Spinnaker Report

1. Volume 4 October 2012 AHW &Co Quarterly Commentary October, 2012 Spinnaker Report Happy Holidays!! This year we got both Christmas and New Years in July. The semi-annual effect which tends to produce such supply and demand patterns this year was even more pronounced. The “negative supply” which was predicted during the spring did in fact occur and created a favorable environment for bond holders and more importantly AHW Co clients. These indicators are never 100% correct but do represent fundamental forces in the marketplace that require consideration and monitoring. While on this subject, now that we have experienced the “negative supply” effect on several occasions, it is an opportune time to consider what the opposite scenario which we will call “invisible supply” could be expected to produce in the municipal bond market. Consider the visible calendar of new issues to be approximately $30 billion on average. Now envision a situation that requires liquidations of an additional $30 billion during the same time period. This supply overwhelms the demand and the process produces more sellers. Suddenly, the equation and balance of buyers and sellers shifts and it is impossible to project how many bonds will hit the market. This invisible supply is much more difficult to predict and usually occurs during periods of reduced liquidity. It can be brought on by factors such as event risk, supply bubbles, unfavorable calendar monthly demand components, potential tax law changes, political uncertainty and all of the above in various combinations. This being an election year, the stakes appear to be relatively high for a kneejerk reaction. Add the continuing European crisis to the mix and from our point of view, the prudent strategy is to employ cautionary trading tactics in implementing our program objectives. Noticeably, we have gradually reduced leverage in our portfolios, purchased more defensively oriented securities, or both, in our managed programs. With reinvestment rates at minimal yields, we have chosen to maintain and hold those positions which are difficult to replicate, intentionally moving them to our core holdings for the time being. While we continue to seek out short term trading opportunities, our approach is towards becoming less patient in holding trading positions. Instant gratification is always welcomed. Our reasoning is that the market will come to us over the next several months. Additionally, we project a significant increase in new issuance during the 4th quarter of 2012. If these observations and scenarios play out, we intend to be purchasers during any “buyers” market that presents itself. This may take several more months to achieve. Mutual fund inflows continue at a robust pace. The market is still flush with money and attractive new issues are continually oversubscribed. As stated, our posture in the short term has changed from earlier in the year. Longer term we still see continued weakness in the overall economy both in the US as well as globally. With the Fed announcing a widely anticipated QE3 and the European Union taking a more aggressive stance, the equity markets have enjoyed a bounce due to optimism. This has produced a steeper yield curve in US Treasuries. It is our hope that rates do increase as we see this is a buying opportunity rather than a significant change in the bond market direction. Not a prediction, but low generational rates may be here for a long time.

2. The rollover for August 1 is a total of $21.3 bn. Table 1 presents the key statesthat are anticipating heavier redemptions. Chart 1 presents the bond redemptionsand coupon payments for all Muni Issuers for August 2012 through December2012.

