How Secure are your Municipal Bonds? Updated: January 2011

During the months of November and December, interest rates on all fixed income spiked, including municipal bonds, leading to many in the media wondering if this is the beginning of “the other shoe dropping” for this much maligned sector of the bond market. The easy assumption during the municipals selloff was that holders were getting scared by an increase in “credit risk.” After all, there are no shortages of articles, generally accurate, on the deterioration of state and local financial and budgetary woes. However, we believe that this assumption largely misses the point for a number of reasons. The increased credit pressure on municipal bonds is not a new story that just hit the headlines, nor was it new last August which prompted our earlier paper. There wasn’t anything occurring in the past few months that would prompt a credit scare in municipal bonds any more than it would in any other month. The selloff in the municipal market was instead primarily due to general increase in the yield level of all fixed income securities (10-Year Treasury yields increased by 70 basis points from the end of October to December 31st) and some technical issues associated with the expiration of the Build America Bonds program, as a boatload of new municipal supply has been issued before the end of the year. We believe that it was the combination of generally rising yields and an abundance of supply flooding the market that caused municipal bonds to lose value in the final months of the year. To be sure, as we have noted repeatedly in the past, including in our August commentary, there are very real problems facing state and local governments. Reduced tax revenues, increasing debt burdens, unfunded pension liabilities, and less federal government support continue to weigh on municipalities and force politicians to make very difficult choices in order to balance budgets. This process will continue and will not likely get any easier in the near to mid-term. We expect that many more articles, like the ones currently grabbing attention, will continue to be written in the press about these struggles. Our emphasis with regard to municipal bonds in response to these difficulties has been three-fold. •

First, we have emphasized that the problems for the municipalities themselves are very different than those being faced by municipal bond investors. While very difficult budgetary choices need to be made by states and localities across the country, these choices (spending cuts, and additional revenue raising measures)

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would actually serve as positives for the credit risk of the bonds. We also believe that the probability of default is overstated given the facts on the ground. More on this shortly… Second, while it is convenient to aggregate the entire municipal market together and present it in a negative light, we find this to be overly simplistic given the extremely heterogeneous nature of the municipal bond market. Third, we do not believe in chasing returns by taking risks in the lower credit segment of this market given that we use this asset class as the “conservative anchor” of our clients’ portfolios.

The following August commentary on the municipal bond market provides greater detail as to our investment approach and further addresses these points. The first point listed above, we believe, has created mush of the headline headwinds - fear in the markets stemming from the possibility that municipal bonds will default. As a means of communicating why we believe that these fears are overstated, we will take a closer look at the facts regarding some of the states that have most people the most worried: New York, Illinois, and California. Before discussing the state-specific issues, a line of reasoning espoused by the media particularly irks us: Drawing comparisons between some of our struggling states and the struggling PIIGS (Portugal, Ireland, Italy, Greece, and Spain) of Europe. We believe that these comparisons have no basis in reality when one actually looks at the numbers. The forecasted gross debt as percentage of GDP for the PIIGS, per the IMF, are ratios of 83%, 94%, 118%, 130%, and 63%, respectively. Per S&P, the percentage of tax-supported debt to gross state product in New York, Illinois, and California, for 2009 was 5.2%, 3.8%, and 4.1%, respectively. Given these numbers, one can easily see that this is a very strange means of comparison, but one that still continues to be made despite the facts. Let’s continue on to look at each of these three states in a little bit more detail. New York New York State has an approximate $1.1 trillion economy and around $60 billion in debt. In 2009, New York collected over $110 billion tax revenue and its total debt service costs were slightly over $4 billion dollars. This means that debt service as a percentage of revenue is slightly less than 4% annually. Additionally, the state constitution requires the legislature to annually appropriate principal and interest payments for general obligation debt on behalf of the state, meaning that the debt has priority claim on just about everything at the state level. Essentially, the state would have to lose nearly all of its revenue in order to jeopardize its debt service payments. We believe this is highly unlikely (per S&P, the average loss of revenue at the overall state level during the Great Depression was 18%). Illinois Illinois has an approximate $650 billion economy and around $22 billion in debt. In 2009, Illinois collected over $32 billion general fund revenue and its total debt service

