2015 Dec Barlcays Muni Primer Dated 2010

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MUNICIPAL RESEARCH 18 October 20

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 28

Municipal Market and Index Primer

The use of broad-based performance benchmarks was initially established in the

equity sector of the capital markets. Within the fixed income arena, the taxable

markets were the first to employ total return indices as a means of performance

evaluation and investment discipline. In September 2008, Barclays Capital bought the

Lehman Brothers Index franchise and continues to develop and apply rules-based

total return indices for the fixed income markets; in fact, approximately 90% of US

institutional investors that subscribe to benchmark management principles use a

Barclays Capital fixed income index.

The municipal market has aggressively adopted the use of total return-based

performance benchmarks. The spread environment has made it more difficult to

distinguish one’s performance relative to peers and provide returns that are in line with

client expectations. Other factors that have increased momentum toward indexing

include an increased reliance on professional money management, the consolidation of

taxable and tax-exempt portfolio management areas, an enhanced focus on asset

allocation, an expanded presence of the consultant community, and the growing use of

quantitative portfolio management theory in the tax-exempt market.

Lehman Brothers began publishing municipal indices in January 1980, and Barclays

Capital now provides total return-based indices to the municipal investment

management community. The municipal market encompasses over 1.2mn issues with

an approximate market value of $2.8trn. This market is as complex as it is expansive,

with optionality, variable rate coupons, principal pay-downs, primary discounts, and tax

implications. Barclays Capital’s municipal indices can be employed to measure aportfolio’s relative total return performance and to enhance a fund manager’s ability to

outperform the market.

The Barclays Capital Municipal Bond Index is particularly useful in measuring the

diverse municipal market. With three quarters of the outstanding issues in the long-

term municipal market containing some type of optionality, the need to analyze this

market from a quantitative perspective is essential. The myriad of structural

idiosyncrasies and the breadth of specialty fund offerings further the need for

quantitative application of relevant performance measures.

This document provides a brief overview of the municipal market, its history over the

past decade, and the indices available through the Barclays Capital index franchise, as

well as the principles behind their construction.

Peter De Groot+1 212 528 1290

[email protected]

Andrew Chan, CFA

+1 212 528 1288

[email protected]

Jormen Vallecillo

+1 212 528 1288

[email protected]

www.barcap.com



Barclays Capital | Municipal Market and Index Primer

18 October 2010 2

Contents

Contents....................................................................................................................................................... 2

Municipal Bond Market............................................................................................................................. 3

Introduction........................................................................................................................................... 3

Municipals over the Past Decade and into 2010 .......................................................................... 7

Performance............................................................................................................................... 7

Tobacco....................................................................................................................................... 7

Airlines......................................................................................................................................... 8

TOB Programs............................................................................................................................ 8

Puerto Rico ................................................................................................................................. 8

The Taxable Municipal Market .............................................................................................. 9

Recent History and Outlook of the Tax-Exempt High-Yield Market ........................................ 9

Municipal Bond Defaults .................................................................................................................. 11

Barclays Capital Municipal Index Design Principles ......................................................................... 13

Sector Hierarchy................................................................................................................................. 14

Index Returns and Statistics ............................................................................................................ 16

Total Return Philosophy ................................................................................................................... 17 Cumulative Returns ........................................................................................................................... 18

Index Evolution ................................................................................................................................... 18

Evolution of the Barclays Capital Municipal Bond Index........................................................... 18

Custom and Mutual Fund Indices .................................................................................................. 20

Historical Measures of Performance in the Municipal Bond Market............................................ 24

Yield....................................................................................................................................................... 24

Peer Group Comparison................................................................................................................... 24

Total Return......................................................................................................................................... 24

Indexing................................................................................................................................................ 24

Asset/Liability Management ........................................................................................................... 25

Tax Treatment of Market Discount, Original Issue Discount, and De minimis for Tax-

Exempts...................................................................................................................................................... 26

Market Discount................................................................................................................................. 26

Taxation of Market Discount........................................................................................................... 26

De minimis........................................................................................................................................... 26

Original Issue Discount..................................................................................................................... 27

Market Discount on an OID............................................................................................................. 27

Taxation of an OID............................................................................................................................. 27




18 October 2010 3

Municipal Bond Market

Introduction

The US bond market can be divided into two major sectors: the taxable bond market

(consisting primarily of Treasury, agency, mortgage-backed, asset-backed, and corporate

bonds) and the tax-exempt market (composed of municipal bonds). In the latter, the

interest from bonds is exempt from federal income taxation and may be exempt from state

and local taxation. Capital gains, however, are still subject to the normal taxation rules that

are applicable. States, municipalities, and counties raise the capital they need by issuing

debt securities referred to as municipal debt securities. Since the majority of municipal debt

securities are tax-exempt, the terms municipal market and tax-exempt market tend to be

used interchangeably. However, with the advent of Build America Bonds (BABs) in April

2009, the label of municipal bond has extended to include taxable issues.

The municipal bond universe is a large, diverse, complex marketplace comprising an

extremely large number of issues with relatively low market value. Other fixed income asset

classes are larger on a market value basis; however, they do not have as many issues as the

tax-exempt market, where the large number of issues enhances an investor’s ability to

diversify by credit quality, sector, and geographical location.

As of June 30 2010, the municipal market contained approximately $2.8trn worth of bonds

outstanding and was represented by 1.2mn CUSIPs with over 45,000 issuers. Over the last 25

years, the total issuance of municipal bonds has increased dramatically as a result of increased

demand for public services, reduced federal funding, and fiscal limitations on pay-as-you-go

funding of capital outlays. Another contributing factor has been the development of creative

new uses for tax-exempt bonds by bond lawyers, public officials, and investment bankers. In

1980, the total new issuance of municipal bonds was $55.3bn. In 2005-09, (excluding notes

and private placement issues), an average of $405.2bn worth of new municipal bonds was

issued per year, with a record $429.9bn in 2007. In 2009, another $409.2bn entered the

marketplace, with 2010’s pace above 2009’s and expected to be near or above record levels.

Municipal bonds may be classified into four main categories: general obligation (GO),

revenue, insured, and pre-refunded bonds. A GO bond is backed by the full faith, credit, and

Figure 1: Indices by Number of Issues (June 30, 2010) Figure 2: Indices by Avg Mkt Value per Bond $mn (June 30, 2010)

Municipal

Index, 46446

Agency

Index, 871

Credit Index,

3978

MBS Index,

1313

ABS Index,

114

Treasury

Index, 180

Treasury

Index,

$26,326.13

Credit Index,

$841.30

MBS Index,

$3,838.62

Agency

Index,

$1,318.78

ABS Index,

$366.75

Municipal

Index,

$26.90

Source: Barclays Capital Source: Barclays Capital




18 October 2010 4

taxation powers of the issuer. For example, a New York State GO bond is backed by the

various taxes that the state levies. These include income, sales, and excise taxes. Counties

and cities tend to rely on property taxes for their GO bonds. The tax base of the issuing

entity and its discretion are important factors in determining the pricing of GO bonds. For

example, certain school districts and counties have a limit on the level of tax they may

charge their residents. The tax base of the issuing city, the growth rate of the local economy,

property values, existing or outstanding debt obligations, and per capita debt are all importantfactors in judging the financial soundness of a GO bond.

Another major category of municipal issuance is the revenue bond sector. These bonds are

issued to fund specific projects, with a portion of the revenue generated from them used to

service the interest payments on the bonds. Typical projects funded by revenue bonds are

bridges, turnpikes, and airports. Rate covenants are usually included in the bond’s indenture

stating that rates will always remain at a level sufficient to cover the interest obligations due

on the bonds. Revenue bonds are further categorized into sub-sectors in our indices,

including housing (e.g., single and multi-family), utility (e.g., public power), health care (e.g.,

hospitals and nursing homes), education (e.g., colleges and universities), industrial

development and pollution control (e.g., corporate obligors) transportation (e.g. toll roads,

airports, and seaports), lease (includes certificates of participation and state appropriation),water & sewer, resource recovery, and special tax.

