Spinnaker Report

1. Volume 2 April 2012 AHW &Co Quarterly Commentary April 1, 2012 Spinnaker Report What a difference a year makes! In January 2011, the municipal bond market was reeling from wave after wave of selling pressure related to the extraordinary amount of new issue supply brought at year end in 2010, and the lingering doomsday forecast provided by Ms. Whitney on 60 Minutes. Fast forward to January 2012, and the perfect storm becomes the perfect market. The laws of supply and demand created an environment that produced one of the most pronounced “January” effects in many years, driving yields down and prices up. While we had expected the cyclical pattern, the strength and depth of the buying was still remarkable. 2011 saw mutual fund redemptions and subsequent forced selling in excess of 20 consecutive weeks. We have witnessed a complete reversal of this trend and now are experiencing weekly inflows, some of which have been in excess of $1 billion. Combine this with the anticipated coupon payments and redemptions of maturing bonds, and the market becomes a seller’s market with a significant amount of money that needs to be invested. Once supply began picking up in mid February and more recently in March, the municipal market has paused as the new issue supply has created equilibrium. A story worth mentioning is that Puerto Rico, which historically commands a yield premium since it is “triple tax exempt” (state, local and federal), has already issued approximately 50% of what normally they would be expected to be issued in an entire year. This has produced an oversupply of PR and other triple exempt municipal securities. This situation has produced a buying and trade opportunity. Accordingly, our portfolios have been active in PR and other similar paper. Noteworthy is that many of the bonds being issued are “high grade”, with AA or better ratings. These have commanded extremely low yields which are at or near generational minimums. While many funds and individuals have no alternative but to purchase these securities to replace those that are being redeemed, many professional managers have sought alternatives including high yield, extended maturities and “kicker” bonds to combat the yield erosion in their client portfolios. This is nothing new to us. Our strategy has always been to construct and maintain for our clients the most attractive selection of securities to provide the highest return and most attractive risk-reward characteristics. It is always nice to get such positive reinforcement and recent articles present confirmation that our investment methodology has been successful. Looking forward into the next quarter and beyond we anticipate more of the same. The Federal Reserve has extended their low interest rate forecast into mid 2013. While recent economic news indicates that the US economy is rebounding, there are many cross currents and the markets have become accustomed to building in risk on/off scenarios that can come at any time. This includes the well documented Greek and Euro situation, geopolitical risks in the Middle East that affect oil prices, and global economic concerns. Since 2012 is a Presidential election year, this also must be factored into any interest rate forecast. While we anticipate a continuation of the low volatility municipal market environment, we have concerns specifically as they relate to the cyclical nature of the tax exempt market. The March – April period traditionally has been a challenge because of the heavy supply and decreased amount of reinvestment dollars available. Also, April 15th taxes could impact the liquidity. Consequently, we have been reducing duration and in some cases leverage, in our client portfolios. As always, we continue to monitor all developments and react accordingly as situations dictate for the benefit of our clients.

2. Watch Out! These Municipal Bonds Come With a Bit of a Kick • SMART MONEY • March 5, 2012, 9:57 p.m. ET By JONNELLE MARTE With high-grade municipal bonds offering meager yields, investors seeking an income jolt are embracing a slightly more exotic product known as "kicker" bonds. Unlike traditional municipal bonds, which have set term dates of 10 years or more, kicker bonds can be called much sooner and unexpectedly—an unattractive feature for a retiree wanting a set-it-and-forget approach to receiving regular checks. They also sell at a premium to the price investors receive when the bonds mature. But investors get rewarded for that uncertainty—and that premium—with income payouts that can be double those of regular munis, plus the potential for an extra "kick" down the road. Interest in these bonds waxes and wanes with the state of interest rates, but in today's low-rate climate, they have turned the $3 trillion muni market on its head. Barclays Capital says they now account for 64% of its Municipal Bond index, nearly twice the share from a year ago. Fans of such premium callable bonds, sometimes called "cushion" bonds, are betting that the Federal Reserve is likely to raise interest rates slowly in coming years. If that happens, kicker bonds could prove a good portfolio protector, says Peter Hayes, head of BlackRock's municipal bond team. Indeed, the kick comes if for some reason the issuer elects not to call these bonds early—usually because interest rates have risen and refinancing becomes unattractive. In that circumstance, the bond owners get bonus years collecting the higher yield. Even if the issuer pays back early, the investor will have collected higher payments than with standard bonds. "It's kind of a win-win," says John Bonnell, portfolio manager of four municipal bond funds at USAA. "In either scenario you're getting better yield." However, there is another potential downside for investors: If the bonds are paid back early because of a lower-rate environment, owners could be left holding cash with no good places to put it. In part for that reason, regular investors have typically shied away from kickers, favoring run-of-the-mill munis for their stability. Demand has helped push the average yield on a Triple-A 10-year muni to a current 1.9% from 3.5% in January 2011, according to Thomson Reuters Municipal Market Data. But now a growing number of firms, including Deutsche Bank , Wells Fargo and LPL Financial are urging clients to buy kickers instead. Patrick Early, chief municipal analyst with Wells Fargo Advisors, points out that a triple-A rated kicker bond with a 5% coupon would yield about 1.75% if it was called at its first possible chance in six years—almost double that of a current market muni that matures over that period. Phil Condon, head of municipal bond portfolio management for DWS Investments, says he is selling regular munis to snap up more kicker bonds. He recommends investors look at long-term bonds with 10 years or more between the bond's call date and maturity date. If they aren't called at the first date, Mr. Condon says, the investor will keep collecting the higher interest.