3. What Others are Saying: By Gillian White Aug. 9 (Bloomberg) -- Municipal bonds maturing in three decades are staging their best rally in five months. The gains may be at risk as investors face federal deficit-cutting proposals that also threaten local debt’s tax-exempt status. Investors have been seeking to pad returns amid the lowest municipal interest rates since the 1960s. They were willing to accept as little as 1.15 percentage points of extra yield last month to lend to states and cities for 30 years rather than a decade, Bloomberg Valuation data show. That gap was the smallest since March and 25 percent below the average since 2008. Investors typically demand a premium for taking on the heightened risk of longer-dated debt. “There’s not a lot of excess return left to be had,” said Michael Zezas, head of municipal strategy at Morgan Stanley in New York. “Barring further weakness in the economy, I don’t think you’ll see that much more of a substantial rally” in longer-maturity munis, he said. There are signs of diminished demand. Investors added $307 million to long-term muni funds last week, a drop of about 40 percent from the prior period, Lipper US Fund Flows data show. It was the steepest decline in a non-holiday week since May. For all of 2012, funds focusing on debt due in more than 10 years have added about $9 billion, compared with $3.5 billion for those concentrating on maturities of three to 10 years. The trend is a reversal from the same period of 2011, when longer-term assets fell about $16 billion, more than double the losses of intermediates.                            Deficit Debate        The tax status of munis is enmeshed in the debate over how to reduce the federal deficit, a discussion that is set to heat up after the November elections. The administration of President Barack Obama last month forecast the imbalance at $1.21 trillion this year. The exemption for local borrowings costs the U.S. government $39 billion a year, according to the administration. Obama, a Democrat, has proposed limiting the break for top earners, and a deficit-cutting panel he appointed recommended scrapping it as part of a tax-code overhaul. Neither plan advanced in Congress. Republican presidential candidate Mitt Romney has suggested cutting income-tax rates, which may require finding ways to make up for lost revenue to avoid swelling the deficit. He hasn’t outlined specifics. “We’ve seen some real concern that the exemption could get capped or go away, and I think that is making it more difficult” for the longest debt to extend its rally, said Justin Hoogendoorn, a managing director at BMO Capital Markets in Chicago.                           Market Beater     Long-term munis have beaten all other segments this year, according to Barclays Plc data . Bonds due in more than 22 years have earned about 9 percent, compared with about 4 percent for the 10-year area. Top-rated munis due in 30 years yielded about 2.99 percent yesterday, compared with 1.74 percent for 10-year tax-exempts, Bloomberg Valuation index data show. Last month, signs of a slowing economy and speculation that European leaders would fail to contain their debt crisis helped push yields on both maturities to the lowest since the Bloomberg indexes began in January 2009. Zezas at Morgan Stanley in a research note last month called seven- to 14-year maturities the “sweet spot” for investors, rather than longer-duration debt. The longer a bond’s duration, the more sensitive its price is to changes in interest rates.                            Fed Efforts  Federal Reserve efforts to keep down borrowing costs to spur the economy help explain the historically low interest rates. The central bank has been swapping short-term debt in its holdings for longer maturities as part of the so-called Operation Twist. “There’s some expectation that rates are going to stay low for a while,” said Alan Schankel , a managing director of fixed income at Janney Montgomery Scott LLC in Philadelphia. The Fed’s moves have made investors less concerned about picking up longer-maturity bonds than they might typically be, he said. The yield spread between 10- and 30-year AAA munis has been smaller than last month’s low on only two occasions  since October 2008. Each time, the gap widened an average of 0.56 percentage point in as little as a month. Guy Davidson, who oversees $31 billion as director of municipal investments at AllianceBernstein LP in New York, is encouraging clients to shift into intermediates from high-grade, • long-term munis. •      “Intermediate bonds have a lot less downside risk to • them,” he said.

4. This chart graphically depicts current supply and demand characteristics . As noted, we monitor and place emphasis on the seasonal patterns in implementing our trading strategies. The September imbalance may be attributable to the lack of supply and lack of sellers .Fund inflows are still positive but not at the pace of July and August. This bears monitoring since the October-November period has traditionally not been bond friendly. We will continue to look for a favorable entry point. At this stage, it may be after the election . AHW Co receives research and commentary from a variety of sources including those that are broadcast to the public but also those which are proprietary and non intended for general public distribution. Clients of AHW Co are entitled to view such information but are not permitted to retransmit or rebroadcast any proprietary reports.

5. TOP: MUNI BOND FUNDS SEE HEAVIEST INFLOWS IN FIVE MONTHS • Aug 10 2012 6:50 • By: James Ramage, The Bond Buyer • NEW YORK - The municipal market may have had a lackluster week, marked by  • rising yields and modest activity in the primary and secondary. • But investors poured into muni bond mutual funds at a rate not seen since the week ended March 7. • Muni bond funds reported $1.14 billion of inflows from funds that •  report their flows weekly for the week ended Aug. 8, more than •  doubling the previous week's number, according to Lipper •  FMI. They have seen inflows for 17 consecutive weeks. • There were net inflows of $504 million in the week ended Aug. 1. • For context, the muni market has now seen positive flows for 46 •  of the past 49 weeks. For the year to date through July 25, there have been $26.6 billion in inflows. • Muni yields rose up to seven basis points from the belly of the curve on out over the week from last Friday. The 10-year triple-A rose six basis points over the period to 1.70%. Muni yields outperformed those of Treasuries on the week, leaving ratios richer. Muni ratios to Treasuries still sit above 100%. • Assets for all muni funds that report their flows weekly rose to $309.3 billion from $308.6 billion the week before. In two months, they have risen $10 billion. The value of the holdings for weekly reporting funds plunged by $490 million. The week before, they increased by $397 million, falling for a second straight week. • The four-week moving average for all municipal bond mutual funds that report their flows weekly saw a $823 million inflow, rising from a $701 million gain the week before. Long-term bond funds continued to see robust flows. They remain more than half of the overall figure for muni bond funds. Long-term bond funds that report their flows weekly saw inflows to the tune of $632 million, rising from $307 million the week before. • High-yield muni funds saw strong inflows yet again. Flows have been positive for 20 consecutive weeks, and 34 of the previous 35 weeks. High-yield funds that report weekly saw $293 million in inflows,Lipper said. The previous week, they reported $130 million in inflows. • Assets for high-yield funds that report their flows weekly increased to $43.17 billion, up from $42.91 billion the previous week. The value of the holdings for weekly reporting funds fell by $34 • million. Last week, they increased by $159 million. The four-week moving average for all high-yield muni bond funds that report their flows weekly was $242 million of inflows, upsomewhat from $212 million the week before.