Before the credit crisis began in August 2007, the insured bond sector was the largest

within the municipal universe. A substantial portion of A-rated or below municipal debt was

brought to the market with some type of credit enhancement or insurance. Insurance on a

municipal bond is an agreement by an insurance company to pay debt service that is not

paid by the bond issuer. The insurance contract assures investors that they will receive

timely payments even if the issuer can not meet its debt obligations. The term of the

insurance is generally for the life of the bond, and investors will suffer a loss of yield in

return for the credit protection, either in the form of a lower original yield or through a fee

paid to the insurer. However, many of the formerly largest insurers in the municipal market

have had their ratings lowered or withdrawn and are no longer active in backing newissuance: American Municipal Bond Assurance Corporation (AMBAC), Municipal Bond

Investors Assurance Corporation (MBIA), and Financial Guarantee Insurance Company

(FGIC). In the past, agencies tended to rate insured municipal bonds at the highest category

of Aaa by Moody’s Investors Service (Moody’s) or AAA by Standard & Poor’s (S&P) and

Fitch Ratings (Fitch). Bonds that are credit enhanced in such a way by a monoline insurer

take on the municipal bond credit rating of the insurer given by the rating agencies.

Currently, there are only two monoline insurance companies with at least an Aa3 (or

equivalent) rating: Assured Guarantee (formerly FSA) and Berkshire Hathaway Assurance.

The fourth major sector of municipal bonds is the pre-refunded sector. GO, revenue, and

insured bonds may be refunded. This usually occurs when the original bonds are escrowed

or collateralized by either US Treasuries specially issued for this purpose (State and LocalGovernment Series, or SLGS) or other types of high quality securities. The maturity schedule

of the securities in the escrow fund is set to pay on a similar schedule to that of the tax-

exempt security. The escrow fund for a refunded municipal bond can be structured so that

the bonds are to be called at the first possible date, a subsequent call date established in the

original bond indenture, or at maturity. The call price usually includes a premium of 1-3%

above par. This type of structure is generally used for those refundings that either reduce

the issuer’s interest payment expenses or change the debt maturity schedule.




18 October 2010 5

There is also a small sector of the municipal universe that has the characteristics of GO and

revenue bonds called double-barreled bonds. These are backed by the full faith, credit, andtaxing power of the municipality, as well as the revenue generated by the project being

financed by the bond.

All municipal bonds can have one of three types of maturity structures. The first is called a

term issue, in which all of the bonds in the issue mature in the same year and the issuer

makes a bullet payment on the last payment date; this type of issuance is popular because

they are actively traded in the secondary markets. These bonds are called dollar bonds

because term issues are quoted in dollar prices. The second type of issue is a serial issue, in

which the bonds are set up to mature successively over many years. It is common for a

serial municipal issue to have ten or more maturity dates. For example, one issue totaling

$100mn may have $25mn worth of bonds mature in 2010, $25mn mature in 2020 and the

final $50mn mature in 2030. The third type of issue is a series issue, in which the issuer

comes to market with a set percentage of the total amount of capital it needs on a schedule

and plans to issue subsequent percentages until all the capital is raised. Municipal bonds

issued in series are often used by large construction projects to stagger the funds required

for the development over the life of the project. Serial and series issues are quoted on a yield

to maturity (or yield to call) basis.

The tax status of municipal bonds attracts a distinct type of investor much different than

those in corporate bonds. Individuals with very high tax brackets tend to favor municipal

securities, as opposed to their taxable counterparts. Similarly, institutions and corporations

that pay taxes at higher effective tax rates will find municipals attractive. Commercial banks,

mutual funds, trust-departments, and property and casualty insurance companies fall into

this category.

Figure 3: Municipal Index Rating Distribution (June 30, 2010) Figure 4: Municipal Index Sector Distribution (June 30, 2010)

AAA

OAD 6.77

30.43%

BAA

OAD 9.94

12.32%

AOAD 9.00

20.88%

AA

OAD 8.59

36.37%

Industrial

3.59%

Resource

Recovery

0.24%Transport

11.75%

Hospitals

7.01%Education

5.77%

REV

OAD 9.26

54.76%

Power

5.61%

Housing

1.82%

General

Obligation

OAD 6.77

15.83%

Insured

OAD 9.04

11.75%

Prerefunded

OAD 3.28

9.53%

Special Tax

7.59%

Lease Rev

4.42%

Water &

Sewer

6.29%

Source: Barclays Capital Source: Barclays Capital




18 October 2010 6

An investor interested in purchasing a municipal bond must be able to compare the tax-

exempt yield of a municipal bond to the after-tax yield earned in the taxable debt securityarena. The following generic formula is used to determine the equivalent taxable yield for

tax-exempt bonds: taxable equivalent yield = (tax exempt yield/(1-marginal tax rate)). An

investor in the 35% federal tax bracket who is a 2010 resident of New York City will have a

combined state, local, and federal effective tax rate of 43.43%. If this investor purchased a

NYC GO bond yielding 4.50%, the equivalent taxable yield would be 7.95%.

Primary offerings of municipal bonds are generally marketed on either a negotiated or a

competitive bid basis. If a negotiated primary offering is used, the issuer and the

underwriting syndicate negotiate the terms that benefit both the issuer and the investor. A

competitive bid issue is awarded to the potential underwriter that submits the best bid on

the issue. The winning underwriter then structures the terms in line with its bid. In both

types of primary offerings, an official statement is written detailing the issue and the issuer.

Over the past ten years, over 80% of the new municipal issues were brought to market by a

negotiated primary offering, about 18% were issued using a competitive bid primary

offering, and less than 2% were brought to market using private placement. More generic,

general obligation issues tend to be brought to market via competitive bidding. Revenue

bond issues, such as housing and health care bonds, are primarily brought to market via a

negotiated basis.

Municipal bonds are traded in the over-the-counter market. Smaller, local issues are largely

traded by regional dealers, local banks, and a limited number of the national brokerage

firms. Larger municipal issues (referred to as general market names) are primarily

supported by larger brokerage firms and banks. The Blue List , a daily publication by

Standard & Poor’s, contains the inter-dealer listings for municipal bonds. The market value

of the bonds available in the Blue List is considered the most accurate indicator of the

supply of bonds available in the municipal dealer community.

Figure 5: Holders of Municipal Debt (December 31, 2009) Figure 6: Holders of Corporate Debt (December 31, 2009)

Brokers and

dealers

1.3%

State and

local gvts

0.3%

Foreign

2.2%

Nonfinancial

corporate

0.6%

Non farm

noncorporate

0.2%

Insurancecompanies

16.5%

Government-

sponsored

enterprises

1.0%

Household

sector

43.6%

Funds (MM,

Mutual,

Closed end,

ETF)

34.4%

Banks

8.4%

REITs

0.2%

Finance

companies

1.8%

Government-

sponsored

enterprises

2.7%

Funds (MM,

Mutual,

Closed, ETF)

12.1%

Brokers and

dealers

1.3%

Funding

corporations

6.5%

Households

19.4%

Federal,State, and

Local

Government

1.5%

Foreign

20.5%

Pension

Funds

(private and

public)

6.2%

Insurance

Companies

19.5%

Source: Federal Reserve Board, Flow of Funds Accounts, March 2010 Source: Federal Reserve Board, Flow of Funds Accounts, March 2010




18 October 2010 7

Municipals over the Past Decade and into 2010

Performance

The municipal market posted stellar relative returns in the first and final years of the decade

(2000: 11.68%, 2009: 12.91%). On a taxable equivalent basis, municipals have

outperformed all taxable investment grade fixed income indices during the past five and ten

years. The most compelling portion of the return story may be associated with the equity

indices. The Municipal Index outperformed the Dow Jones Industrial Average, the

NASDAQ, the S&P 500, and Russell 2000 indices for the decade.

During the first few years of the new millennium, the euphoric ascent of the tax-exempt

market had its underpinnings in both technical and fundamental issues. As the Fed eased the

funds rate from 6.50% in 2000 to 1.00% through early 2004, municipal assets traded at

cheaper levels than at any time in the 1990s, with the exception of the flat tax concerns of

1995, the Asian debt crisis in 1997, and the great spread sector crash in 1998. As municipal

yields fell, issuance surged as states increased new money deals and refunded older debt in

order to support their growing budget deficits. The relative cheapness of municipal assets and

large supply caused all major demand sectors of the municipal market to accumulate assets

actively. Mutual fund managers, motivated by a lenient Fed and flush with cash from generous

coupon and redemption periods, were active in the intermediate and long end of the curve.

These portfolio managers competed with crossover investors (arbitrage desks and hedge

funds) and tender-option programs. These non-traditional buyers, who were attracted by the

relative cheapness of the municipal asset class, provided greater liquidity and visibility to the

market. Insurance companies have been selective investors as a result of asset allocation out

of other spread products into the relative quality of the tax-exempt market.

