The Muni OpinionFebruary 2012

Bond investing in a low-yield world

Over the past year muni prices have risen and yields have dropped. Have we changed our position on munis? Yes! What worked last year will likely not work this year.

The U.S. Federal Reserve Board (Fed) intends to keep its target federal funds rate extraordinarily low until at least late 2014, thereby anchoring U.S. Treasury yields for an eon, as measured in trader years.1 When a central bank maintains ultra-low rates for extended periodsa practice some call financial repressionit denies investors the ability to earn a reasonable yield on their government securities. This can be viewed as a form of taxation on savers and investors. Predictably, it motivates investors to look elsewhere for returns. The beneficiaries of low U.S. Treasury yields recently have included highyielding equity stocks, corporate bonds and munis. Muni investors now face an important decision: Having seen yields decline and prices run up, what should we do? The answer, we believe, stems from the role we want munis to play in our investment portfolios.

DIFFERENT TYPES OF INVESTORS As shown at the top of page 2, a year ago muni yields were unusually high, attracting nontraditional buyers of munis such as hedge funds and other institutional investors who wanted exposure to an asset class that had apparently become dislocated from fundamentals. AUTHORS

Philip G. Condon, head of municipal bond portfolio management, DWS Investments Carol L. Flynn, CFA, head of municipal bond research, DWS Investments Ashton P. Goodfield, CFA, head of municipal bond trading, DWS Investments Anthony Parish, CFA, investment strategy analyst, DWS Investments

Investment products: No bank guarantee I Not FDIC insured I May lose value

MUNI YIELDS2010 TO 2011 6% Yields were unusually high one year ago 5%

4% They made a round-trip over 14 months 3% 05/10 05/11 12/09 01/10 02/10 03/10 04/10 06/10 07/10 08/10 09/10 10/10 11/10 12/10 01/11 02/11 03/11 04/11 06/11 07/11 08/11 09/11 10/11 11/11 12/11 $25 $20 $15 $10 $5 $0 $5 $10 $15 $20 $25 10/11 11/11 12/11

Bond Buyer 20-Bond GO Index

Source: Bond Buyer as of 1/26/12. Performance is historical and does not guarantee future results. The Bond Buyer 20-Bond GO Index is a representation of municipal bond trends based on a portfolio of 20 general obligation bonds that mature in 20 years. The index is based on a survey of municipal bond traders rather than actual prices or yields.

Meanwhile at the beginning of 2011, retail fund investors couldnt get out of their munis fast enough. The blue line in the chart below shows industry muni fund net flows, which plummeted for the first four months of 2011, stayed flat for the next four, and then climbed gradually for the last four months. During those first eight months the cumulative monthly returns of the index, driven mainly by institutional investors, rose to impressive levels. Unfortunately, by the time fund investors warmed again to munis in Q4, they had already missed most of the full years cumulative returns.

There are two lessons from the chart below. First, retail fund investors can be fickle. Second, although fund investors can substantially move the muni market when their collective sentiment is strong, when they overshoot, we have seen the emergence of nontraditional buyers operating with a short-term tactical timeframe. Other traditional muni buyers such as insurance companies and separately managed accounts tend to be relatively more stable in their demand for

MONTHLY RET URNS VS. CASH FLOW 12% 8% 4% 0% 4% 8% 12% 05/11 12/10 01/11 02/11 03/11 04/11 06/11 07/11 08/11 09/11 2011 muni funds cumulative monthly net cash flows (billions, right axis) 2011 Barclays Capital Municipal Bond Index cumulative monthly total returns (left axis)

Source: Morningstar (returns). Investment Company Institute (net flows) as of 12/31/11 This data does not represent performance of any DWS fund.
The Muni OpinionFebruary 2012 2

munis. By contrast, retail fund investors and cross-over buyers occasionally exhibit huge swings in their marginal demand, and their activities tend to be inversely related. Stated differently, nontraditional muni investors serve as a tactical counterbalance when retail investors temporarily misjudge risk. It happened after the Lehman collapse in 2008, and again after the muni Armageddon scare a year ago. For tactical investors, the value of munis is now much lower than it was a year ago. However, for traditional investors who view munis as a source of tax-free income and diversification in their stock and bond portfolios, we believe munis continue to represent decent value at current levels. THE YIELD CON UNDRUM Today, the environment is substantially different from one year ago. Yields have declined, prompting many investors to assume they will spring up again soon. From our perspective, thats not something to bet on. If U.S. Treasury rates remain repressively low, there should continue to be demand for higher-income assets such as munis, all else being equal. The muni market also has a long history punctuated by years and even decades of low yields. True, in January the 3.6% yield of the Bond Buyer 20-Bond GO Index was

lower than any other time since the late 1960s.2 But what is also true is that the yield was around that leveland at times substantially below that levelfor more than 30 years prior to 1966. Yes, those ultra-low years coincided with different tax regimes than what we have today. But then again today we have different activitiessuch as those by the Fed discussed abovethat could keep the yields low for longer periods than many investors expect. Please note, we are not saying we believe muni yields will stay low or go lower. This is not a call on interest rates. Sure theyre low, but they could stay range-bound for a long time, or go lower, or possibly go higher. We are simply saying there is uncertainty regarding the movement of muni rates. As such, we dont believe muni investors should attempt to manage their portfolios based on their predictions of what interest rates will do. History has repeatedly shown the folly of such efforts. Just ask investors who one year ago bet the 10-year U.S. Treasury yield would be 4% right now. Instead, we recommend investors follow the timehonored tradition of owning the investments that represent good value, however defined, and maintaining a balanced portfolio.