costs were slightly over $2 billion dollars. This means that debt service as a percentage of revenue was slightly over 6% annually. Additionally, state statute requires the governor to annually appropriate principal and interest payments for general obligation debt, and payments for debt service have a priority claim on revenues and funds for the state. All special funds are available to support general obligation bonds if necessary. Essentially, the state would have to lose nearly 85% of revenue in order to jeopardize its debt service payments. California California has an approximate $2 trillion economy and around $75 billion in debt. In 2009, California collected over $84 billion general fund revenue and its total debt service costs were slightly over $5 billion dollars. This means that debt service as a percentage of revenue was slightly over 6% annually. After K-12 education, payments for debt service have a priority claim on general fund revenues and funds of the state. In 2009, this meant that California had nearly $44 billion dollars to cover $5 billion in debt service. S&P estimates that a 45% annual revenue loss, or 2.5 times the average loss that was experienced during the Great Depression, would be required in order to place material pressure on the state’s ability to fund its debt service. Conclusion While we are not endorsing these three states in any way, and we rely upon our managers to conduct extensive, independent credit analysis for client portfolios, we wanted to present some important facts to give you a sense for why we believe default at the state level is highly unlikely. All too often, we see a lot of opinion masquerading for facts in the popular press. We also see a tremendous amount of speculation about what the Federal government may or may not do with regard to helping states and municipalities that are struggling; and concerns over the structure of the municipal market itself. While it is obviously important to track legislative agendas and keep apprised as to how possible Federal intervention may impact this market, we don’t make investment decisions involving pure speculation and conjecture. Instead, we and our managers will continue to remain vigilant; focusing on the facts at hand, rather than on headlines and opinion. Please read on for more detailed insight on the municipal bond market that we provided in August of 2010.

How Secure Are Your Municipal Bonds? An Analysis (August 2010) For the majority of our clients, their municipal bond portfolio represents their largest single asset class. Appropriately, over the years we’ve frequently addressed questions as to the quality, safety and diversification of client municipal bond portfolios, but never more so than during the past year. The ratcheting up of the stream of questions reflecting concerns about the municipal bond market is completely understandable; as this market has very real fundamental issues stemming from The Great Recession, which have been exacerbated by the severity of the financial crisis within the credit markets. There has been a steady stream of media headlines about the municipal bond market, often warranted, which portray the market in a deeply negative light. While certain risks have escalated, we feel that risks need to be placed in the proper context given the historically low credit risk of the sector. We believe that from an asset allocation perspective, a portfolio comprised of carefully selected, high quality municipal bonds should still serve as the “conservative anchor” of the fixed income portion of client portfolios. The purpose of this paper is to take a closer look at the municipal bond market, examine its underlying economics, our portfolio strategies and, in an attempt to separate fact from fiction, frame our response to the often-asked question: “Just how safe is my municipal bond portfolio?” Along with the municipal bond managers with which we partner on behalf of our clients, we acknowledge that the municipal bond sector has some very real problems and risks. But, similar to all broad-based asset classes, the coverage of the sector tends to paint all municipal bonds with the same negative brush, with very little regard for the massive differentiation that exists within the market. A good analogy is the taxable fixed income markets. Over the past several years, we’ve worked hard to educate our clients as to the major differences within the many sub-sectors of taxable fixed income, a sector perhaps even more diverse than the equity markets, as we have employed within our client portfolios: TIPS, high-yield bonds, developed and emerging market sovereign debt, government-backed and non-government mortgages; the list goes on. Although the municipal market is not quite so diverse, there still are major sub-sector and credit differentiations that need to be made within this space. As an example, although the credit quality of Greenwich, Connecticut is light years ahead of that of the State of California, most of the commentary on the municipal market does not reflect these very meaningful differences.