3. Redemption estimates for the next year We estimate about $199.4bn of principal redemption and $130.4bn of coupon redemption for municipal bonds in 2012. Chart 1 shows estimated monthly principal and coupon redemptions for municipal bonds. January, February, and the summer months are usually periods of technical strength in the muni market as the chart below shows. Chart 1: Estimated principal redemption and coupon redemption for muni bonds in 2012

4. We are entering the weaker seasonal period for the Muni market, as supply traditionally begins to pick up and redemptions are typically lighter. Chart 1 shows the average total return on the BofAML Muni Master Index by month since 1989 with March exhibiting the worst performance, on average.

5. Bloomberg December 16, 2011 *Reprinted* Whitney’s Armageddon Belied by Best Returns of 2011: Muni Credit To be sure, concerns about U.S. public finances remain. Many states and cities are still grappling with budgets squeezedby the 18-month recession that ended in June 2009. Rising costsfor health care and the impact of federal deficit cuts will alsoweigh on future budgets.                       Inadequate Pensions      Thirty-three states had pension assets last year of lessthan the 80 percent considered adequate to pay benefits,according to a 2011 study by Bloomberg Rankings. Median fundingfell to 73.7 percent from 76.2 percent in 2009, the data show.      And while state tax collections in the third quarter rose7.3 percent, according to the Albany, New York-based Nelson A.Rockefeller Institute of Government, they remain below peaklevels of 2007 and 2008.      For 2011 at least, the 10.5 percent total return ofmunicipal bonds beats Treasuries, which earned 9.6 percent, andcorporate debt, up 6.9 percent, Merrill indexes show. The S&P 500 stock index has fallen 3.3 percent, while the  S&P GSCI SpotIndex of commodities lost 2.2 percent.      When returns are adjusted for price volatility, municipalbonds returned about three times more than corporate bonds andtwice as much as Treasuries, according to Bank of AmericaMerrill Lynch and Bloomberg data. •    Behind Outperformance • The outperformance comes down to supply and demand, saidMatt Dalton, who oversees $925 million of munis as chiefexecutive officer of Belle Haven Investments Inc. in WhitePlains, New York. •      “Demand has continued to increase in part because wehaven’t had the multiple defaults that Meredith pointed to,”Dalton said. •      After suffering $44 billion in withdrawals from November2010 through May 2011, tax-exempt municipal-bond mutual fundshave taken in about $8.3 billion through Dec. 7, according tothe Investment Company Institute. •      That’s as individual investors, who make up 75 percent ofmunicipal-bond holders, pulled $153 billion from stock funds inthe last 7 1/2 months, according to the ICI. •      At the same time, state and local borrowing fell to $285billion this year from $407.7 billion in 2010, RBC’s Mauroestimates, as officials put off capital projects and thefederally subsidized Build America Bonds program expired.                       Benefits Reinforced      Tax increases in high-wealth states such as New York andConnecticut reinforced the benefits of municipals, as did lowrates on taxable securities. The yield on top-rated 30-year tax- exempt bonds exceeded that of comparable Treasuries in all but10 days of the year.      “Munis make too much sense versus CDs, corporates andTreasuries,” Dalton said. “When you’re looking at 10-yearTreasury bonds at 2 percent and you can buy a 10-year muni bondat 2 percent, a taxable buyer moves to the tax-exempt side ofthe ledger.”      Whitney, 42, gained prominence after her 2007 predictionthat Citigroup Inc. would cut its dividend because of mortgage-related losses proved correct in 2008. Her recommendation tosell bank stocks before the credit crisis  hit with full forcepropelled her to fame. Fortune magazine dubbed her “The WomanWho Called Wall Street’s Meltdown.”      A graduate of Brown University in Providence, Rhode Island,she started New York-based Meredith Whitney Advisory Group LLCin 2009 after leaving Oppenheimer & Co.                           Debt Warning      She said last year after her September report entitled“Tragedy of the Commons” that state and local borrowers had too much debt and were a systemic risk to financial markets. Shedidn’t return a telephone call or respond to an e-mail seekingcomment yesterday.      Part of the reason the municipal market performed well wasbecause of, not despite, Whitney, said Priscilla Hancock,municipal strategist at JPMorgan Asset Management.      In the fourth quarter of last year, Whitney’s doomsayingcollided with rising debt sales stemming from the soon-to-endBuild America Bonds program to depress the market. That helpedspark the withdrawal of $20 billion from municipal-bond funds inthe quarter. By the end of April, investors had pulled outanother $23 billion.      Merrill Lynch’s Municipal Master Index lost 4.5 percent inthe quarter, the most since the first quarter of 1994.      “This set the market up for good performance as thosefactors changed,” said Hancock. “The market benefitted fromboth low rates and from a correction.”      Investors chasing 2011’s returns  will be hard-pressed toget them in 2012, said Fitterer of Wells Capital.      “That’s the sad part,” he said. “They got out of theasset class when there was great value, and now in some casesthey’re buying back in when the numbers look good again.” For Related News and Information: Top muni-bond news: TOPM <GO> Most read muni-bond stories: TNI MUN READ <GO> State fundamentals: MIFA <GO> On municipal issuers: SMUN MAP <GO> --With assistance from Michael McDonald in Boston and  William Selway in Washington. Editors: Jerry Hart , Mark Tannenbaum