Since mid-2004, when the Fed began its tightening cycle, the funds rate rose back to 5.25%

from 1.00% by July 2006. During this period, retail investors drove demand in the 1-10y part

of the municipal curve in response to the interest rate environment and flattening yield

curve. Investors took on greater risks for higher yield in the non-investment grade area,

driving sector spreads to historical lows. The Fed began easing in September 2007 asinflation risks and the effects of the subprime crisis began to slow growth. With the crash of

the credit markets in September 2008, the funds rate dropped in December 2008 to

0-0.25% and has remained there. Municipals responded similarly to the rest of the credit

markets, as yields rose, credit spreads widened, and the curve steepened to historic levels.

The Municipal Index (-2.47%) had its lowest return since 1994 (-5.17%).

In 2009, municipals roared back with its best performance (12.91%) in 14 years (1995:

17.45%). The Municipal High Yield Index led all domestic fixed income asset classes, even

on a pre-tax basis, returning 32.73% for the year. The yield levels across high-grade curve

reached 45-year lows across the curve in early October 2009.

TobaccoSecurities backed by tobacco-settlement payments, known as tobacco bonds, added a

significant amount of supply to the yield sector of the market. Issuance reached over $55bn

outstanding at its peak. Tobacco bonds have generally received an investment grade rating,

but some have been issued below investment grade and a few were downgraded in April

2004. Tobacco bonds attract investor attention because they command a yield level similar

to sub-investment grade municipal debt. Issuers offered higher yields to compensate for the

uncertainty over the potential quantity of issuance, the risks associated with the asset-

backed (pay-downs) structure, and a lack of familiarity with the underlying obligors in the

tax-exempt market. More recently, these sector spreads have come in dramatically after the




18 October 2010 8

credit crisis, as investors have started seeking greater yields again in the low rate

environment, rulings in law suits against the industry have been favorable to the tobacco

companies, and the overall financial conditions of the Master Settlement Agreement

members improved.

Airlines

At the start of the millennium, airline-backed municipal bonds made up about 0.50% of the

investment grade index, or more than $3bn outstanding. But as the industry faltered in

aftermath of 9/11, these securities were either downgraded by the rating agencies to a

speculative rating or defaulted. Spreads in the sector widened as airline bankruptcies, lawsuits,

and a negative industry outlook caused yields to skyrocket; many of these bonds traded as low

as a handful of cents on the dollar. Speculative trading activity in this sector had high yield

investors taking positions on the timing of the recovery of the industry. As airlines came out of

bankruptcy with newly merged companies and further consolidation was rumored, spreads

turned around to their tightest level in early 2007. But the industry faced uncertainty again at

the start of the recession as revenues fell, oil prices skyrocketed, and air travel diminished.

Spreads widened to bankruptcy-fear levels by the end of 2008 but have tightened near 10-

year averages to start 2010. The industry has forecast a profit in 2010, resulting from an

improved economy, higher ticket prices, and reduced capacity.

Tender Option Bond Programs

Tender Option Bond (TOB) programs reached their height of popularity in 2007, with the

volume of TOBs at more than $200bn before the credit crisis in 2008 forced the unwinding

of many highly leveraged trusts. The losses for investors reduced their appetite for

leveraged risk, causing TOB volume to fall to about $60bn in early 2009. However, the

recent environment has been favorable for municipals, and TOB activity has slowly

picked up ($4.0bn through 2Q10). The leverage needed in the current environment is

much less than in 2007 (and, therefore, not as reliant on liquidity providers), and bonds in

the trusts are fundamentally higher quality now (allowing for better liquidity than some of

the insured bonds of lower underlying ratings prevalent before the crisis), which hasencouraged buyers to return to the market.

In 2007, the average 2s-30s high grade spread in the first six months was 68bp. Trusts were

leveraged 10-12x to generate the higher returns because of the thin spreads. At the end of

June 2010, the 1-year average 2s-30s spread was 354bp. As a result of this dramatic

increase, TOBs require less than a quarter of the leverage to create a return similar to

that in 2007. There is also less risk in the underlying collateral, as the securities in the trust

are typically AA quality or better, versus the A or lower underlying insured bonds typical of

programs in 2007. The environment for TOBs remains positive, as SIFMA has reset near its

historical lows and the yield curve remains steep by historical standards. Funding has been

inexpensive at approximately 55bp, and the 2-30y spread remains near 350bp. The largest

impediment to growth of the market is the limited availability of high-quality longer-datedbonds for use in these programs. Still, approximately $2bn has been issued during the first

half of 2010.

Puerto Rico

The commonwealth of Puerto Rico initiated the first multi-year budget ever planned in an

attempt to close a $3.2bn structural imbalance by fiscal 2013. Puerto Rico’s total public

debt to gross national product is 100.2%. From 1975 to 2009, the average was 69.5%, and

it was not until 2005 that it broke higher, to 74.9%, increasing after that until it reached

100.15% in 2009. At the end of 2009, the commonwealth restructured $375mn of general




18 October 2010 9

obligation debt to reduce fiscal 2010 GO debt service by $198mn. Its fiscal 2010 debt

service is projected to be $570mn, down from $768mn, with interest costs, beginning in

fiscal 2010, increasing roughly $20mn each year as a result of the restructuring.

The Taxable Municipal Market

On February 17, 2009, President Obama signed into law the American Recovery and

Reinvestment Act of 2009, creating tax-advantaged municipal securities known as Build

America Bonds (BABs), which allowed states to issue taxable municipal bonds with a 35%

federal subsidy of the interest payments made. The vast majority is issued as issuer subsidy

BABs, which allow municipal issuers to sell taxable BABs and receive a subsidy directly from

the Treasury equal to 35% of the interest on the bonds, payable on the interest due date.

Proceeds of BABs can be used to fund non-private activity, governmental purposes and can be

issued only in calendar years 2009 and 2010. This includes GO/general fund needs,

transportation, public power, water & sewer, public higher education, multi-family housing,

and publicly owned healthcare institutions, among others. Private activity bonds, including

501(c)(3) debt, are not eligible to be issued as BABs.

The first BABs were available in mid-April 2009 with $7.63bn coming to market; two California

GO deals ($2bn and $3bn) and the New Jersey Turnpike ($1.375bn) issue were the largest.Over the course of the year, $64.1bn BABs were issued. $117.7bn of BABs came to market

through early July 2010 since the program began. We expect 2010 annual taxable supply to

reach $120-140bn, with most of it coming as BABs, as states take advantage of the 35%

subsidy available this year. Before the August recess, the federal government was debating an

extension to the BAB program that would be for another two years through 2012, with the

subsidy rate declining to 32% in 2011 and then to 30% in 2012. The bill also contains

provisions that exempts water and sewer facility bonds from state volume caps, exempts

private activity bonds from the alternative minimum tax for another year, and extends the

recovery zone bond programs through 2011. Current refundings would also be permitted.

Recent History and Outlook of the Tax-Exempt High-Yield Market

Moving into 2010, the higher yielding sectors of the municipal market have been trading at

tighter spreads since the credit markets collapsed in late 2008. Spreads have contracted to

their current levels due to several factors: increasing fund flows; improved airline, tobacco,

and hospital credit conditions; and demand for yield in a low interest rate environment.

Mutual fund flows have affected both the high yield and high grade sectors of the tax-exempt

markets; however, the former is far more dependent on institutional buyers than the latter.

Several classes of buyers exist in the high-grade market, which do not participate in high yield.

Retail, crossover, and tender-option buyers will support the high-grade municipal market

when institutional buyers are on the sideline. The high-yield sector of the market does not

have these additional groups of buyers on which to rely.

Before 2000, several sectors of the high-yield market had been affected by credit-related

issues including healthcare, power, airlines, tobacco, other corporate sectors, and Puerto

Rico. The healthcare sector has been under pressure since the Federal Balanced Budget Act

(1997) substantially reduced Medicare expenditures. The well-publicized default of the

AHERF hospital system at the end of 1998 confirmed the diminished profitability of the

sector. In mid-July 2000, Moody and S&P lowered the rating on Hillcrest HealthCare System

to Ba1 from Baa2 and to BB+ from BBB, respectively, affecting $236mn of the Series 1999

bonds outstanding. Oklahoma Hillcrest’s financial condition worsened and it was eventually

bought out; its bonds were defeased to the call.




18 October 2010 10

Deregulation of the power industry became an issue in the tax-exempt market in the late

1990s. While deregulation has been a prominent issue in the market, the public power

industry has not been negatively affected. Unlike their corporate brethren, most public

utilities are protected from price volatility, as they tend to get their electricity from owned

generating units. In addition, most states have been slow to enact legislation to deregulate

the industry since the California energy crisis.