The Municipal Bond Market: A Quick Review The U.S. municipal bond market is currently capitalized at around $2.9 trillion, spread over an estimated 55,000 issuers. The issuers include states, counties, cities, and special tax districts, along with special agencies of state and local governments. The two major subsets of the municipal bond market are general obligation, and revenue bonds. General obligation bonds are issued by governmental issuers with taxing authority. Outlined in the legal documents of a general obligation bond offering, the issuer pledges to raise taxes, without limit if necessary, to ensure that the debt payments will be met and the principal repaid. The other primary bond sector, revenue bonds, will pay principal and interest derived only from a specified source of revenue. The issuers’ promise to pay interest and principal on a bond that is backed by various types of pledges and sources of security, depending on the type of bond and the purpose of issuance. These bonds may be issued by stadiums, highways, or hospitals, just to name a few. The distinguishing characteristic of municipal securities is that the interest paid on the securities is exempt from the regular federal income tax (certain types of special use bonds may be taxable to those in the AMT, Alternative Minimum Tax). States provide an exemption from state income tax for interest on municipal securities issued by, or within their own state. Credit Quality and History of Default From a credit quality perspective, short of Treasuries, municipal bonds have one of the highest credit quality profiles within the fixed income universe. History serves to back up this claim. This February, Moody’s presented an historical default matrix for the U.S. issuers they rate from 1970-2009. In summary, Moody’s-rated municipal issuers have experienced only 54 defaults over this 40-year period. The study clearly illustrated that municipal bonds carried a much lower default rate than corporates sharing the same rating symbol. For example, the five year average historical cumulative default rate for investment-grade municipal debt is a miniscule 0.03% compared to 0.97% for corporate issuers, while for speculative-grade (junk) bonds, the default rates are 3.4% for municipal bonds and 21.4% for corporate bonds, respectively. The conclusion is that, not only have municipal bonds been extremely unlikely to default, in the instances when they have defaulted, they already had been rated “junk” before they did so. From a credit ratings perspective, AAA-rated municipal bonds have a zero (0.00%) 5-year cumulative default rate, while AA and A-rated issues have experienced a 0.01% 5-year cumulative default rate. Even municipals carrying the lowest investment-grade rating, BBB, experienced a meager 0.08% 5-year cumulative default rate. This is a miniscule 1/25th of the rate of defaults experienced by BBB-rated corporate bonds over the same period.

Amongst the sub-sectors of the municipal market, General Obligation (G.O) bonds have experienced much lower rates of default then non-G.O. bonds (primarily revenue bonds). The five-year average historical cumulative default rate for all ratings of G.O. debt is zero (0.00%) compared to 0.11% for non-G.O. issuers. Yet, even the very small default rate experienced by non-G.O. issues is skewed by the fact that almost all “junk” rated municipal debt fall into the non-G.O. category. If we were to look at only investmentgrade non-G.O. debt, the cumulative default rate over five years falls to 0.05%, barely discernable from the rates experienced by the general obligation sector. The conclusion from this study is simple - high quality municipal bonds historically have had an extremely minimal risk of default. But That Was Then… Although we believe that a study of the past forty years serves as a very good foundation to judge the overall creditworthiness of the municipal bond sector, we are the first ones to acknowledge that today’s economic landscape looks far different and far more precarious than that of the past four decades. Seldom has the economic environment been less supportive of municipalities as it is today, as states and municipalities across the U.S. face very real issues. According to the Center on Budget and Policy Priorities, lower state revenue collections are setting the stage for yet another round of budget cuts for the upcoming fiscal year with budget shortfalls likely to add up to $140 billion, the largest gap since the beginning of the recession. Since states legally are required to balance their budgets, closing this enormous gap will have a severe impact on services and jobs, many in areas facing unprecedented demand during these difficult economic times, following two years of massive budget cuts. Also addressing these budget gaps are additional tax increases on top of the pervasive increases over the past two years. The combination of deep spending cuts and tax increases will have a profound impact on overall economic growth, and is yet another reason why we believe the current economic recovery is very tenuous. Without additional federal aid, the Center on Budget and Policy Priorities estimates that closing the current state budget gaps may cost the economy up to an additional 900,000 public and private-sector jobs. Combining these problems with highly partisan state and local politics provides for a very uncomfortable budget balancing process, a nearly endless source of media drama. Once again, we do not dismiss these headlines or the problems that exist for municipalities; but as investors, we need to distinguish between the difficulties being faced by municipalities, versus those being faced by municipal bond investors. Practical Implications for Municipal Bond Investors To be sure, as the economic problems escalate at the state and local level, the credit risks for municipal bonds will increase as well. This would be true in any economic downturn, and the risk is much higher than normal given the magnitude of the current economic