6. What others are saying : By Michelle Kaske      Dec. 19 (Bloomberg) -- Tax-exempt yields  are set to extendtheir longest rally in seven months as investors pour the mostmoney into municipal-bond funds in more than a year and debt sales fall to the lowest level since last December.      Investors should buy munis and not wait for higher yieldsas the U.S. Federal Reserve keeps its benchmark interest ratebelow 0.25 percent, making money-market funds and other short- term securities unattractive, said Michael Pietronico, chiefexecutive officer at Miller Tabak Asset Management.      “In an environment where the overnight rate is essentiallyzero and short rates are effectively zero and cash yields  arenext to nothing, waiting is not an option,” Pietronico, whomanages $620 million of municipals, said in a telephoneinterview from New York.      Rates on 10-year tax-exempt bonds  fell to a record low 1.88percent last week, according to data compiled by Bloomberg. The$3.7 trillion market has endured the biggest U.S. municipal bankruptcy in Jefferson County, Alabama, and predictions byanalyst Meredith Whitney of “hundreds of billions of dollars”of defaults. States cut spending to close more than $325 billionof budget deficits in the last four fiscal years, bolsteringtheir finances and protecting bondholders.      States and cities plan to borrow  about $909 million thisweek, the least since the last week of 2010, when issuers sold$499.5 million, according to data compiled by Bloomberg.                           Fewer Issues      Sales this year will total about $285 billion, Chris Mauro,head of U.S. municipal strategy at RBC Capital Markets, said ina Dec. 15 interview. That’s down about 30 percent from 2010 asstates and cities contracted budgets in the wake of the longesteconomic downturn since the 1930s. Borrowing will rise 20 percent in 2012 to about $340 billion, Mauro forecast.      Investors added $1.49 billion to municipal-bond funds inthe past two weeks, the most since $1.57 billion in the firsthalf of September 2010, according to Lipper US Fund Flows. Tax-exempt securities have outperformed U.S. Treasuries, stocks andcommodities this year.      “You’re seeing a certain degree of a buying frenzy rightnow,” said Neil Klein, who helps manage $1 billion of municipalassets as senior managing director at Carret Asset Management in New York. “New issuers coming to market are being met withvery, very strong demand.”      Rates on tax-exempt debt maturing in 2021 recorded their10th consecutive daily decline on Dec. 16, the longest stretchsince May, when they fell for 16 days. The yield is the lowestsince at least January 2009, when the Bloomberg Valuation Indexbegan.                           Lower Still      “You’ll probably see in the next two to three weeks, fiveto 10 basis points lower in a grinding fashion beyond 10years,” Pietronico said. A basis point is 0.01 percentagepoint.      Tax-exempt yields have fallen less than those ofTreasuries, making them relatively more profitable. Municipalsdue in 10 years yielded 101.4 percent of equivalent-maturityfederal debt last week, more than the 91.33 percent average  overthe past decade, data compiled by Bloomberg show.      An investor in the 35 percent income-tax bracket would haveto earn 2.89 percent taxable to match the tax-free 10-yearyield, according to data compiled by Bloomberg. Taxable 10-year Treasuries yielded 1.85 percent on Dec. 16.      Tax-exempts have returned 10.5 percent this year comparedwith 9.9 percent for federal debt, according to Bank of AmericaMerrill Lynch indexes tracking price change and interestpayments. The Standard & Poor’s 500 stock index fell 3 percentand the S&P GSCI Spot Index of commodities lost 2.2 percent.                        Declining Defaults      Municipal defaults in which an issuer has missed aninterest or principal payment totaled $805 million this yearthrough Nov. 30, down from about $2 billion in the same periodof 2010, according to J.R. Rieger, vice president for bondindexes at S&P.      “There simply hasn’t been the tidal wave of defaults thatwere predicted by some analysts,” Rieger said in a researchnote last week.

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