Volume 2, Issue 1

Portfolio Advisory
February 27, 2008

Risks Worth Taking: Long-Term Municipal Bonds

Over the past month the previously highly efficient municipal auction rate market has ceased to function as a reliable source of liquidity for investors or as a cost-effective source of variable rate financing for issuers. This disruption, which is a liquidity issue and not a credit issue, stems from a confluence of events with origins in the sub-prime mortgage markets. This disruption has broader implications for the municipal market such as an unwinding of the increased use of leverage which impacted the shape of the yield curve and related investment performance. The real opportunity in the municipal market is not so much in the short end of the market by purchasing failed high max rate auction securities, but the ability to capture and lock in higher yields on longer- term tax-exempt bonds at yields above 5%. To gain a better understanding of the current market environment it is useful to review in broad terms events in the fixed income markets over the past year. At the epicenter was the deterioration of the sub-prime mortgage market which led to credit deterioration and sharp price decreases for asset-backed securities such as Collateralized Debt Obligations (CDOs) and/or Structured Investment Vehicles (SIVs). Reductions in valuations of the underlying assets in such structures had a negative impact on many asset-backed commercial paper issues, many of which carried the highest ratings. These credit and valuation issues had a negative impact on cash-management programs of corporations who held such issues. Devaluation also hurt the monoline bond insurers who wrapped guaranteed timely payment of principal and interest on many now-distressed structures. As conditions in the sub-prime mortgage market continued to deteriorate, monoline insurers potential losses grew and, consequently, the insurers were put on negative credit watch by the rating companies. This concerned many individual and institutional investors in the

This document contains information and material prepared by employees of the Portfolio Advisory group within the Private Investment Management Division. It is not a product of Lehman Brothers Fixed Income Research Department. Any observations or views expressed herein are subject to change without notice, and may differ from, or be inconsistent with the views of Lehman Brothers research analysts. Lehman Brothers Inc. and/or its affiliates may have a position in the instruments discussed in this report. The firms interests may conflict with the interests of an investor in those instruments.

Fixed Income Insights |

February 27, 2008

municipal bond market. The chance that one or more of the bond insurers would be downgraded was especially troubling to some corporate treasurers operating under investment guidelines requiring minimum ratings on purchases. News stories about corporate treasurers being terminated due to investments in assetbacked commercial paper of now-distressed SIVs frightened others with similar responsibilities and there was a move to liquidate issues exposed to bond insurer downgrades. Add in selling by individual investors reacting to the negative press on the bond insurers and it lead to a market with more sellers than buyers. None of this would necessarily be a problem if the yields on auction-reset municpals were allowed to rise high enough to attract buyers at par. But auctions are subject to maximum rates or caps on the highest interest rate the bond would pay. An alternative solution, albeit one less attractive for current holders, would allow a secondary market to be established where investors may ask for a bid or offer auction securities. Such markets are starting to develop for accredited investors on restricted securities trading systems, but in the mean time auctions are failing and current holders who wish to sell are left with no viable alternatives.

Deconstructing ARS
At this point it is useful to deconstruct a municipal auction rate security. A municipal auction rate security has three parts: i) a municipal obligation, ii) generally an insurance wrap, and iii) a market-based pricing and liquidity function.

Municipal Credit
As previously mentioned the current problems in the auction market are of liquidity not credit. From a credit perspective there is little difference if a municipal bond is issued as a fixed rate or floating-rate bond. The credit quality is still that of the underlying municipal issuer. Overall, municipal bonds have a historical default rate of 0.1% with investment-grade municipal bonds having a default rate of 0.06% according to a Moodys special report dated March 2007. That same report states that corporate bonds have an overall default rate of 9.6% with investment-grade issues having a default rate of 2.08%. Investors often forget that the 50 States are sovereign credits. States and local governments do not go out of business. Recent stress in the credit quality of the monoline bond insurers due to the sub-prime meltdown has scared many investors. With close to 50% of newly issued municipal bonds being insured over the past decade, as well as a significant amount of secondary insurance being applied to municipal bonds, many investors mistakenly view the insurers as the credit strength of the municipal market instead of the underlying governmental issuers. Unintentionally, Moodys assists in this misperception by using two different rating scales: one for municipal bonds and another for the rest of the world known as Moodys Global Scale Ratings (GSR). When municipal bonds ratings are mapped to the GSR most municipal bonds receive increases in their ratings by several increments, particularly state general obligations, local general obligations, essential service revenue bond issues such as water and sewer, as well as state agency debt. An A1-rated state general obligation would receive a rating of AAA on the Moodys GSR. The other major rating companies have not publicly admitted that they apply different rating scales to municipal and corporate credits, but, given the differences in default experience between corporate and municipal bonds, it is clear that their approach is similar to Moodys. 2

Note: Opinions expressed herein are subject to change without notice.