Tax-exempt credits that carry asbestos-related liabilities on their balance sheets have also

experienced broad-based declines. In October 2000, Owens Corning and its subsidiaries

filed for bankruptcy protection. The company sought relief from the escalating liabilities

resulting from its multi-billion dollar asbestos obligations. The bankruptcy was the first of

many credit events related to asbestos liabilities; other companies to suffered credit-related

issues as a result of such liabilities include Armstrong, US Gypsum, and Georgia-Pacific.

High debt levels, slowing demand, and increased competition from abroad have plagued

municipal credits with exposure to the steel industry. Wheeling-Pittsburgh Steel Corp. filed

for Chapter 11 bankruptcy protection in November 2000. The steel-producing concern

suffered from issues endemic to the industry. Also in November 2000, several US steel

corporations were subject to negative actions by the ratings agencies as a result of the

deteriorating conditions.

Tobacco issuance from the MSA has made up 1.3-1.8% in market value but 30-40% of the

par value of the High Yield Index since entering the index in 2004. Most of the tobacco

securities issued below investment grade have been very long maturing (40+ years) zero

coupon bonds with OIDs between 6.30% and 7.875%.

After the tragedy of 9/11, the airline industry lost $41bn, and four of the top seven US carriers

have filed for Chapter 11 bankruptcy (United Airlines, Delta Airlines, Northwest Airlines, and

US Airways twice). Competition from low-cost regional carriers and the rising price of fuel

forced the legacy airlines to reduce expenses in order to compete. Major cutbacks in

operations and labor concessions were required: lower salaries, workers on furlough, pension

funds terminated, and reduced benefits. Some airlines that were in bankruptcy reorganizationwere allowed to miss payments on airport bonds as the courts judged the terms of the leases.

In 2006 and early 2007, better financial conditions, a drop in oil prices, and consolidation in

the business brought a resurgence of interest and improved evaluation of airline-backed debt.

However, the industry received another major setback during the recession. Oil prices reached

record levels in July 2008, leaving some airlines unprotected; when the price fell almost 75%

from the highs just five months later, many suffered hedging losses. In 2009, revenues fell

$80bn after a decrease in air travel, leading to an industry loss of $11bn, its worst since the

9/11 attacks ($13bn).

On April 1, 2008, Jefferson County failed to make a principal payment on sewer warrant bank

bonds held by liquidity providers; on September 15, principal payments on GO bank bonds

held by liquidity providers were missed. Downgrades of XL Capital and FGIC, which togetherinsure over 90% of the county's sewer debt, led to a series of failed re-marketings of the

county's variable rate demand (VRD) sewer debt, all of which was put back to the liquidity

providers. Also, a series of failed auctions on the county's auction rate securities (ARS) led to

higher interest rates on them. Given the accelerated principal repayment of the $567mn in

VRD sewer debt held by liquidity providers, combined with declines in the index on its swap

agreements relative to the penalty interest rates on VRD and ARS, the county’s debt service

cash flow requirements increased dramatically. The county entered into forbearance

agreements with the liquidity providers and swap counterparties, who waived their rights to

demand accelerated payments while negotiations continued. Negotiations continued without




18 October 2010 11

solution, and eventually, the forbearance agreements lapsed without further extensions. The

trustee and the bond insurers filed suit in federal court requesting a receiver be appointed to

manage the sewer system, but it was initially ruled that the federal government does not have

the jurisdiction to influence rate-setting for a local public utility. Eventually, a federal judge

appointed a receiver to administer Jefferson County Sewer System with “full power and

authority to administer and operate the System…and the sole and exclusive right and

authority to fix and charge rates …sufficient to provide for the payment of Parity Securities.”

On May 6, 2008, the city council in Vallejo, California, voted 7-0 to file for Chapter 9

bankruptcy and became the largest municipal bankruptcy since Orange County, California

in 1994. Vallejo plans to complete the bankruptcy by the end of summer 2010. It is largely

blamed on exorbitant salaries and benefits for Vallejo firefighters and police officers, which

have reportedly accounted for 80% of Vallejo's general fund budget. The city has reached

agreements with three unions (police, firefighters, managers) and is tied up in arbitration

with one other labor group (electrical workers). The city has asked for a three-year

moratorium on debt payments on its $51.6mn of general fund bond debt.

As for rates, the Fed appears to be on hold until the end of the year, depending on the tenor

of the economic data. We expect annual supply to reach a record $440-450bn, with $120-

140mn as taxable, but with the lowest tax-exempt supply in nearly 10 years. The most

prominent issues within the tax-exempt market moving into the end of 2010 and 2011 are

the future shape of the steep yield curve, low absolute yields, and the relative value of the

high yield sector.

Municipal Bond Defaults

Municipal bonds have been known for their security and preservation of capital, as well as

their ability to generate tax-exempt income. Based on Moody’s February 2010 Special

Comment report, Moody’s-rated issuers in the United States municipal bond market have

had only 54 defaults over 1970-2009. The majority of these (78%) occurred in the

healthcare and housing project finance sectors.

In addition, historical recovery rates for defaulted US municipal bonds are higher, on average,

than those for corporate bonds. The average historical 30-day post-default trading price for

municipal bonds is $59.91 relative to a par of $100 for 1970-2009, much higher than the

$37.50 average recovery for corporate senior unsecured bonds over the same period.

The study was done when the meaning of the municipal and corporate rating scales were

different, with municipal debt known to carry much lower default rates than corporates

sharing the same rating symbols. For example, the average 5-year historical cumulative

default rate for investment-grade municipal debt is 0.03%, compared with 0.97% for

corporate issuers, while for speculative-grade debt the rates are 3.4% and 21.4% for

municipals and corporate issuers, respectively.

In April 2010, Moody’s recalibrated its municipal ratings to match its global scale. The shift

in criteria aligned municipal rating standards with those established for corporates,

sovereigns, and local governments outside the US. The revision came after many years of

lobbying by elected officials, who were concerned that municipalities were paying elevated

interest costs on their debt because the agencies held them to higher standards than other

asset classes.

This had the largest effect on lower-rated GOs, water & sewer, distributional utilities, and

municipal utility districts. Baa1 through Baa3 bonds in this category received two or three

notch upgrades. Most investment grade special tax, mass transit, non-utility enterprises, tax




18 October 2010 12

increment financing, grant anticipation revenue, and public university bonds were upgraded

one notch. Healthcare, private universities, infrastructure enterprises, power generating

utilities, state revolving funds, bond banks, and federal leases did not receive upgrades.

Figure 7: Average Cumulative Default Rates, 1970-2009, Non-General Obligation

Rating 1 2 3 4 5 6 7 8 9 10

Aaa 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

Aa 0.00% 0.01% 0.01% 0.01% 0.02% 0.02% 0.03% 0.03% 0.04% 0.05%

A 0.00% 0.01% 0.01% 0.01% 0.02% 0.02% 0.03% 0.04% 0.06% 0.07%

Baa 0.01% 0.04% 0.09% 0.14% 0.19% 0.23% 0.27% 0.31% 0.35% 0.39%

Ba 0.35% 1.14% 1.74% 2.20% 2.64% 3.29% 3.99% 4.52% 4.91% 5.10%

B 3.97% 6.55% 8.64% 10.92% 13.00% 13.78% 13.78% 13.78% 13.78% 13.78%

Caa – C 8.43% 10.74% 13.33% 14.07% 14.07% 14.07% 14.07% 14.07% 14.07% 14.07%

Inv. Grade 0.00% 0.01% 0.03% 0.04% 0.05% 0.07% 0.08% 0.09% 0.11% 0.13%

Spec. Grade 1.55% 2.77% 3.75% 4.57% 5.29% 5.93% 6.48% 6.90% 7.20% 7.37%

All Rated 0.02% 0.04% 0.07% 0.09% 0.11% 0.12% 0.14% 0.16% 0.18% 0.19%

Source: Moody’s U.S. Municipal Bond Default and Recoveries, 1970-2009, February 2010

Figure 8: Average Cumulative Default Rates, 1970-2009, General Obligation

Rating 1 2 3 4 5 6 7 8 9 10

Aaa 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

Aa 0.00% 0.00% 0.01% 0.01% 0.01% 0.02% 0.02% 0.02% 0.02% 0.02%

A 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

Baa 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

Ba 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.01%

B 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%Caa – C 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

Inv. Grade 0.00% 0.00% 0.00% 0.00% 0.00% 0.01% 0.01% 0.01% 0.01% 0.01%

Spec. Grade 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.01%

All Rated 0.00% 0.00% 0.00% 0.00% 0.00% 0.01% 0.01% 0.01% 0.01% 0.01%

Source: Moody’s U.S. Municipal Bond Default and Recoveries, 1970-2009, February 2010




18 October 2010 13

Barclays Capital Municipal Index Design Principles

Tax-exempt managers are increasingly moving toward more disciplined approaches to

investing their assets. Utilizing a benchmark as part of an investment discipline enhances

the diversification of assets, discourages wholesale duration positions, provides objective

performance measurement, encourages stable returns, and fosters efficient transaction

management. A well-designed benchmark should have the following attributes:

Universe is well defined

Securities are investable

Current characteristics are available (e.g., price, coupon, duration, etc.)

