GSAM s Perspectives on Municipal Bonds

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1 Fixed Income March 2011 Ben Barber Head of Municipal Asset Management David Alter Head of Municipal Research GSAM s Perspectives on Municipal Bonds Municipal bond markets started the year under considerable pressure. Speculation over the fallout from budget problems has driven market volatility as state and local authorities work to cut spending and repair the damage left by the recession. To bring context to the budget problems and their market impact, we talked to Goldman Sachs Asset Management s head of municipal asset management Ben Barber and head of municipal research David Alter. We have heard a lot in the media about the potential for a wave of defaults across US state and local governments. Is this a material risk in your view? Alter: We don t believe the US will see a significant increase in defaults at the state or local government levels. It s true that state budgets are severely strained; some much more so than others. This was a very deep recession, and financial adjustments are likely to be painful and protracted, particularly in states with more divisive political processes. A pickup in one-off defaults among municipal issuers is possible, but we reject the wave of defaults scenario expounded by the most vocal market skeptics, for three key reasons. First, this is a diverse market, covering 50 states and tens of thousands of local issuers, of which only a handful the most distressed dominate headlines. So we believe the broad brushstrokes view is misleading. Second, that view overstates the extent of budget shortfalls. Most states entered this recession with healthier reserves than they had leading into prior downturns. Even now, reserve fund balances are on average around their historic norms, and approximately half of states pension plans are adequately funded, according to official standards. 1 Third, states are clearly willing and able to address their deficits. The alternative, Chapter 9 bankruptcy, is inefficient and politically unpalatable. The city of Vallejo, California, filed in 2008 sparking talk of a wave of bankruptcies that didn t materialize. In bankruptcy, Vallejo is still working through an arbitration process that hasn t solved the problems with its pensions system. Meanwhile, state governors have made headway in cutting spending and tackling pension reforms. We believe these efforts are likely to continue across the country for the foreseeable future. Federal support has helped tide states and local governments over, as has been the case in downturns since the Great Depression. Most importantly, as that support winds down, we anticipate revenues and growth will gradually fill the breach. Nationally, the latest figures on state revenues indicate a fourth 1 Government Accountability Office This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures.

2 consecutive quarter of growth in 2010, and this trend appears to be continuing in For example, general fund revenues in the State of California were 17.7% higher on the year in January, and in Texas, sales tax receipts in January posted a healthy 10.4% annual increase. 2 You say states have made headway in repairing their finances. What measures have they taken, particularly with regard to the main problem of underfunded pension plans? Alter: Pension reform is perhaps the most important issue for states to address in correcting their long-term budget problems. First we should address misconceptions about the size of funding shortfalls, and contest the broad brushstrokes view. The more extreme estimates of pension funding gaps measure the shortfall from 100%, instead of the 80% level deemed adequate by the US Government Accountability Office. More than half of state pension plans are funded above 80%. Even if that funding level were as low as 65-75%, we would anticipate no substantial threat to that fund s ability to make pension payments for at least the next 15 years. Most importantly, though, states are taking action on pension reform. Last year, 19 states implemented changes, such as reducing benefits, increasing employee contributions and/or raising the retirement age. We expect this trend of reforms to continue. And while state and local governments may have been slow to react to the sharp revenue declines that came with the recession in 2009, many have since made substantial adjustments. These include changes to organizational structure and budget processes, as governments consider ways to streamline their administrative functions. In terms of budget and spending cuts, we believe a lot of work remains to be done for some states, while others are better positioned. Typically states overspend in boom periods, well beyond their growth rates. The period up to 2007 was no exception, but the exceptional depth of the recession means the necessary cuts are more aggressive than in previous downturns. States have made progress, though, with an overall 25% reduction in budgets and spending has shrunk by 11% from its peak in What caused that market upheaval and do you expect volatility to continue? Barber: We saw major price declines across municipal bond markets in the November to January period. 4 Alarming headlines were a factor, but in our view this upheaval was mostly driven by technical factors, rather than a direct result of credit events. The sell-off started with a reversal of exceptionally supportive demand dynamics. In the two years to late 2010, municipal mutual funds experienced heavy inflows in excess of $100 billion. 5 In our view, uncertainty over the global economic backdrop was a driving factor, as municipal bonds have historically offered attractive yields with low risk relative to much of the corporate credit sector. But by November 2010 these supportive demand factors had reversed: confidence in the global growth outlook had rebounded, thanks 2 Texas Comptroller of Public Accounts web site 3 National Association of State Budget Officers The Fiscal Survey of States, Bureau of Labor Statistics, State budget statistics fiscal year Source: Barclays Capital Municipal Bond Aggregate indexes 5 Source: AMG/Lipper US Fund Flows This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures. Goldman Sachs Asset Management 2

