However, most other sectors of the bond market were under extreme stress and in isolated cases ceased to function normally. The main culprit for much of this turmoil is the continuing fallout from the deteriorating mortgage market. The stress was evidenced in the expanding yield spreads, or yield differential, on virtually any other sector when compared to the "riskless" U.S. Treasury yields. This heightened perceived risk also affected the liquidity in the marketplace. Bear Stearns found this out the hard way as their counterparties eventually refused to provide the daily funding needed to continue to operate and the Federal Reserve had to engineer a rescue with the help of J.P. Morgan. The use of the word "unprecedented" became very popular in describing the various calamities endured by the bond markets during this period.

Unprecedented is a very apt description of what has happened in what was a quiet corner of the tax exempt market. Auction rate securities have been utilized by municipalities for decades as a very efficient way to fund a variety of projects. The securities themselves are actually long term borrowings and were often insured by one of the monoline insurance companies and thus carried the highest rating available. However, the unique aspect of these bonds was the funding mechanism. Auctions were held either weekly or monthly and, depending on supply and demand, the interest rate was established for the next week or month. Therefore, even though the bonds were long term, the interest rate was more indicative of short term rates. The appeal to investors was the money market like liquidity combined with a slightly higher yield. This arrangement worked like a charm for many years, until the aforementioned mortgage market struggles began to impact the insurance companies who had rated the auction rate securities. As the ratings agencies began to downgrade the insurance companies, the demand for these securities seemed to evaporate. The result was what brokerage firms euphemistically called "failed auctions".  In layman's terms, these bonds that had enjoyed money market like liquidity suddenly enjoyed no liquidity. The auction rate market has essentially ceased to function as intended and those holding the securities are not able to sell them or redeem them. The effect of these failed auctions on the broader tax exempt market has been significant and presents a buying opportunity in our opinion.

Municipal bond yields across the entire maturity spectrum are currently higher than those offered on U.S. Treasury securities. This is highly unusual since the income from municipal bonds is tax exempt and the income earned on Treasury securities is taxable, at least at the federal level. Normally, because of the tax advantaged nature of the income, the yield on municipal bonds is less than that offered by taxable alternatives. For this reason, we believe high quality, intermediate term municipal bonds represent attractive investments for portfolios where appropriate. The biggest challenge we have found is availability, as there have been few new issues and the secondary market is very sparse.