Historical information is accessible

Rules are objective and well understood

Returns are a reliable reflection of market performance

Weightings are based on market value outstanding

Risk characteristics are stated in advance of performance period

As with all of the indices in the Barclays Capital Global Family of Indices, to represent the

market more completely and accurately, the Barclays Capital Municipal Bond Index uses a

rule-based methodology. To be included in the index, a security must meet certain

eligibility requirements. A well-defined set of rules has been established to minimize

arbitrary exclusion of securities, assure that the issues included have reasonable trading

availability, and allow for the maintenance of complete market data. This approach

ensures that the Municipal Bond Index is consistent, objective, replicable, reliable, and

representative of the marketplace.

All Municipal bonds that comply with the following are eligible for inclusion in the Barclays

Capital Municipal Bond Index:

Deal size over $75mn

Maturity size of at least $7mn

Investment grade (Baa or better)

Dated date later than December 31, 1990

Maturity of one year or greater

Fixed coupon rate

Tax-exempt or AMT

No secondary insured or private placement bonds

No partially prerefunded CUSIP where no new CUSIPs are issued




18 October 2010 14

Sector Hierarchy

As illustrated in Figure 9, the bonds in the Barclays Capital Municipal Bond Index are

categorized into the following sector types: Pre-refunded, Insured, General Obligation, and

Revenue. The pre-refunded security type supersedes all other sector designations. Bonds

with enhanced credits are classified as insured. Securities that have not been pre-refunded

and are not insured are classified as general obligation or revenue bonds based on their

funding source. In addition to the sector breakdown, the bonds in the Municipal Index are

further classified into twelve sub-sectors: education, industrial, health care, housing, power,

resource recovery, transportation, special tax, lease revenue, water and sewer, state general

obligation, and local general obligation. Historical performance and statistical data are

available for all sectors, as well as a substantial number of standard and custom indices.

Figure 9: Municipal Bond Index Hierarchy

Source: Barclays Capital

Municipal Bond Index

General Obligation Pre-refunded Revenue Insured

State Local Education

Hospital

Transportation

Resource Recovery

Housing Water & Sewer

IDR/PCR Special Tax

Power Lease




18 October 2010 15

In addition to these sector classifications, our index is decomposed into a more granular

classification scheme (Figure 10).

Figure 10: MuniView Classifications

HOUSING EDUCATION

SINGLE-FAMILY HOUSING

MULTI-FAMILY HOUSING

SINGLE-MULTI FAMILY HOUSING

NEW PUBLIC HOUSING

CMO BACKED HOUSING

OTHER HOUSING

PRIMARY – SECONDARY EDUCATION

HIGHER EDUCATION

STUDENT LOANS

LIBRARY, MUSEUMS

OTHER EDUCATION

GOVERNMENT/PUBLIC SERVICE INDUSTRIAL/ECONOMIC DEVELOPMENT

GOVERNMENT PUBLIC BUILDINGS

FIRE STATION EQUIPMENT

CORRECTIONAL FACILITIES, COURTS

GENERAL PURPOSE PUBLIC IMPROVEMENTS

POLICE STATION EQUIPMENT

REDEVELOPMENT, LAND CLEARANCE

LAND PRESERVATION

OTHER GOVERNMENT PUBLIC SERVICE

INDUSTRIAL DEVELOPMENT

POLLUTION CONTROL

SOLID WASTE RESOURCE RECOVERY

ECONOMIC DEVELOPMENT

OFFICE BUILDINGS, LAND PARTNER

MALL, SHOPPING CENTERS

OTHER INDUSTRIAL/ECONOMIC DEVELOPMENT

HEALTH CARE RECREATION

HOSPITALS

HOSPITAL EQUIPMENT LOANS

NURSING HOMES

LIFECARE RETIREMENT CENTERS

OTHER HEALTH CARE

CIVIC CONVENTION CENTERS

STADIUMS/SPORTS COMPLEX

THEATERS

PARKS, ZOOS, BEACHES

OTHER RECREATION

TRANSPORTATION UTILITYAIRPORTS

SEAPORTS, MARINE TERMINALS

TOLL ROADS, STREETS, HIGHWAYS

BRIDGES

TUNNELS

PARKING FACILITIES

MASS RAPID TRANSIT

OTHER TRANSPORTATION

ELECTRIC PUBLIC POWER

WATER & SEWER

GAS

TELEPHONE

SANITATION

FLOOD CONTROL, STORM DRAIN

COMBINED UTILITIES

OTHER UTILITY

OTHER

VETERANS

AGRICULTURE

IRRIGATION





18 October 2010 16

Index Returns and Statistics

Returns and Statistics Universes: Each Barclays Capital index consists of two universes of

securities. Returns are based on a set determined at the beginning of each month and held

constant until the beginning of the next month. This universe is not adjusted for securities

that become ineligible for inclusion in the index during the month (e.g., due to downgrades,

called bonds, or securities falling below one year in maturity) or for newly eligible issues(e.g., upgrades, newly issued bonds). Daily, month-to-date, and monthly returns reflect the

performance of the return universe. Holding the return universe constant throughout a

month means that a fund manager avoids having to match a moving benchmark and is able

to rebalance at the end of the month.

The statistics universe is a dynamic set of bonds that changes daily to reflect the latest

composition of the index. This universe accounts for changes due to new issuance, calls,

ratings changes, and remaining maturity. Changes due to new issuance, calls, or partial

redemptions (e.g., sinking funds) occur as of settlement date. Statistics such as market values,

sector weightings, and various averages (e.g., coupon, duration, maturity, yield, price, etc.) are

updated and reported daily. At the end of each month, the latest statistics universe becomes

the return universe for the coming month. The statistics universe allows a manager to monitorchanges in the index throughout a month. Active managers can modify their portfolios as the

index changes, while passive managers can be prepared to execute all rebalancing

transactions at the end of the month to match the upcoming returns universe.

The relationship between the returns and statistics universes during a month can be

represented by two overlapping circles (Figure 11). Circle 1 (area A) is the returns universe

during the month. Circle 2 (area C) is the statistics universe during the month. Area B

denotes securities that are in both returns and statistics universes. Area A represents

securities that have dropped out of the statistics universe during the month but remain in

the returns universe, and Area C is new additions to the statistics universe that will be part

of the returns universe beginning with the next month.

Figure 11: Barclays Capital Index Dynamics

Returns (Backward) Universe Statistics (Forward) Universe

• Static universe set at beginning of month- avoids "hitting a moving target"

• Includes bonds that during the month have been:

- called- downgraded below investment grade- sunk below $5mn maturity s ize

• Used to report index performance (returns)

• Dynamic universe that changes daily- used for rebalancing purposes

• Includes bonds that during the month have been:

- newly issued- upgraded to investment grade

• Used to report index statistics (duration, marketvalues, etc.)





18 October 2010 17

Total Return Philosophy

Barclays Capital Municipal Index results are reported on daily, month-to-date, monthly,

annual, and since-inception bases. Returns are cumulative for the entire period. Intra-month

cash flows contribute to monthly returns, but are not reinvested during the month and do

not earn a reinvestment return. They are, however, reinvested into the returns universe for

the following month. Thus, index results over two or more months reflect monthly

compounding.

Market Weighting: Returns and most summary statistics are fully market value weighted.

Returns data are weighted by full market value at the beginning of the period. Statistics,

such as average duration and maturity, are market value weighted based on end-of-period

full market value. Average price is weighted by end-of-period par value, while average

coupon is calculated both ways.

Total Return: The holding period return on the bonds in the index consists of price

appreciation (or depreciation) and coupon income, expressed as a percentage.

