All in all, 2010 was quite a year.  From the slow motion train wreck that is the European Debt Crisis to the massive, damaging and difficult to plug Deepwater Horizon oil spill in the Gulf of Mexico, coupled with the ongoing housing and unemployment mess and the 'flash crash' in May, there was little reason to feel hopeful.  Strangely enough, the stock markets responded by moving higher throughout the year.  When the markets closed for the year, the S&P 500 was up 15.06% including dividends.

So what is the stock market seeing that you and I are not?  As it turns out, corporate profits and cash levels are at record highs.   Global demand for the products that many American companies make is strong.  Oil and commodity prices have stayed high due to demand from emerging markets and a weak dollar.  Here at home, jobs and houses are still causing us fits.  17% of the workforce either can't find employment or are surviving on part-time work.  The collective gloom is contagious.   In spite of historically low interest rates, the housing market is operating at levels far below those seen as recently as 2 years ago.  According to Business Week, there were 202,000 new homes on the market in October - the fewest since 1968.  Following decades of growth, the housing market - and the psychology behind the dream of homeownership - has suddenly been replaced by the new religion of austerity.  Perhaps not surprisingly, even political reality defies perception.  Polls taken around the time of the recent midterm elections saw 2 out of three voters say that taxes had gone up, the economy had shrunk, and the billions of taxpayer dollars lent to banks as part of the TARP bailout would never be recovered.  In fact, taxes have been cut by some $240 billion since 2009, growth in the US and most major economies has continued without interruption in 2010, and the US Treasury is forecasting a $16 billion profit on the TARP rescue. 

Going in to 2010, the general consensus on the direction of interest rates was that they were headed higher, some thought much higher.  In looking back now, we see that the market did its best to confound the consensus and interest rates actually ended the year lower than where they started.  That is not to say they moved steadily lower throughout the year, however, they did finish lower and bond investments provided attractive if not spectacular investment returns for the year.  The fourth quarter was the worst quarter of the four for fixed income investments when they actually provided negative returns for the period.  In fact, according to Thomson Reuters, municipal bonds had their worst quarterly performance in 16 years.  This sector in particular came under special scrutiny for a number of reasons.   

There has been a steady drumbeat of warnings about the coming credit crisis for state and local municipalities.  These warnings have come from both qualified and unqualified sources, in our opinion.  The concerns center on the difficult situation many state and local municipalities find themselves in of declining revenues, increasing expenses, and seemingly unquantifiable retirement/pension obligations.  The response in the market has been to essentially sell now and ask questions later.  Beginning in January of 2009 and each consecutive month through October of 2010, municipal bond funds experienced inflows every single month for a grand total of just over $101 billion dollars or just about $4.6 billion each month.  That trend changed, and changed dramatically in November and December as the negative sentiment about this sector of the bond market reached a crescendo.  There were net outflows of $7.6 billion in November and $12.5 billion in December.*  These heavy redemptions required fund managers to sell bonds to meet the withdrawal needs and this placed additional downward pressure on the prices of municipal bonds.  This selling was happening at the same time that supply in the form of new issuance of municipal bonds rose dramatically in December.  All of these factors were contributors to the underperformance of this particular sector in December.

So, what is our take on municipal bonds in general?  In short, we still believe the judicious use of high quality municipal bonds is appropriate where they can be justified based upon a client's investment objective, income needs, tax bracket, and other considerations.  Following are just some of the salient facts that give us confidence in this particular segment of the bond market:

• There is no legal provision for states to enter bankruptcy, and 26 states have regulations which prohibit their local municipalities from declaring bankruptcy as well
• Unlike most corporate or sovereign debt, almost all state and local government debt is fully self-amortizing with principal and interest payments included in operating budgets.  As a result, issuers generally do not rely on market access to rollover principal maturities(Moody's)
• Debt service costs as a percent of total expenditures for the average municipality is between 4% and 8%(Citi Investment Research)
• Many state constitutions or statutes dictate that general obligation debt service has a first lien on revenues(Blackrock)
• States have in fact responded by cutting expenditures for each of the past two fiscal years, by 4.3% in FY2009 and 6.8% in FY2010(National Assoc. of State Budget Officers)
• Third quarter 2010 tax revenues for state and local governments were up 5.21%, marking the fourth consecutive quarter of positive growth(U.S. Census Bureau)
• 2010 ending reserve balances were expected to approach 20% of general fund expenditures for local governments based upon a survey by National League of Cities

We do not take lightly the challenges facing municipalities in this current environment.  Of all of the challenges, the pension and retirement obligations piece is likely to be the most difficult.  However, we still believe that with careful and conservative selection, municipal bonds can be a meaningful contributor to a portfolio's performance. 

*fund flow statistics from the Investment Company Institute

Dividends will maintain their favorable tax treatment at 15% and long-term capital gains will also continue to be taxed at 15%. 

The tax deal also included a new estate compromise provision that creates an estate tax exemption of $5 million per person (which would be about $10 million per married couple) and then a top tax rate of 35% on amounts transferred above the exemption.   

Because of the new estate tax provisions, you may want to consider checking in with your estate planning attorney to ensure that the new law doesn't significantly impact your estate plans. 

And for those of you who make gifts to children or grandchildren each year, the annual gift tax exclusion amount remains at $13,000 per recipient.  That means you can make a gift of $13,000 to any person and not be subject to a gift tax on the transaction and the recipient doesn't pay any tax on the receipt of the funds.  The exemption is per person, so if you're married, both you and your spouse could each make a $13,000 gift to the same person, for a total transfer of $26,000. 

  
  Fred Taylor

  Charlie Farrell 
  Dick Kopp

Disclosure and Disclaimer:  The content in this email does not constitute tax or legal advice.  Consult your individual tax or legal advisor.  Past performance is no guarantee of future returns.  Investing involves multiple risks, including but not limited to the risk of loss of principal.