6. Banks’ Biggest Local-Debt Bet Since ’85 Fuels Rally: Muni Credit 2012-10-01 04:01:00.2 GMT • By Michelle Kaske and Michael J. Moore • Oct. 1 (Bloomberg) -- JPMorgan Chase & Co., Wells Fargo & Co. and PNC Financial Services Group Inc. are leading U.S. banks making the biggest bet on municipal debt in 27 years, helping fuel the longest rally in state and local bonds since 2001. Banks nationwide held $330 billion of munis as of June 30, a $20 billion quarterly increase, Federal Reserve data show. It was the biggest jump since the end of 1985, according to Municipal Market Advisors, an independent research company. • The purchases reflect the securities’ relative safety, which helps banks meet regulatory requirements. Munis are on a pace to beat Treasuries and corporate debt for a second-straight year when adjusting for volatility, data compiled by Bloomberg show. Local-debt yields have also been above federal interest rates on average for the past two years. “As long as those two dynamics stay in place, this trend is probably here to stay for a while,” said Peter Hayes, a managing director at New York-based BlackRock Inc., which oversees about $105 billion of munis. The demand has fueled increased bidding for localities’ debt, he said.The banks have eclipsed property and casualty insurers as the third-largest investors in the $3.7 trillion muni market, behind households and mutual funds, Fed data show. Their increasing appetite has helped depress borrowing costs for states and cities that are still under fiscal pressure three years after the worst recession since the 1930s.  • Longest Rally  Munis gained the past seven quarters, the longest stretch since 2001, according to Bank of America Merrill Lynch data. After accounting for price swings, state and city debt has earned about 3.5 percent this year through Sept. 27, compared with a 2.5 percent risk-adjusted gain for corporates and 0.7 percent for Treasuries, data compiled by Bank of America and Bloomberg show. “It’s probably one of the better risk-adjusted returns out there, said Chris Kotowski, a bank analyst at Oppenheimer & Co. in New York. “Especially since rates on just about everything else are so shockingly low.” As investors sought a haven from Europe’s debt crisis, yields fell this year to the lowest since the 1960s, a Bond Buyer index shows. Yields on tax-exempts due in 30 years have still exceeded those on Treasuries of a similar maturity by about 9 percent on average for the past two years, data compiled by Bloomberg show.  • Regulatory Fuel  Increased regulatory scrutiny is also supporting banks’move into munis. Since the 2008 collapse of Lehman Brothers Holdings Inc., the Basel Committee on Banking Supervision has set guidelines to reduce banks’ risk. The measures, known as Basel III, will more than triple the core capital that lenders must hold to at least 7 percent of assets, weighted for risk. “By regulatory standards they need a lot of something they can turn to cash very quickly without really a lot of losses,” said Paul Miller, a bank analyst at FBR Capital Markets Corp. in Arlington, Virginia. “Munis fit that category. Percentage-wise, New York-based JPMorgan added the most munis among the banks reviewed by Bloomberg. The nation’s biggest bank by assets held $37.5 billion of munis as of June 30, up from $14.7 billion two years earlier, according to quarterly filings. Jennifer Zuccarelli, a spokeswoman, declined to comment.  • ‘Risk-Return’  Wells Fargo, based in San Francisco, increased state and local debt to about $40 billion from $18 billion in the period. The bank has boosted munis “because we think we can get a good risk-return there,” Tim Sloan, chief financial officer at Wells, the fourth-largest U.S. bank, said at a Barclays Plc conference in New York on Sept. 11. Pittsburgh-based PNC’s state and local debt also more than doubled in the period. Fred Solomon, a spokesman for the seventh-largest U.S. bank by deposits, declined to comment. Some banks have bucked the trend. Bank of America cut tax- exempts by almost two-thirds, to $2.8 billion. Jerry Dubrowski, a spokesman for the Charlotte, North Carolina-based bank, declined to comment. Citigroup Inc. held $24.6 billion of munis, down 1 percent. Scott Helfman, a spokesman for the New York- based bank, declined to comment. As most banks have expanded municipal holdings, deals have gone from having two or three times more orders than available bonds to sometimes as much as 20 times, said Hayes of BlackRock, the world’s biggest asset manager. “As institutional investors, we certainly get access to more bonds, but nonetheless, in these new-issue markets, we’re competing and it’s harder to get bigger allocations” as the banks have become bigger buyers, he said. In trading last week, the yield on 10-year AAA munis fell 0.06 percentage point to 1.72 percent. It dropped to 1.63 percent July 27, the lowest since at least January 2009, data compiled by Bloomberg show.