3 in part to additional US stimulus. We believe the extension of the Bush tax cuts lowered incentive for investors to take advantage of the tax-exempt municipal markets, and the Fed s quantitative easing boosted demand for risk assets. Corporate bonds have been big beneficiaries, with yields pushing substantially lower. Meanwhile, we have seen Treasury yields which are closely correlated with municipals rise substantially, and resulting declines in net asset values of mutual funds have been a factor in the recent outflows. These factors, in our view, have all weighed on sentiment in municipal bond markets. We believe these conditions are stabilizing, with new buyers coming into the municipals markets, particularly retail and crossover investors, who traditionally invest in corporate bonds. Retail investors are drawn to the price discounts that suggest healthy returns on long-dated municipal debt. Crossover investors are attracted to the uncharacteristically high yields on 30-year municipal bonds relative to Treasury bonds. Municipal bond value is commonly expressed as a ratio of the municipal bond yield over the comparable Treasury yield. This ratio in the case of the 30-year yield peaked at 112% in January, compared a longer-term norm around the low-90% level. 6 We believe, this demand is lending support to the long end of the municipals market that took the brunt of the selloff, and we have already seen yields start to come back from their peaks. In our view, selective buyers should be able to capture the total return benefits of spread tightening as this market normalizes. Which sectors do you consider the most attractive under these conditions, and which are you inclined to avoid? Barber: The price declines we ve seen since November have created buying opportunities across a wide range of municipals sectors. State general obligation (GO) bonds have traditionally been the top tier of the municipals market: they are backed by a judicially enforceable pledge to repay bondholders using the full range of resources at the government s disposal, including tax funds. Nevertheless, investors have become more wary of this sector, because of the budget problems we ve discussed. We see opportunities among GO bonds issued by fiscally conservative states, particularly in the southeast and southwest, with comparatively benign political processes and generally lower labor costs. In our view, though, GO bonds of even the most fiscally challenged states often provide solid risk-adjusted value. The recent dispute in the Midwest reflects a broader battle between government unions and their state capitals. With escalating employment and related costs leading up to the recent recession, many governors and legislatures are looking to significant labor concessions to achieve savings. We expect these pressures to continue for the current states budget cycle, through June 30. We also see solid value in local municipal bonds that are less exposed to the state-level 6 Source: Thomson Municipal Market Data This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures. Goldman Sachs Asset Management 3

4 politics of correcting budget problems. Revenue bonds issued by municipal utilities, such as water and electricity providers, can tend to offer stable income without the noise of a contentious budget process. Utility revenue bonds tend to provide bondholders with strong legal protections that are highly regarded in the current environment. Sales tax bonds have also proven resilient to market turmoil so far, in part because they offer significant excess debt service coverage, well beyond what was needed even in the recent downturn. By contrast, we are reticent to buy bonds of smaller issuers, in cases where the disclosures may be weaker. As discussed, the municipal market is extraordinarily diverse, and investors can be comfortable buying in sectors that they aren t going to read about in the press, provided they have read some research. That said, not all research is equal. The increased appeal of municipal bonds for corporate investors has given rise to more analysis by practitioners unfamiliar with the idiosyncrasies of the municipals markets, in particular the significance of political dynamics. How has the expiry of the Build America Bonds (BAB) program affected the municipals market, and do you see a possibility of that program returning in any form? Barber: The BAB program, which ran from April of 2009 until the end of 2010 as part of the government stimulus package, supported the municipals market at a particularly volatile time. Ratios had reached 188% at the end of 2008, far above the January 2011 peak of 112%. 7 The BAB program created a market in excess of $180 billion, relieving supply pressure in the tax-exempt space. In our view, uncertainty over whether the BAB program would be extended into the new year caused additional pressure for municipal bond markets in the final weeks of Its termination raised concerns that issuance previously diverted to the BAB market might come back into the tax-exempt municipals market. We believe the reinstatement of the BAB program in its original form is unlikely unless dislocations within the municipals market became so severe that high-grade issuers were unable to effectively access the capital markets. That said, there is some momentum towards recreating the BAB program with a lower subsidy rate. Debates on this proposal will be watched closely by municipal market participants. Thank you, Ben and David. 7 Source: Thomson Municipal Market Data This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures. Goldman Sachs Asset Management 4

