dont Believe Everything You Read (Or Hear)

The combination of AAA insurance and reported historical infinitesimal municipal default rates left markets with a dearth of independent analysts trained in credit research.
Moodys Average 10 Year Cumulative Default Rates of Rated Bonds (1970-2009) Municipals vs. Corporates
Security Rating Municipal Investment Grade Municipal All Rated Corporate Investment Grade Corporate All Rated 1 0.00% 0.01% 0.08% 1.57% 2 0.01% 0.02% 0.24% 3.22% 3 0.01% 0.03% 0.46% 4.73% 4 0.02% 0.04% 0.71% 6.03% 5 0.03% 0.05% 0.97% 7.14% 6 0.03% 0.06% 1.26% 8.10% 7 0.04% 0.07% 1.54% 8.92% 8 0.05% 0.07% 1.84% 9.67% 9 0.05% 0.08% 2.16% 10.38% 10 0.06% 0.09% 2.50% 11.06%

Source: Moodys Investors Service, January 2009.

No part of this confidential presentation may be copied, reproduced, stored in a retrieval system, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the written permission of Gurtin Fixed Income Management, LLC. This presentation is incomplete without the accompanying oral commentary and discussion.

Copyright 2012 by Gurtin Fixed Income Management, LLC Chicago | San Diego

Dont Believe Everything You Read (Or Hear)

In a world without insurance, the low default rate for rated bonds may be deceiving; sector matters.
Gurtin Fixed Income Municipal Default Study (1970 2010) Sector State General Obligation State Lease Local Government Essential Revenue Higher Education Non-Essential Revenue Health Care Corporate Special Assessment
Source: Gurtin Fixed Income proprietary study.

Incident Rate 0.00% 0.00% 0.20% 0.49% 0.85% 2.56% 4.76% 5.26% 7.69%

Do individuals know what they own? What do bond funds own?

No part of this confidential presentation may be copied, reproduced, stored in a retrieval system, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the written permission of Gurtin Fixed Income Management, LLC. This presentation is incomplete without the accompanying oral commentary and discussion.

Copyright 2012 by Gurtin Fixed Income Management, LLC Chicago | San Diego

Dont Believe Everything You Read (Or Hear)

Are things getting worse?
Ratings Agency Risk Obligor Credit Event Type Date of Credit Event Investment Grade Rating at Time of Credit Event Current External Rating City of San Bernardino, CA City approved bankruptcy filing July 2012 BBB+ (S&P) CC (S&P) Municipal Derivative Risk Jefferson County, AL County filed for Chapter 9 bankruptcy November 2011 A3 (Moodys) Caa3 (Moodys) Indirect Debt Risk City of Harrisburg, PA City defaulted on guarantee payments September 2009 Baa2 (Moodys) Withdrawn (Moodys) Municipal Pension Risk City of Central Falls, RI City went into receivership (later filed for Chapter 9 bankruptcy) May 2010 Baa1 (Moodys) Caa1 (Moodys)

In a world with a dearth of research and an unsophisticated buyer base, are the credit ratings agencies good arbiters for forward looking credit risk assessment? This leaves the market vulnerable to Armageddon-like prognostication by market pundits, untrained in municipal research, such as Meredith Whitney predicting hundreds of billions of imminent defaults in late 2012.
No part of this confidential presentation may be copied, reproduced, stored in a retrieval system, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the written permission of Gurtin Fixed Income Management, LLC. This presentation is incomplete without the accompanying oral commentary and discussion.

Copyright 2012 by Gurtin Fixed Income Management, LLC Chicago | San Diego

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Dont Believe Everything You Read (Or Hear)

Individuals tend to confuse total return for sustainable income, and when rates rise and prices fall many assume that falling prices are due to credit deterioration.
Net Municipal Bond Fund Flows vs. 10-Year Municipal Yields
15,000 10,000 5,000 (5,000) (10,000) (15,000) 1.00 1.50 2.00

Millions ($)

3.00 3.50 4.00 4.50 5.00

Muni Bond Fund

Source: Thompson Reuters and Investment Company Institute

10 YR AAA GO

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Yield (%)

2.50

Copyright 2012 by Gurtin Fixed Income Management, LLC Chicago | San Diego

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Whats going on in California?