Total Return = Price Return + Coupon Return + Pay-down Return

Price Return: Component of total return stating the percentage increase/decrease in theprice of the bonds in the index. Given for a single index period by:

Price Return = (Price at end - price at beginning) * 100

(Price at beginning + accrued interest at beginning)

Coupon Return: Component of total return derived from the current yield of the bonds in

the index. Given for a single index period by:

Coupon Return = (Accrued at end - accrued at beginning) + coupon payment

Price at beginning + accrued interest at beginning

Pay-down Return: Component of total return for securities with sinking funds (due to

change in amount outstanding). Calculated as:

(Outstanding beginning - outstanding ending)/outstanding beginning

*

(Sink price - ending price - accrued ending)/(price beginning + accrued beginning)

Cumulative Return: Total and price return can be calculated for multiple index periods by

compounding the returns over N periods:

Cumulative Return = { [( 1 + return1 ) * ( 1 + return2 ) * …*(1 + return n ) ] -1} * 100

100 100 100

Note: Coupon return is the difference between total and price returns over multiple periods.




18 October 2010 18

Cumulative Returns

Calculations for cumulative returns over any period can be calculated by the following formula:

1+[S.I.(end) / 100]R= ( {------------------------} -1 ) * 100

1+[S.I.(beg) / 100]

where,

S.I.(end) = since inception return at the end of the period

S.I.(beg) = since inception return at the beginning of the period

R = the return over the period in percent

Index Evolution

The inception date for the Barclays Capital Municipal Bond Index is January 1, 1980. Initially,

thirty-five indices were published on a monthly basis with a hard copy distribution to a

limited number of clients. Today, we offer over twenty-five hundred municipal indices, withan extensive distribution via the Barclays Family of Indices monthly publication; Barclays

Capital Live, our client website; Bloomberg; Reuters; and custom distribution via the

internet. On the road to our current state of evolution, several dates are worth noting:

Evolution of the Barclays Capital Municipal Bond Index

January 1980 – Inception of the Barclays Capital Municipal Bond Index

January 1988 – Addition of pre-refunded sector, transportations added to revenue sector,

5-year index added to all sectors.

January 1990 – Implemented stratified market capitalization weightings; enlarged index

through addition of Insured Sector; 3, 7, and 15 year indices added to all sectors; addedseveral purpose class sectors to revenue and general obligation sectors.

July 1993 – Implementation of bond-by-bond market capitalization weightings and revised

rules. Began compiling results for state-specific indices, mutual fund indices, and several

customized indices.

February 1995 – Began calculating and publishing option adjusted duration.

June 1995 – Barclays Capital Municipal Bond Index published as part of the Barclays Capital

Global Family of Indices.

January 1996 – Addition of alternative minimum tax and zero coupon bonds to the Barclays

Capital Municipal Bond Index. Publication of the Barclays Capital Non-Investment Grade

Municipal Index. Compilation of six new enhanced state-specific indices.

August 1997 - Increased the frequency of index production from monthly to semi-monthly.

January 1998 - Increased the frequency of index production from bi-monthly to weekly.

September 1998 – OAD volatility changed from 12% to 8%.

January 2000 – Increased the liquidity constraint on the index from $50/$3mn to

$50/$5mn. Added certificates of participation to the index. Enhanced the classification

scheme to include special tax and lease revenue bonds.




18 October 2010 19

December 2000 – Increased the frequency of index production from weekly to daily.

October 2004 – All pre-refunded bonds have Aaa rating (non-re-rated showed up with

underlying rating).

January 2005 – Increased the liquidity constraint on the index from $50/$5mn to

$75/$7mn. Added mandatory put bonds and partially pre-refunded bonds with new CUSIPs

to the index. Changed the quality constraint to the lower of Moody’s or S&P ratings. More

State Enhanced Indices with increase liquidity requirements for larger states. Managed

Money Indices and Insurance Mandate Indices added.

June 2005 – Fitch ratings included to determine index eligibility. The middle rating will be

used if all three agencies rate the issue differently. If two of the rating agencies have

equivalent ratings (other than non-rated) for an issue, that rating will be selected. If only

two agencies have ratings, the more conservative of the two ratings will be chosen. If only

one rates the bond, it must be investment grade.

January 2010 – Insured Index allows Aa3 as minimum monoline insurer rating. New

Taxable Municipal Index created to provide broader range of bonds not eligible for the

Aggregate Bond Index using same rules as Municipal Index. Newly issued zeroes afterDecember 1, 2009, with accreted value of over $7mn will be allowed into index. Pre-

refunded bond rating will not be forced to AAA and must have an index rating of

investment grade to be in main index.

April 2010 – Moody’s and Fitch recalibrated their bonds to match their global scales,

upgrading thousands of bonds from one to three notches. This has an overall effect of

increasing the quality of the Municipal Index from AA3/A1 to AA2/AA3.

The implementation of bond-by-bond market capitalization weightings, in July 1993, this

resulted in an index encompassing 22,442 issues with a market value of over $353bn. The

market capitalized weighting system, based on the securities in the index, produced a

methodology for creating indices that is consistent with the weight of the issues in the

municipal market. As a result, several of our most popular benchmarks were introduced in

July 1993, including our mutual fund and custom index blend indices. These maintain a

large following in the fund management and banking communities.

Pricing Service – The Barclays Capital Municipal Bond Index is priced by Interactive Data

Corporation, a division of Financial Times Information. The bonds in our index are priced on

the bid side using close of business pricing. Evaluations are based on extensive consultation

with market professionals on both the buy and sell side and a myriad of automated

quantitative and qualitative information.

Quality Control – The daily production of municipal index returns and statistics includes an

extensive library of automated reconciliation reports and the scrutiny of our research staff.

The automated reports screen for potential return and bond descriptive anomalies. Potentialtotal return discrepancies are isolated by analyzing the deviation from the mean within a

given sector and spot on the curve. Indicative data inconsistencies are uncovered by

running a series of reports designed to identify such problems.

In January 1996, we eliminated the 5-year rolling dated date constraint and added

alternative minimum tax and zero coupon bonds. The former resulted in a fixed minimum

dated date of January 1, 1991. The addition of alternative minimum tax and zero coupon

bonds added approximately 2,500 bonds to the index with a market capitalization equal to

approximately 9% of the index.




18 October 2010 20

In addition to modifying the rules for existing indices, the Non-Investment Grade and

Enhanced State indices were introduced in January 1996. The former began with a market

value of $13.6bn and totalled 624 issues. As of January 1, 2010, it totalled over $51bn in

market value and maintained 3290 securities. All municipal bonds that comply with the

following rules are eligible for inclusion in the Barclays Capital Non-Investment Grade

Municipal Bond Index:



Sub-investment grade (below Baa3 or non-rated)



Fixed coupon rate

To achieve greater representation in smaller capitalization states, the enhanced state indices

were developed. To be included in the Barclays Capital Enhanced State-Specific Indices,bonds must meet the following criteria:



Investment grade (Baa3 or better)



Fixed coupon rate

The following enhanced state-specific indices were introduced in January 1996:

Connecticut, Maryland, Massachusetts, Ohio, Arizona, and Minnesota.

The Non-Investment Grade Index and enhanced state-specific indices are not components

of the Municipal Bond Index. These are published as separate tax-free indices, available on

request through your Barclays Capital municipal salesperson.

The rule changes implemented in January 2000 resulted in a 28% reduction in the number of

issues, while that in 2005 lowered the number of issues by 31%. The streamlined index

maintained the diversity of the old benchmark while eliminating some of the difficult to price

(lower liquidity) securities. In addition to creating a more efficient measure of the municipal

market, the changes resulted in relatively mild adjustments to the overall composition of the

index. The rule changes in 2005 had an effect on states with larger issuances, so a fewenhanced state-specific indices were created with the old $50mn deal size/$5mn outstanding:

California, Florida, Michigan, New Jersey, New York, and Pennsylvania.

Due to a lack of reliable pricing and indicative data, partially pre-refunded bonds, derivative

instruments, remarketed issues, and variable rate bonds are not included in the index.

Custom and Mutual Fund Indices

Custom Indices: A well-constructed performance benchmark for a given fund should match

the curve exposure and investment constraints of that fund. Many total return investors




18 October 2010 21

manage funds that differ from our standard benchmarks in terms of the types of securities

they are permitted to purchase. Unnecessary tracking error is created when classes of

securities exist in the benchmark that are not permitted in the fund.