MUNI YIELDS 14% 12% 10% 8% 6% 4% 2% 0% 2/1/1928 3/2/1950 9/8/1955 1/2/1975 3/26/1905
2/1/1940 5/29/1947

12/4/1952

6/12/1958

3/16/1961

9/22/1966

6/26/1969

3/30/1972

10/6/1977

7/10/1980

4/14/1983

1/16/1986

7/25/1991

4/28/1994

1/30/1997

11/4/1999

8/8/2002

5/12/2005

12/19/1963

10/20/1988

2/14/2008

Bond Buyer 20-Bond GO Index yield

Current level (1/26/2012)

Low level (2/28/1946)

Source: Morningstar as of 12/31/11. Performance is historical and does not guarantee future results. The Bond Buyer 20-Bond GO Index is a representation of municipal bond trends based on a portfolio of 20 general obligation bonds that mature in 20 years. The index is based on a survey of municipal bond traders rather than actual prices or yields.This data does not represent performance of any DWS fund.
The Muni OpinionFebruary 2012 3

11/18/2010

TO REACH, OR NOT TO REACH? Investors who have seen their yields decline may be tempted to maintain high yields by increasing the riskiness of their allocations. Were not a member of that club. We tend to orient ourselves toward risk first, yield second. In other words, we prefer to build our portfolios around what we believe is the right level of risk as opposed to the right level of yield. In fact, if yields get unusually low, we may view that as a signal to become very conservative in our allocations. However, were not there yet. Although the absolute yields of municipal bonds are low, credit spreads are still wider than average and the muni yield curve is still steeper than average.3 We believe the risk/reward trade-off in replacing a 5-year AAA muni with a well-chosen 20- or 25-year A or BBB muni, for instance, continues to be favorable.4 By historical standards, the current compensation-per-unit-of-risk favors some risk taking. Also, certain bond structures, such as premium-priced cushion or kicker bonds, offer good value in the lowyield world. Some of them offer relatively high coupons as well as structures that have a defensive bias should interest rates creep up. For more information, see our November 2010 Muni Opinion Structuring a Defensive Portfolio.

We also place a premium on liquidity. We remain vigilant and nimble in our allocations, and that means favoring the larger muni issues which trade relatively frequently and whose prices should hold up if we decide we want to exit our positions quickly. SHIFT ALLOCATIONS AS VIEWS SHIFT This last point is driven home by our assessment that what worked last year may not work again this year. Last year, the longest durations reigned.5 Long-term funds comprised the best performing Morningstar Muni National Long category with an average return of 10.64%. Rarely do we see a year in which theres a true linear relationship between duration and return across the entire yield curve. (By the way, these returns were almost a mirror image of what we saw during the sell-off of late 2010). Another type of strategy that worked well last year was the levered closed-end muni fund. Funds in the Morningstar Closed-End Muni National Long category returned an average of 18.11%. For traditional investors looking to put money to work now, we would not advocate buying ultra-long funds or levered closed-end funds as their core positions. After their run-ups last year, those types of funds could exhibit high levels of volatility.

2011 TOTAL RETURNS 16% 14% 12% 10% 8% 6%

14.88% 13.98% 12.64% 12.32% 10.14% 1.58%

4% 2% 0%

6.93%

Municipal Long 22+Yr

Municipal 20Yr

Municipal 15Yr

Municipal 10Yr

Municipal 7Yr

Municipal 5Yr

Municipal 3Yr

3.46%

Municipal 1Yr

Source: Morningstar as of 12/31/11. Please see page 5 for index and category definitions. Performance is historical and does not guarantee future results. This data does not represent performance of any DWS fund.
The Muni OpinionFebruary 2012 4

Also, be wary of bonds trading at significant discounts to par. After the big run-up last year, significant discounts may be red flags for credit problems. There may be something quirky about a bond that has resulted in an anomalous mispricing, but we would view that as an exception to the rule. One year ago that wasnt necessarily the case, when short-term panic was weighing down prices. There are times for bond pickers to get very aggressive but this is not one of those times. At this point of the credit cycle we seek positions that offer relatively attractive after-tax income with muted volatility.

In summary, be nimble, take some risk but avoid the extremes, and accept that we could be in a low-yield world for a long time. As appropriate, look to diversify your income sources with munis, taxable fixed income, dividend-yielding stocks, etc. Although the Feds extraordinarily low rates may fuel demand for risk assets, they may also exacerbate volatility, leading to sudden, painful market reversals. Balance is key.