malaise. With this in mind, we have to keep in perspective what “higher than normal” actually means in the context of municipal bonds. As a foundation, we have already established that the historical risk of default in the municipal bond market is exceedingly low, particularly if one focuses on the investment-grade market where defaults have been minimal over the past 40 years. As an example, even if we assume that the risk of default for investment-grade municipal bonds is a mind-boggling 30 times greater than normal, the resulting default rate at 0.90% would still be lower than the historical default experience on investment-grade corporate bonds (0.97%). Although there is no rational basis for choosing a given risk multiple, even at a strictly hypothetical 30 times higher than normal, the credit risk would still be extremely low in absolute terms. Since we are now more than two years from the beginning of this Great Recession, it might be more informative to look at the actual municipal default experience during these very trying times. According to Richard Lehmann, publisher of the Distressed Debt Security Newsletter, municipal borrowers defaulted on $8.2 billion of bonds in 2008; $6.9 billion in 2009; and so far, $1.5 billion have defaulted in 2010. These numbers are very small in the context of a $2.9 trillion market. To be sure, municipal default rates have accelerated, with the default rate running at about three times higher than normal. But as you might have deduced from the name of Lehmann’s newsletter, the defaults are coming from issues that are already “distressed” – that is, “junk.” While it is certainly possible that some investment-grade rated issues can migrate down the credit rating matrix and default, it would seem to be exceedingly rare. During 2008-2009, there were zero defaults among Moody’s-rated issuers that began each year rated “A” or better (85% of the market). Even “Baa” municipals, the lowest rated investment-grade, which represents approximately 12% of the municipal market, have experienced a 0.02% default rate in 2008 and 2009. So even in this very difficult economic environment, there have been essentially zero defaults among investment-grade issues. Almost all of the defaults that have occurred over the past two years, similar to the past forty years, have emanated from the less than 3% of the market that is rated “high yield”, an area in which we do not invest. It is our belief that default risk is not the primary risk faced by municipal bond investors. The main risk is "headline” risk, which impacts the issuers of the bonds and investors in very different ways. Bad press for an issuer, Illinois for example, will cause an increase in price volatility of all Illinois bonds. For the issuer, this is not much of a problem. Actually, the bad press, more often than not, serves as a wake-up call for the issuer to take more aggressive actions. For investors, the “headline” risk can be far more unsettling, as the additional press can cause price volatility to increase on a mark-tomarket basis. Most “headline” risk stems not from the issuers “ability” to pay, which is rarely in question. Instead, the risk is mostly political because it takes a good deal of time for both sides of the aisle to find the appropriate mixture of revenue increases and spending cuts to balance a budget. Although “headline” risk may cause price volatility and increase investor anxiety, we do not believe it has any meaningful impact on the issuer’s ability to make interest and principal payments in a timely manner.