Fixed Income Insights |

February 27, 2008

The Insurance Wrap

This nuance in rating supports our perspective that most municipal bonds have stronger credit quality than the insurers in good times and, in todays stressed credit environment, municipal issuers are significantly stronger than the insurers. Hence, insurance has little value other than making a diverse market of 50,000+ issuers a little more commoditized, which aids the liquidity of smaller lesser-known issues.

The Rate-Setting Mechanism

Municipal auction rate securities are long-maturity, variable-rate bonds. Rates are reset, usually weekly or every 35 days, through one of two mechanisms: a Dutch auction or at maximum rate. In the Dutch auction process buyers bid a rate at which they want to own the security. The interest rate or level where buying interest is sufficient to cover selling interest is the level or rate that all holders, existing and new, receive until the next auction. Previous holders who entered sell orders into the auction get taken out a par. This process has worked very efficiently for several decades until recently. Due to the negative press on the monoline insurers credit quality there have been more sellers than buyers at yields at or below the maximum rate, which have led to what is know as a failed auction. A failed auction is not a default by the issuer, which is generally a strong quality municipal issuer as described above, but an imbalance of sellers and buyers. This is the liquidity issue at hand. The Dutch auction process is a market-based pricing and liquidity function and, during times of extreme market stress, such as what we have been experiencing for the past year, the possibility of failed auctions increases. Over the years, the dealers managing the auctions would step in and commit their own capital in order to clear the market, although they were not required to do so under the broker/dealer agreements. But the sheer size of the imbalances between sellers and buyers, as well as dealers capital constraints which have been under tremendous pressure, has for the most part removed the dealer / remarketing agent from committing further capital to support these auction programs. When auctions fail, the rate received by holders is based on a predetermined rate that is established at the time of the underwriting and can be found in the prospectus. The rate may be a fixed rate or it may be formulaic based upon a percentage or spread to a well-established reference rate such as LIBOR. The rate may also change according to the current rating of the issuer and/or the rating of the credit support provided by the insurer. The fail rate which is often referred to as the max rate, was intended as a penalty rate for the issuer and is higher than interest rates available through other financing mechanisms in the municipal market such as fixed-rate bonds or variable-rate demand obligations. From an issuers perspective, continuously failing auctions are not a good thing as they are paying a higher interest rate for their issue than they have to. Logic would dictate that the issuer will act in time to no longer pay a higherthan-market-rate, most likely by calling the auction rate issue and refinancing the obligation in some other form. There have been numerous news stories about issuers doing just that, refinancing their auction issues into fixed-rate mode. The Treasury Department has recently provided some relief and guidance to municipal issuers who have variable-rate debt outstanding, including auction-rate debt, to make it easier for them to refinance. This should, over time, reduce the supply of auction-rate securities and increase the supply of longer-term municipal debt.

Note: Opinions expressed herein are subject to change without notice.

Fixed Income Insights |

February 27, 2008

If You Are a Buyer

As the number of failed auctions increased, opportunistic buyers of auction-rate securities, attracted by high max rates, started participating in auctions. As a result, fewer auctions are failing providing some, albeit minor, improvements in liquidity for high max-rate issues. This may be short-lived as tax season selling pressures may overwhelm the new opportunistic buyers. Opportunistic-buyers of auction rate securities include hedge funds, long-term municipal bond mutual funds, as well as individual taxpayers who do not need liquidity. Entering the market at this time is easy. Getting out could be much harder. So the decision needs to be considered carefully. Opportunistic buyers need to be thoughtful about portfolio construction and how long the illiquidity could last. It could be a long time before a reliable exit is available, and new buyers must be prepared for that. Of critical importance, therefore, are (i) (ii) (iii) (iv) (v) Absolutely no need for liquidity The underlying credit quality of the municipal issuer without the insurance wrap, The max rate on each issue, Concentrations with respect to issuers, as well as Exposure to any single auction.