(A case study on why you should never believe everything you read or hear) 1) California shares the distinction with Illinois of being the lowest rated state by Moodys and S&P 2) Multiple local government bankruptcy filings (Vallejo, Stockton, San Bernardino, & Mammoth) 3) Moodys downgrades of all redevelopment agency debt in California to below investment grade 4) Media misreporting about the danger of capital appreciation (zero coupon) bonds Is it safe to invest in California municipal debt? Are there misperceptions? Are there opportunities arising from misperceptions? Is the real or perceived weakness in California a precursor to Credit stress nationally?

No part of this confidential presentation may be copied, reproduced, stored in a retrieval system, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the written permission of Gurtin Fixed Income Management, LLC. This presentation is incomplete without the accompanying oral commentary and discussion.

Copyright 2012 by Gurtin Fixed Income Management, LLC Chicago | San Diego

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Whats going on in California?

Misperceptions: California vs. Illinois
Statistics General Obligation Ratings Personal Income Debt/Personal Income Debt/Capita Debt/Total Expenditures Pension (% Funded) Annual Pension Payments/Budget Debt Service Constitutional Preference Pension Reform Measures CA A1/A$1,677M 0.4% $155 9% 80% 3% After Prop. 98 Payments Recent Savings $42B-$55B over 30 years IL A2/A $568M 6.0% $2,654 10%+ 43% 15% None None

Conclusion: The State of California as a sovereign entity is actually a solid credit safe for investment.
No part of this confidential presentation may be copied, reproduced, stored in a retrieval system, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the written permission of Gurtin Fixed Income Management, LLC. This presentation is incomplete without the accompanying oral commentary and discussion.

Copyright 2012 by Gurtin Fixed Income Management, LLC Chicago | San Diego

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Whats going on in California?

Notable Issues 1) Potential Moodys downgrade of all cities in California due to speculation of continued bankruptcies Does little to solve problem of lack of forward looking analysis of individual credits by ratings agencies, should create opportunities Pockets of very weak cities 2) Moodys downgrade of Redevelopment Agencies to below investment grade due to dissolution of agencies by the governor Should not come as a surprise 3) Headlines regarding Poways $1 billion of Capital appreciation bonds $1 billion due in roughly $50 million increments over 19 years from 2033 2051 Not one bullet maturity Real Long-Term Issues Pensions Entitlements Dysfunction of Legislation Many defaults from credits already experiencing credit distress
No part of this confidential presentation may be copied, reproduced, stored in a retrieval system, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the written permission of Gurtin Fixed Income Management, LLC. This presentation is incomplete without the accompanying oral commentary and discussion.

Copyright 2012 by Gurtin Fixed Income Management, LLC Chicago | San Diego

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Whats going on in California?

Opportunities Arising from Misperceptions
Ratings Detail S&P rating prior to bankruptcy S&P rating after bankruptcy Gurtin rating prior to bankruptcy Gurtin rating after bankruptcy City of Stockton A+ D Do Not Buy Do Not Buy The rating is based on the continued weak local economic with persistent high unemployment, a sizable but weak tax base with well above average foreclosure rates and a continued weak financial position. Stockton Water Enterprise A+ BBB+ Do Not Buy Do Not Buy The rating is based on the weak service area given high unemployment and foreclosure trends. Debt service coverage has declined markedly in recent years and the debt profile includes significant exposure to derivatives. Stockton-East Water System A BBB+ N/A Buy The rating is based on the Utility's large service area, its role as a wholesale water provider to four different municipal utilities, an adequate financial position and relatively modest debt levels with reserves greater than outstanding debt.

Gurtin Rating Rationale

Conclusion: The City of Stocktons bankruptcy created contagion across all credits with Stockton in the issuer name.
No part of this confidential presentation may be copied, reproduced, stored in a retrieval system, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the written permission of Gurtin Fixed Income Management, LLC. This presentation is incomplete without the accompanying oral commentary and discussion.

Copyright 2012 by Gurtin Fixed Income Management, LLC Chicago | San Diego

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Dont Believe Everything You Read (Or Hear)

Are the perceived and real problems in California a precursor to an increase in credit stress nationally? Yes and No.

Yes The number of weak obligors experiencing credit stress is increasing. No Some issues are distinct to California (i.e., redevelopment agencies).

No part of this confidential presentation may be copied, reproduced, stored in a retrieval system, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the written permission of Gurtin Fixed Income Management, LLC. This presentation is incomplete without the accompanying oral commentary and discussion.

Copyright 2012 by Gurtin Fixed Income Management, LLC Chicago | San Diego

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