INDEX AND CATEGORY DEFINITIONS The Barclays Capital 1-Year Municipal Bond Index tracks the performance of investment-grade municipal bonds with maturities between one and two years. The Barclays Capital 3-Year Municipal Bond Index tracks the performance of investment-grade municipal bonds with maturities between two and four years. The Barclays Capital 5-Year Municipal Bond Index tracks the performance of investment-grade municipal bonds with maturities between four and six years. The Barclays Capital 7-Year Municipal Bond Index tracks the performance of investment-grade municipal bonds with maturities between six and eight years. The Barclays Capital 10-Year Municipal Bond Index tracks the performance of investment-grade municipal bonds with maturities between eight and 12 years. The Barclays Capital 15-Year Municipal Bond Index tracks the performance of investment-grade municipal bonds with maturities between 12 and 17 years. The Barclays Capital 20-Year Municipal Bond Index tracks the performance of investment-grade municipal bonds with maturities between 17 and 22 years. The Barclays Capital Municipal Long Bond Index tracks the performance of investment-grade municipal bonds with maturities of more than 22 years. Morningstar Muni National Long category is comprised of funds that invest in bonds issued by various state and local governments to fund public projects. The income from these bonds is generally free from federal taxes. To lower risk, these portfolios spread their assets across many states and sectors. These portfolios have durations of more than 7.0 years (or, if duration is unavailable, average maturities of more than 12 years). Morningstar Closed-End Muni National Long category is comprised of closed-end funds that invest in bonds issued by various state and local governments to fund public projects. The income from these bonds is generally free from federal taxes. To lower risk, these portfolios spread their assets across many states and sectors. These portfolios have durations of more than 7.0 years (or, if duration is unavailable, average maturities of more than 12 years).

The Muni OpinionFebruary 2012 5

The federal funds rate is the interest rate, set by the U.S. Federal Reserve Board, at which banks lend money to each other, usually on an overnight basis. The Bond Buyer 20-Bond GO Index is a representation of municipal bond trends based on a portfolio of 20 general obligation bonds that mature in 20 years. The index is based on a survey of municipal bond traders rather than actual prices or yields. Credit spread is the spread between Treasury securities and non-Treasury securities that are identical in all respects except for quality rating. The yield curve is a graphical representation of how yields on bonds of different maturities compare. Normally, yield curves slant up, as bonds with longer maturities typically offer higher yields than short-term bonds. Credit quality measures a bond issuers ability to repay interest and principal in a timely manner. Rating agencies assign letter designations such as AAA, AA and so forth. The lower the rating, the higher the probability of default. Credit quality does not remove market risk and is subject to change. Duration, which is expressed in years, measures the sensitivity of the price of a bond or bond fund to a change in interest rates.

This article is not intended to provide tax or legal advice and should not be relied upon as such. Any specific tax or legal questions concerning the matters described in this article should be discussed with a tax or legal advisor. DWS Investments, including its subsidiaries and affiliates, does not give tax or legal advice. The opinions and forecasts expressed herein are those of the authors, do not necessarily reflect those of DWS Investments, are as of 2/6/12 and may not come to pass. This information is subject to change at any time, based on market and other conditions, and should not be construed as a recommendation of any specific security. The analysis stated herein represent the views of Private Clients and Asset Management, and not other divisions of Deutsche Asset Management or Deutsche Bank AG, which may recommend different courses of actions for its clients or own accounts. IMPORTANT RISK INFORMATION Bond investments are subject to interest-rate and credit risks. When interest rates rise, bond prices generally fall. Credit risk refers to the ability of an issuer to make timely payments of principal and interest. Although municipal bond funds seek income that is federally tax-free, a portion of their distributions may be subject to federal, state and local taxes, including the alternative minimum tax. Credit quality is a measure of a bond issuers ability to repay interest and principal on time and is subject to change. Rating agencies assign letter designation such as AAA and AA. The lower the rating, the higher the probability of default. Credit quality does not remove market risk. See the prospectus for details.

OBTAIN A PROSPECTUS To obtain a summary prospectus, if available, or prospectus, download one from www.dws-investments.com, talk to your financial representative or call (800) 621-1048. We advise you to carefully consider the products objectives, risks, charges and expenses before investing. The summary prospectus and prospectus contain this and other important information about the investment product. Please read the prospectus carefully before you invest. Investment products offered through DWS Investments Distributors, Inc. Advisory services offered through Deutsche Investment Management Americas, Inc. DWS Investments is part of Deutsche Banks Asset Management division and, within the U.S., represents the retail asset management activities of Deutsche Bank AG, Deutsche Bank Trust Company Americas, Deutsche Investment Management Americas Inc. and DWS Trust Company. DWS Investments Distributors, Inc. 222 South Riverside Plaza Chicago, IL 60606-5808 www.dws-investments.com inquiry.info@dws.com Tel (800) 621-1148

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