Reasons Why the Possibility of Rampant Municipal Bond Default Remains Highly Unlikely Extending our historical perspective to the present, we are going to examine some of the reasons why we believe that municipal defaults will remain only a remote possibility. State debt burdens actually appear to be very manageable. According to the Federal Reserve’s Flow of Funds Accounts report, at the end of the first quarter, the aggregate state and local government debt outstanding represents 16.3% of national GDP. This is well within historical norms and is approximately 5% less than it was in the early 1990’s. Even in states like California and New York, the two largest issuers of municipals, debt service expenses are very manageable. At the end of 2009, debt service expenses for California and New York were less than 7% and 5%, respectively, of their state’s total general fund revenues. That is, the revenue required to service their outstanding debt is more than sufficient. And while many have rightfully worried about the large unfunded future pension liabilities, the extent of the problem may be exaggerated from the perspective of municipal bond holders, given the contributions made by public participants, and the very long-term nature of these liabilities. Additionally, many states are starting to recognize the need to take steps to alleviate the pressure on their pension funds, including increasing the retirement age, closing pension fund plans to new hires, and requiring employers to match pension contributions. Municipal bondholders have very strong legal protections that make default unlikely. Bondholders are protected by balanced budget requirements, borrowing caps, and legal clauses that prioritize debt repayment, constrain spending increases, and mandate voter approval for new bond issuance. For example, the only California expenditure that gets funded before debt service is K-12 education. Everything else is subordinated. Similar provisions exist across most other state constitutions and statutes. Another way to look at these legal protections is that when budget cuts need to be made, they almost always come at expense of other creditors and constituents, not bondholders. While recent news of job furloughs, IOUs, and cuts to programs sound scary, and can inflict very real pain to many, they actually provide evidence in favor of the strong legal protections that bondholders have. One also should remember that the states have the ultimate weapons to make sure debt gets paid - taxing powers. So far, states are doing what they need to in order to protect bond market investors. According to the National Association of State Budget Officers, states have cut spending by $74 billion since 2008, and more than half have raised taxes and fees in 2009. Expect this trend to continue into 2010 and beyond. It would be both political and fiscal suicide for elected officials to allow municipal defaults. From a purely political perspective, most municipal bondholders are residents of that same state. Voters typically would not react kindly to politicians that caused them to lose money on their municipal bond investments. Also, from a fiscal management perspective, a bond default would make pre-existing fiscal problems far worse, not better,

as access to future credit would completely dry-up. This would have hugely negative implications for the state or municipality’s ability to finance its operating activities, infrastructure projects, and just about everything else. Lawmakers have an extremely strong incentive to avoid municipal defaults. Even during a period when unthinkable events have become commonplace, for all of the reasons listed above, we feel strongly that municipal bond defaults, while not impossible, will continue to be very low probability events. What Clarfeld Does to Further Mitigate Credit Risk Hopefully, we’ve been able to demonstrate that municipal bonds historically have been among the highest credit quality instruments available in the financial markets, while also providing a strong basis for why we believe they will remain that way. From a portfolio management perspective, we also want to discuss how we (Clarfeld, and our partner bond managers) further mitigate risk in our clients’ municipal portfolios. At the onset of every new client municipal bond account that we open up with a manager, we have the client and the investment manager sign an investment policy statement (IPS) that delineates very specific investment guidelines for each portfolio. While the policy statement may differ somewhat based on portfolio size and individual investment objectives, these guidelines mandate that the aggregate credit quality of each portfolio be rated A or better. The policy statements also limit the percentage of the portfolio that can be invested in BBB-rated securities, generally to 12% or less. Another very important aspect of our investment mandates is that our managers are conducting their own independent credit analysis before making a purchase on behalf of our clients. They do not rely on the ratings agencies to validate the relative credit risk of individual issues, but instead make their own determinations of credit risk. While we have always believed that this was incredibly important, it has become even more so following the collapse of the municipal bond insurance industry. Prior to 2008, nearly 50% of municipal bond issuance was insured and, because of this, the market was thought to be somewhat commoditized. During that time, many believed that credit analysis was less important, since ultimately, the insurer would be “on-the-hook” for any losses resulting from a possible default. This turned out to be a wildly faulty assumption. Neither our managers, nor we ever believed that real credit analysis could be taken for granted. As a result, the credit analysis conducted by our partnering managers always focuses on the underlying credit quality of the obligor, with a keen eye towards the safety and security of the revenue streams backing up the interest and principal payments on the bonds. Ongoing Municipal Investment Strategy Our approach to our municipal investment strategy, past, present and future, is extremely protective and conservative. We, and our bond management partners, know that the allocation to municipal bonds is designed to be the low-risk anchor of your portfolio.