5 Ben Barber is a managing director and head of GSAM s Municipal Bond Portfolio Management team. Ben joined Goldman Sachs Asset Management in 1999, and is a member of the National Federation of Municipal Analysts and the California Society of Municipal Analysts. David Alter is a managing director and manages the GSAM Municipal Research team. He is responsible for investment decisions for the High Yield Municipal Fund, as well as other mutual funds and accounts managed by the Municipal Fixed Income Team. David joined Goldman Sachs in 1996, and is a member of the Municipal Analyst Group of New York. For more information, please speak with your investment professional. A summary prospectus, if available, or a Prospectus for the Fund containing more information may be obtained from your authorized dealer or from Goldman, Sachs & Co. by calling Please read the summary prospectus, if available, and the Prospectus, which contains a fund s objectives, risks, charges and expenses, and other information about the Fund, carefully before investing. Goldman Sachs Asset Management 5

6 Risk Considerations: The Municipal Income Fund invests in municipal securities, the interest on which is exempt from regular federal income tax. The Fund may include securities whose income may be subject to the federal alternative minimum tax and state income taxes. The Fund may be adversely impacted by changes in tax law rates and policies, and is not suited for IRAs, and other tax-exempt or deferred accounts. Investments in fixed income securities are subject to the risks associated with debt securities including credit and interest rate risk. The Fund also invests a portion of its assets in municipal obligations of issuers located in the State of California, and are consequently affected by political and economic developments within California. The High Yield Municipal Fund invests in high yield municipal securities that, at the time of purchase, are medium quality or noninvestment grade. High yield, lower rated securities involve greater price volatility and present greater risks than higher rated fixed income securities. Non-investment grade securities are considered speculative. The Fund may invest in securities whose income is subject to the federal alternative minimum tax and state income tax. Investments in fixed income securities are subject to the risks associated with debt securities generally, including credit/default risk and interest rate risk. The Fund is non-diversified and may invest more of its assets in fewer issuers than diversified funds. Accordingly, the Fund may be more susceptible to adverse developments affecting any single issuer held in its portfolio and may be susceptible to greater losses because of these developments. Additionally, because the Fund may focus its investments in particular sectors (for example, specific states or specific types of municipal securities), the Fund is subject to greater risk of loss as a result of adverse events affecting those sectors than it would otherwise be. The High Yield Municipal Fund may own a large percentage of any one general or special assessment bond issuance. The Fund may be adversely impacted if the issuing municipality fails to pay principal and/or interest on general assessment bonds, or if the developer, builder or owner of the property on which a special assessment is levied fails to pay that assessment. At times, including during periods of relative illiquidity in municipal credit markets, the High Yield Municipal Fund may be unable to sell certain of its portfolio securities without a substantial drop in price, if at all. Certain shareholders, including clients or affiliates of the investment adviser, may from time to time own or control a significant percentage of the Fund s shares. Redemptions by these shareholders may impact the Fund s liquidity and NAV. The Fund may be adversely impacted by changes in tax law rates and policies, and is not suited for IRAs and other tax-exempt or deferred accounts.

7 Additional Disclosures: Opinions expressed are current opinions as of the date appearing in this material only. No part of this material may, without GSAM s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient. Past performance is not indicative of future results, which may vary. The value of investments and the income derived from investments can go down as well as up. Future returns are not guaranteed, and a loss of principal may occur. This material has been prepared by GSAM and is not a product of the Goldman Sachs Global Investment Research (GIR) Department. The views and opinions expressed may differ from those of the GIR Department or other departments or divisions of Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This information may not be current and GSAM has no obligation to provide any updates or changes. Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. We have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. Goldman, Sachs & Co. is the distributor of the Goldman Sachs Funds 2011 Goldman Sachs. All rights reserved. Date of first use: March 07, MF.MED.OTU / FI-SI33-MUNI / NOT FDIC-INSURED May Lose Value No Bank Guarantee