Barclays Capital has developed customized indices for municipal clients that closely mirror

their investment universe. They are tailored to their unique objectives and constraints, such

as credit quality, maturity, duration, liquidity, callability and/or issuer. For example, aportfolio manager interested in benchmarking a high-quality intermediate term fund that is

not allowed to hold issues rated under single A or have maturities below 5 years or above

15 years, can create a customized index with the appropriate bonds removed. The

remaining bonds are still weighted according to market capitalization.

Composite Indices: Other investors may be interested in a composite index, allowing them to

assign their own weights to sectors within the overall benchmark. Various asset allocation mixes

can be used to parallel their own portfolios as a benchmark. For example, an index can be

created to match the base allocation of 40% long Insured, 30% local GO, and 30% A rated or

better industrial revenue bonds, regardless of changing market values among sectors. Within

each sector, the securities will still be weighted according to their market capitalization.

Mutual Fund Indices: The SEC ruled that, effective July 1, 1993, mutual fund managers must

include in their prospectuses and annual reports a line graph comparing their performance with

an appropriate broad-based market index along with standardized 1-, 5- and 10-year total return

figures. The Barclays Capital Municipal Mutual Fund indices were created to provide fund

managers with objective and comprehensive market-based benchmarks for measuring

performance as an alternative or in addition to the more traditional peer group comparisons.

The three general categories that were added include the short, intermediate, and short-

intermediate mutual fund indices. The short indices cover bonds with a maturity of one to

less than five years; the intermediate indices contain securities with five to less than ten

years remaining to maturity; the short-intermediate indices are composed of issues with

maturities of one to less than ten years. If a different allocation is desired, customized

indices can be created to meet the specifications of fund managers.

Managed Money Indices: Starting January 1, 2005, the Barclays Capital Municipal Managed

Money Indices became available. These benchmarks are directed towards money managers with

high net worth individual clients and designed to represent the universe of bonds that fit the

investment criteria of their customers. In addition to adhering to the general Municipal Index

rules, bonds in the Managed Money Index must be non-AMT, issued within the past 5 years, and

rated at least Aa3 and may not be an airline, hospital, housing, or tobacco bond. State specific

indices will be available for California, Connecticut, Florida, Massachusetts, New Jersey, and New

York. Short (1 up to 5 year maturities), intermediate (1 up to 17 year maturities), and long (10 or

more year maturities) components of each index will also be offered.

Insurance Mandate Indices: The property & casualty insurance industry has become a

prominent investor in the municipal market. Insurance companies that invest in taxable and

tax-exempt assets will have a composite index made up of 50% Barclays Capital US

Aggregate Index and 50% Municipal Bond Insurance Mandate Index. The benchmark is

representative of the insurance company’s portfolio manager’s allocation between taxable

fixed income asset classes and the universe of municipals. The rules on the US Aggregate

portion of the index will be the same, but on the municipal segment, bonds in the index will

be A3 rated or above, non-AMT, and from 1 up to 22 year maturities. Short (1 up to 5 year

maturities) and intermediate (1 up to 10 year maturities) subsets will also be matched with

their US Aggregate counterparts to create maturity-constrained indices.




18 October 2010 22

Figure 12: Index Results for June 30, 2010

Number

Issues

Price

Return

Coupon

Return

MTD

Total

Return

Past

3m

Past

6m

Year-

to-Date

Since

Inception

Munici al Bond Index 46,514 -0.32 0.38 0.06 2.03 3.31 3.31 9.61

1 Year (1-2) 3,487 -0.27 0.37 0.09 0.55 0.87 0.87 2.43

3 Year (2-4) 6,135 -0.07 0.38 0.29 1.21 1.51 1.51 4.30

5 Year (4-6) 5,076 -0.05 0.36 0.31 1.68 2.46 2.46 6.88

7 Year (6-8) 4,647 -0.07 0.37 0.29 2.27 3.55 3.55 8.14

10 Year (8-12) 8,608 -0.06 0.37 0.31 2.68 4.12 4.12 9.58

15 Year (12-17) 8,918 -0.41 0.38 -0.03 2.11 3.41 3.41 10.23

20 Year (17-22) 5,164 -0.65 0.39 -0.25 2.12 3.64 3.64 11.80

Long Bond (22+) 4,479 -0.60 0.41 -0.19 2.43 4.49 4.49 14.99

GO Bond Index 12,724 -0.32 0.37 0.05 2.19 3.35 3.35 8.86

State GO 5,863 -0.35 0.38 0.03 2.31 3.52 3.52 9.04

Local GO 6,861 -0.29 0.36 0.07 2.03 3.12 3.12 8.61

1 Year GO (1-2) 881 -0.32 0.37 0.04 0.50 0.75 0.75 2.36

3 Year GO (2-4) 1,660 -0.06 0.36 0.30 1.20 1.45 1.45 4.35

5 Year GO (4-6)1,513 -0.02 0.35 0.33 1.75 2.45 2.45 6.977 Year GO (6-8) 1,469 -0.04 0.36 0.32 2.42 3.53 3.53 7.98

10 Year GO (8-12) 2,740 -0.06 0.36 0.30 2.89 4.24 4.24 9.48

15 Year GO (12-17) 2,595 -0.40 0.37 -0.02 2.34 3.47 3.47 9.95

Long Term GO (17+) 1,866 -0.87 0.39 -0.48 2.50 4.51 4.51 12.78

Revenue Bond Index 23,836 -0.37 0.39 0.02 2.10 3.68 3.68 11.28

Electric 2,134 -0.20 0.39 0.18 1.92 3.19 3.19 9.59

Hospital 2,647 -0.07 0.43 0.36 2.53 4.91 4.91 13.78

Housing 1,153 -0.19 0.42 0.23 2.35 4.35 4.35 11.09

IDR/PCR 640 -1.29 0.45 -0.83 1.03 2.78 2.78 19.75

Transportation 4,823 -0.32 0.38 0.06 2.29 3.91 3.91 11.06

Education 3,061 -0.33 0.38 0.06 2.10 3.30 3.30 9.60

Water & Sewer 3,393 -0.28 0.38 0.10 2.09 3.36 3.36 9.28

Resource Recovery 160 -0.79 0.39 -0.40 1.27 2.24 2.24 8.38Leasing 2,294 -0.35 0.40 0.04 2.21 3.70 3.70 9.93

Special Tax 3,531 -0.51 0.37 -0.14 2.00 3.46 3.46 10.28

Pre-refunded Index 3,976 -0.04 0.37 0.32 1.37 1.44 1.44 3.89

1 Year Preref (1-2) 1,283 -0.28 0.36 0.08 0.49 0.61 0.61 1.53

3 Year Preref (2-4) 1,646 -0.01 0.40 0.36 1.30 1.26 1.26 3.36

5 Year Preref (4-6) 629 0.24 0.36 0.60 1.93 1.93 1.93 5.53

7 Year Preref (6-8) 223 0.16 0.34 0.50 2.53 2.90 2.90 6.23

8+ Yr. Preref 195 -0.08 0.32 0.23 2.66 3.06 3.06 8.63

Insured Bond Index 5,978 -0.35 0.38 0.03 1.95 3.15 3.15 9.14

Long Insured 628 -0.39 0.39 -0.01 2.17 3.90 3.90 12.79

California Exempt 6,237 -0.56 0.39 -0.17 2.30 4.16 4.16 11.69

New York Exempt 5,843 -0.23 0.38 0.15 2.07 3.37 3.37 9.40

AMT Index 2,321 -0.21 0.43 0.22 2.46 4.76 4.76 13.35Zero Coupon Index 1,290 -1.12 0.00 -1.12 3.06 4.69 4.69 17.14

Conventional Muni 42,910 -0.31 0.39 0.08 1.99 3.20 3.20 9.23

Non-Investment Grade 3,341 -0.04 0.53 0.49 3.10 7.29 7.29 21.90

Managed Money Index 19,550 -0.35 0.36 0.02 2.04 3.04 3.04 8.78

Short Term (1-5) 3,267 -0.20 0.35 0.15 1.04 1.25 1.25 4.22

Sht/Interm (1-10) 8,598 -0.08 0.35 0.27 2.03 2.78 2.78 6.58

Intermediate (1-17) 15,203 -0.19 0.36 0.16 2.12 2.96 2.96 7.67

Long (10+) 10,952 -0.51 0.37 -0.13 2.05 3.20 3.20 10.04





18 October 2010 23

Figure 13: Index Results for June 30, 2010

Number

Issues

Durat.