Diversification is a risk-management tool and should be applied across all sub-sectors of an asset allocation. New buyers should also have realistic expectations about the available yields; there have been several news stories of 20% yields on failed auctions. Such rates are rare and, while they might have been achieved in the darkest days, weeks ago, with many new buyers coming in and bidding on high max rate issues, those auctions are not failing as often and are trading at lower yields than their respective max rates. Issuers with high max rates also have the greatest incentive to refinance and take the issue out of the market reducing the supply of high-quality high max rate issues. There is, however, a reasonable supply of high single-digit tax-exempt yields on high quality, albeit illiquid, paper. Focusing exclusively on issues with double-digit max rates may mean missing any opportunity at all. Given the current illiquidity, a reasonable yield benchmark would be the level at which a fixed-rate, uninsured bond of the same underlying issuer is trading to its stated maturity. That is, if issuer Xs bonds that mature in 2025 are trading at 4.75%, then Xs auction-rate bonds maturing in 2025 should not trade at a much higher yield than 4.75% because they are the same credit quality and maturity. Any excess yield due to max rates would reflect a fear of the unknown yield premium. However, the possibility that issues would be called and refinanced if yields stay at the max rates and/or the potential for liquidity to return in time would bode for yields on auction rates to be lower than where Xs 2025 bonds are currently trading to maturity. The way this market normalizes itself is through a combination of actions on both the supply and demand sides. Remember that the issue here is an imbalance where there are more sellers than buyers. On the supply side, issuers refinancing auction-rate debt into either fixed rate or VRDN (variable rate demand note) modes, thus reducing the available supply of auction-rate securities, lessens selling pressures. On the 4

Note: Opinions expressed herein are subject to change without notice.

Fixed Income Insights |

February 27, 2008

demand side new, longer investment horizon, buyers enter the market also absorbing selling pressure. At the same time, recapitalization of the monoline insurance companies, such as the reported potential rescue of AMBAC this week, would prevent further rating downgrades and reduce forced liquidations due to investment guideline constraints. Based upon observable reports in the financial press, it appears that such actions are taking place and that, in time, this market will reach equilibrium. However, no one can say how long this will take.

Broader Market Implications

The implications of monoline downgrades and a disorderly short-term market for the broader municipal market may be significant. While this is not a credit event it most likely will increase the available supply of longer-term bonds in a weak-demand environment, potentially steepening the yield curve as longer-term yields move higher. This is the real opportunity in the municipal market. Over the past 10 years there has been a steady increase in the use of leverage among investors in the municipal market. This is found in low-levered closed-end municipal bond funds, highly levered municipal total return funds, global macro hedge funds, insurance companies and broker/dealers. Closed-end mutual funds issue auction rate preferred stock to gain leverage. Auctions for these issues are also failing in large numbers because these preferred shares generally carry relatively low max rates. The other borrowers utilize tender option bond (TOB) programs to fund their leverage. Historically the municipal market has had a consistent positively sloping yield curve where one can borrow at low short-term rates while investing in higher-yielding long-term issues and capture a positive spread. This positive arbitrage and the use of leverage increased demand for longer-term municipal bonds flattening the yield curve. A significant amount of the levered exposure in the municipal market involved insured bonds. For municipal money market funds, insured variable-rate demand notes (VRDNs) have played a significant role. The current problem is that in order for a VRDN to be eligible for purchase by a money market fund, it must carry a long-term rating of AA- or better. With several bond insurers now rated below AA- and others still on negative credit watch, money market funds have been selling insured VRDNs whose underlying rating is below AA-. This selling pressure has resulted in higher yields on insured VRDNs with lower underlying ratings reducing the economics of leverage. It has also had the effect of reducing yields on tax-exempt money market funds to very low levels, both absolutely and relative to taxable cash yields. Taxpayers with money in municipal money market funds should be checking their yields to see whether they may be better off in a taxable fund. This may not appear to be significant by itself but, when institutional investors start to unwind structures employing leverage of 5 to 10 times or more and auction-rate issuers start to refinance by issuing new longterm bonds there is potentially a significant amount of supply entering a market with weak demand. This de-leveraging is already occurring and has caused the yield curve to steepen, as longer term yields move higher and tax-exempt money market yields move lower. This is having a material effect on investment performance for longer-term holdings and should be viewed as a buying opportunity for investors to lock in higher longer-term rates. In our view, longer-term municipal bonds offer compelling value when yields on higher-quality issues start to exceed 5%. The taxable equivalent, assuming a 35% federal tax rate and a 6% state tax rate, would be approximately 8.2%, close to our median estimated equilibrium return on equities. Given the seasonal 5

Note: Opinions expressed herein are subject to change without notice.