7. Comerica economist Robert Dye's forecast for 2013: A lot depends on politics • By Tom Henderson • Robert Dye The chief economist at Comerica Bank said today that he can't remember a more unsettled time to try to make an economic forecast. • As a result, primarily because of political uncertainty, Robert Dye's forecast for the first six months of 2013 was actually three forecasts — one predicting decent growth in gross domestic product of 3 percent; one predicting what he called a "growth recession," with growth of 1.5 percent to 2 percent; and one predicting a recession with a GDP decline of about 2 percent. • "My sense of trying to forecast the economy is, I can't recall a period when we have so many question marks lurking out there. Some question marks are looming earlier and some are lurking farther away," Dye told a luncheon audience of the bank's business clients and wealth management customers at the Grosse Pointe War Memorial. • The title of his talk: "Passages Through a Sea of Uncertainty." • Chief among Dye's question marks: What will legislators in Washington do about the so-called looming financial cliff, a combination of tax increases and spending cuts that will kick in automatically after the first of the year unless the Senate and House agree on a different policy? • If they don't act, and both sharp tax increases and sharp declines in federal spending kick in, it will take hundreds of billions of dollars out of the economy, Dye said, and will almost certainly lead to recession. • If they completely kick the can down the road and delay taking any action, GDP should grow at 3 percent. If they agree on some tax increases and some spending cuts, that could bring GDP growth down to 1.5 percent to 2 percent. • "It's all about political forecasts, now. It's not about economic forecasts," he said. • Adding to the uncertainty over the fiscal cliff is the ongoing recession in Europe and whether the eurozone will survive, whether what has been predicted as a soft landing for the Chinese economy is going to be harder than most have predicted, and news out last week that the U.S. GDP for the second quarter was revised downward last week to 1.3 percent from the original estimate of 1.9 percent. • "That's starting to feel quite weak," he said, "and the employment numbers for the last several months have been weak, as well." • As for Europe, Dye said: "There's no magic bullet. There's not a single problem in Europe. There are many intertwined problems." • Regarding China, he said: "Are we going to see 4 to 5 percent growth instead of 6 or 7 percent? That's still a soft landing, but it's not as soft as people predicted. And then you add in troubles in Japan and India, and Asia is a concern." • But there are reasons for optimism, Dye said. First is what appears to be the beginning of a sustained housing recovery. • "Home sales are trending up nicely. Prices are coming up, and construction is coming up," he said. "We're finally turning a corner on housing, and that has broad affects on the economy as a whole." • Of importance to Michigan is that the pace of auto sales seems primed to break through what has been a ceiling of an annual rate of 14 million to 14.5 million vehicles. • "Some economists are predicting we'll be at a 15 million rate by the end of the year, although I'm going to be more cautious and say it will be 14.6 million or 14.7 million, and we could hit 16 to 17 million in a couple of years," Dye said. • A third reason for optimism is that the ratio of consumer debt is "back down to historic lows" — which, coupled with pent-up demand for autos and housing, could spark spending. • "Consumers who have access to credit will go out and buy big-ticket items," Dye said. "Consumers are feeling more comfortable taking on appropriate levels of debt."

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