Even though there are managers who have done well for their clients investment in highyield municipal issues, we are firmly committed to the proposition that municipal bonds is not an area where investors should be “shooting for the moon” or in investment parlance, “reaching for alpha.” Within our shop, our guiding principle is that municipals serve a very simple and straightforward purpose - provide tax-free income, and the preservation of capital. As such, our managers have continually been focused on the upper strata of the credit quality spectrum. However, when it makes sense, and is limited to a very small percentage of a portfolio, our managers may opportunistically take advantage of relative value trades, and occasionally purchase a name that has been in the “headlines” if it has become way-too-cheap relative the manager’s evaluation of the risks. Diversification, important throughout all asset classes, has also taken on an added layer of importance in this market. There are various layers of diversification that can be made in a municipal portfolio - sector (G.O.’s vs. revenue bonds), structural (callable vs. noncallable), and geographical diversification. On a tactical basis, we often get asked about the best strategy for this environment. Counter to traditional thinking some managers have actually started to favor high quality revenue bonds over certain general obligation bonds as general tax collections have declined. But while different managers may pursue different strategies, we believe one of our managers had it right by saying, “there are good and bad G.O.’s, good and bad revenue bonds – we are just looking for good bonds.” Ultimately, diversification within this environment requires a diversity of very strong revenue streams backing up the bonds. Whether these revenue streams come from different states or sectors is less relevant than whether the revenue streams themselves are secure and stable. This, once again, reinforces the need for strong and independent credit analysis. While we have spent the majority of the time focused on the fundamentals of the municipal bond market, from a technical perspective, demand for tax-exempt debt continues to be very strong. As it generally has become conventional wisdom that tax rates are likely headed higher for those in the highest tax brackets, investors have continued to place their money into the municipal bond market given the increasing attractiveness of tax-free income. Along with the high quality nature of the overall market, this may help explain why municipal bonds have performed so well over the past two years, despite persistently negative headlines. Conclusion We recognize that the nearly unprecedented nature of the economic times that we are in requires intense vigilance. As we have seen, market conditions can change quickly and extreme events (How overused is the term “Black Swans”?) have become more probable. We also believe that the global economic environment will continue to be problematic, which will lead to more fiscal pressure on municipalities. The problems for states and municipalities are very real, and we will continue to read about them for the indefinite future. One of the major points of this write-up, however, is to differentiate between the problems of municipalities and the minimal risk bestowed upon the creditors, or bondholders, for these same municipalities.

While municipal difficulties have certainly elevated the risks to municipal bonds, and may continue to lead to more price volatility than in the past, we believe that the municipal market remains a very sound place for investors to generate income and protect capital. We will continue to monitor the dynamic conditions in the municipal bond market, realizing that complacency is an investor’s worst enemy. Given the conditions on the ground today, however, we believe that municipal bonds should retain their mantle as the “conservative anchor” of our clients’ portfolios. Important Disclaimer: This report contains general information. The reader should not assume that any discussion or information contained in this report serves as the receipt of, or as a substitute for, personalized advice from Clarfeld Financial Advisors. Nothing herein constitutes or is intended to constitute legal or tax advice, or any other client specific advice. The information may not reflect current legal/tax developments or otherwise be applicable to the reader’s individual circumstance. With respect to investment-related content, please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this report will be profitable, equal any corresponding indicated historical performance levels(s), or be suitable for your portfolio. Due to various factors, the content may no longer be reflective of current opinions or positions. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisors of his/her choosing. Accordingly, each reader agrees, as a condition precedent to his/her/its access to this newsletter, to release and hold harmless Clarfeld Financial Advisors, its officers, directors, owners, employees and agents from any and all adverse consequences resulting from any of the reader's actions and/or omissions which are independent of his/her/its receipt of personalized individual advice from Clarfeld Financial Advisors. A copy of Clarfeld’s current written disclosure statement discussing our advisory services is available for review upon request.