Fixed Income Insights |

February 27, 2008

weakness of the municipal market during tax time and the issues surrounding the market, the next few months may very well be an attractive entry point to go long municipal bonds outright. Municipals are already attractive relative to other fixed-income investments and with yields now above 5% for many quality issuers, including AAA-rated PSF school bonds, we are recommending that investors be opportunistic and extend maturities capturing higher longer-term yields. For the first time in several years the Estimated Probability Weight Average Return analysis, displayed in Exhibit 1, shows that longer-term maturities have more attractive return profiles than shorter-term maturities. Due to the credit issues of the insurers and the recommendation to focus on issues with A-rated or better underlying ratings, this months analysis includes A-rated municipal bonds. Return profiles for municipal bonds are significantly more attractive at this time then they were in December as displayed in exhibit 2. We recommend that investors continue to focus on general obligation and essential service issues with A or better underlying ratings. For intermediate-term maturities higher-coupon bonds structures are preferred. Income-oriented investors may want to focus on longer-term higher-coupon issues with 8- to 10-years of call protection. Investors looking for capital appreciation as well as income may consider longer-term coupon structures trading below par, such as 4.5% to yield 5% at a value approximating $92. When comparing to a 5% par bond the current yield on the 4.5% is only 11 basis points lower, but there is greater potential for appreciation should the market normalize to where treasury yields are currently trading. While many investors view the disruption in the auction market to be an opportunity to earn high yields this phenomenon will be relatively short-lived from an investment horizon perspective. The real opportunity may be the collateral devaluation of longer-term, high-quality issues due to the deleveraging of the market. Locking in longer-term tax-exempt yields above 5% may be the better investment opportunity. Buy Mortimer, Buy

Adam Topalian Fixed Income Strategist 212.526.8060 adam.topalian@lehman.com

Note: Opinions expressed herein are subject to change without notice.

Fixed Income Insights |

February 27, 2008

Exhibit 1: Estimated Probability Weighted Average Returns

Return 9%

6%

3%

0%

(3% ) 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Maturity Years AAA Municipal AAA Municipal TEY @35% FTB UST A Municipal USA A Municipal TEY @ 35% FTB

Source: Lehman Brothers

7
Exhibit 2: Estimated Probability Weighted Average Return Comparison 12/2007 vs. 2/2008 (TEY @ 35% FTB)
Return 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Maturity Years AAA Municipal 12/11/2007 AAA Municipal 2/27/2008 A Municipal 12/11/2007 A Municipal 2/27/2008

Source: Lehman Brothers

Note: Opinions expressed herein are subject to change without notice.

Fixed Income Insights |

February 27, 2006

Investment Management comprises the following: "Lehman Brothers" and "Neuberger Berman" are marketing names used by Lehman Brothers Holdings Inc. and its subsidiaries worldwide, including Lehman Brothers Inc. and Neuberger Berman, LLC. Investment Services, Portfolio Advisory, Wealth Advisory, Capital Advisory, and the Institutional Client Group are services provided by Lehman Brothers Inc. ("LBI"), a broker dealer, member SIPC and a registered investment adviser. Neuberger Berman Private Asset Management is a service provided by Neuberger Berman, LLC, ("Neuberger Berman") a broker dealer, member SIPC and a registered investment adviser. Neuberger Berman Funds are distributed by Neuberger Berman Management Inc., a broker dealer and registered investment adviser. Lehman Brothers Asset Management is the marketing name used by Lehman Brothers Asset Management Inc. ("LBAM"), a registered investment adviser and commodity trading advisor, Lehman Brothers Alternative Investment Management LLC ("LBAIM"), a registered investment adviser, Lehman Brothers Asset Management LLC, a registered investment adviser, and Neuberger Berman. Absolute Return Strategies is the marketing name for products provided by LBAM, LBAIM, Neuberger Berman and affiliated investment advisers. Private Equity is part of LBI. All of the aforementioned entities are affiliated companies. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. Information in this document has been obtained from various sources; we do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they produce may fluctuate and / or be adversely affected by exchange rates, interest rates, or other factors. Additional information will be provided upon request. Model, backtested, simulated and hypothetical results are subject to high levels of uncertainty regarding future economic and market factors that may affect actual future performance. Accordingly, such data should be viewed as merely representative of a broad range of possible returns. The data shown herein should not be construed as providing any assurance or guarantee as to returns that may be realized in the future from investments in any asset or asset class described herein and may not be representative of how we will manage any of our portfolios or allocate funds to such asset classes. Past performance may not be indicative of future results. Lehman Brothers Inc. and / or its affiliated companies may make a market or deal as principal in the securities mentioned in this document or in options or other derivatives based thereon. In addition, Lehman Brothers Inc., its affiliated companies, shareholders, directors, officers and / or employees, including persons involved in preparation or issuance of this material, may from time to time have long or short positions in such securities or in options, futures, or other derivative instruments based thereon. One or more directors, officers, and / or employees of Lehman Brothers Inc. or its affiliated companies may be a director of the issuer of the securities mentioned in this document. Lehman Brothers Inc. or its affiliated companies may have managed or co-managed a public offering of securities for any issuer mentioned in this document within the last three years. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers Inc. 2008 Lehman Brothers Inc. All rights reserved. Member SIPC.