To

Worst

MDur.

To

Worst

Mod.

Adj.

Durat. Quality Cpn

Time

To

Worst Mat. Price

Yield

To

Worst

Market

Value Index Agg.

Municipal Bond Index 46,446 5.72 5.60 8.28 AA2/AA3 4.98 7.53 13.51 100.67 3.41 1,249,231 100.00 100.00

1 Year (1-2) 3,476 1.39 1.39 1.39 AA2/AA3 5.04 1.45 1.47 106.03 0.85 80,031 6.41 6.41

3 Year (2-4) 6,118 2.57 2.56 2.56 AA2/AA3 5.01 2.76 2.88 109.72 1.31 144,756 11.59 11.59

5 Year (4-6) 5,055 3.96 3.92 3.98 AA2/AA3 4.93 4.41 4.88 111.32 2.10 110,749 8.87 8.87

7 Year (6-8) 4,648 4.86 4.80 5.17 AA2/AA3 4.95 5.60 6.89 110.28 2.76 103,923 8.32 8.32

10 Year (8-12) 8,611 5.61 5.52 7.05 AA2/AA3 4.93 6.67 9.88 107.82 3.33 182,495 14.61 14.61

15 Year (12-17) 8,966 6.10 5.98 9.65 AA2/AA3 4.91 7.49 14.33 102.19 4.03 195,233 15.63 15.63

20 Year (17-22) 5,114 6.92 6.75 11.73 AA3/A1 4.97 9.15 19.25 97.05 4.58 156,787 12.55 12.55

Long Bond (22+) 4,458 8.77 8.54 14.05 AA3/A1 5.06 13.44 27.14 86.56 5.00 275,256 22.03 22.03

GO Bond Index 12,699 5.40 5.30 7.65 AA2/AA3 4.86 6.61 11.40 104.69 3.04 299,296 100.00 23.96

State GO 5,861 5.30 5.20 7.17 AA2/AA3 4.95 6.64 10.71 107.28 2.98 172,518 57.64 13.81

Local GO 6,838 5.53 5.43 8.29 AA1/AA2 4.73 6.56 12.34 101.35 3.13 126,778 42.36 10.15

1 Year GO (1-2) 878 1.35 1.35 1.34 AA1/AA2 4.75 1.40 1.43 105.51 0.75 16,567 5.54 1.33

3 Year GO (2-4) 1,652 2.58 2.57 2.57 AA1/AA2 4.80 2.76 2.88 109.41 1.21 34,634 11.57 2.77

5 Year GO (4-6) 1,525 4.02 3.98 4.04 AA1/AA2 4.83 4.45 4.88 111.90 1.91 34,048 11.38 2.737 Year GO (6-8) 1,483 4.93 4.87 5.23 AA1/AA2 4.88 5.64 6.89 111.40 2.50 32,328 10.80 2.59

10 Year GO (8-12) 2,760 5.80 5.71 7.28 AA2/AA3 4.87 6.83 9.86 109.41 3.14 58,371 19.50 4.67

15 Year GO(12-17) 2,592 6.03 5.92 9.89 AA2/AA3 4.82 7.23 14.27 103.77 3.83 54,338 18.16 4.35

Long Term GO (17+) 1,809 7.83 7.64 13.17 AA2/AA3 4.93 10.63 22.44 94.03 4.63 69,011 23.06 5.52

Revenue Bond Index 23,891 6.28 6.15 9.26 AA3/A1 5.01 8.66 15.89 97.61 3.92 684,107 100.00 54.76

Electric 2,150 5.30 5.20 8.13 AA3/A1 5.04 6.66 13.23 105.70 3.40 70,021 10.24 5.61

Hospital 2,692 7.18 7.01 10.41 A1/A2 5.34 10.77 19.24 101.50 4.65 87,560 12.80 7.01

Housing 1,147 7.41 7.23 11.39 AA1/AA2 5.07 11.35 20.78 99.51 4.85 22,788 3.33 1.82

IDR/PCR 619 9.04 8.77 9.80 BAA1/BAA2 5.10 16.92 19.51 76.36 5.60 44,893 6.56 3.59

Transportation 4,836 6.10 5.97 9.02 AA3/A1 4.92 7.99 14.94 97.16 3.81 146,755 21.45 11.75

Education 3,104 6.03 5.92 9.79 AA2/AA3 5.00 7.70 16.63 106.35 3.61 72,035 10.53 5.77

Water & Sewer 3,405 5.23 5.13 9.52 AA1/AA2 4.97 6.41 16.46 106.30 3.45 78,571 11.49 6.29

Resource Recovery 160 4.17 4.08 7.00 A1/A2 4.91 5.33 11.88 102.38 3.76 3,009 0.44 0.24Leasing 2,291 5.57 5.45 7.78 AA3/A1 5.04 7.55 12.50 103.07 3.65 55,202 8.07 4.42

Special Tax 3,487 6.42 6.29 8.95 AA2/AA3 4.83 8.04 14.53 87.93 3.61 103,272 15.10 8.27

Pre-refunded Index 3,871 3.21 3.18 3.28 AA1/AA2 5.18 3.73 3.78 109.61 1.18 119,011 100.00 9.53

1 Year Preref (1-2) 1,268 1.42 1.42 1.42 AA1/AA2 5.32 1.48 1.48 107.13 0.53 35,402 29.75 2.83

3 Year Preref (2-4) 1,619 2.62 2.61 2.62 AA1/AA2 5.31 2.80 2.80 111.96 0.90 49,761 41.81 3.98

5 Year Preref (4-6) 585 4.12 4.09 4.16 AA1/AA2 5.03 4.65 4.68 115.28 1.49 16,836 14.15 1.35

7 Year Preref (6-8) 214 5.52 5.46 5.59 AA1/AA2 4.90 6.55 6.55 114.64 2.25 7,713 6.48 0.62

8+ Yr. Preref 185 9.67 9.48 10.41 AA1/AA2 4.41 13.22 13.84 95.35 3.75 9,299 7.81 0.74

Insured Bond Index 5,985 5.76 5.64 9.04 AA2/AA3 4.92 7.20 14.64 100.82 3.61 146,817 100.00 11.75

Long Insured 619 8.28 8.08 14.18 AA2/AA3 4.84 11.32 26.09 90.33 4.75 34,162 23.27 2.73

California Exempt 6,194 6.46 6.31 8.83 AA3/A1 4.94 9.08 14.44 97.86 3.78 214,731 100.00 17.19

New York Exempt 5,831 5.04 4.94 8.04 AA2/AA3 4.97 6.52 13.68 104.63 3.15 182,554 100.00 14.61

AMT Index 2,316 6.72 6.55 9.61 AA3/A1 5.21 10.23 17.27 99.54 4.75 58,381 100.00 4.67Zero Coupon Index 1,275 14.40 14.00 14.79 AA3/A1 0.00 15.60 16.91 33.12 5.02 29,127 100.00 2.33

Conventional Muni 42,862 5.45 5.34 8.05 AA2/AA3 5.09 7.19 13.24 106.19 3.31 1,161,763 100.00 93.00

Non-Investment Grade 3,320 8.52 8.22 9.62 BA3/B1 5.83 14.44 17.90 52.86 6.81 53,764 100.00 100.00

Managed Money Index 19,246 6.33 6.22 9.38 AA1/AA2 4.81 7.61 14.37 100.80 3.36 448,848 100.00 35.93

Short Term (1-5) 3,247 2.91 2.89 2.89 AA1/AA2 4.63 3.13 3.14 109.74 1.27 58,317 12.99 4.67

Sht/Interm (1-10) 8,466 4.79 4.73 4.95 AA1/AA2 4.79 5.46 5.89 112.02 2.15 165,030 36.77 13.21

Intermediate(1-17) 15,008 5.59 5.51 6.93 AA1/AA2 4.82 6.53 9.08 109.72 2.79 290,477 64.72 23.25

Long (10+) 10,780 7.23 7.08 11.95 AA1/AA2 4.83 8.85 19.30 95.25 4.06 283,818 63.23 22.72





18 October 2010 24

Historical Measures of Performance in the Municipal Bond Market

Yield

Yield has often been used as a generic term to express the expected annual rate of return of an

investment. However, for bonds, yield is the present value discounting factor used on future

cash flows in pricing a security. If we were to be able to reinvest each of our cash flows at the

stated yield throughout the lifetime of the investment, we could use yield as our return. In

practice, changing market conditions affect the reinvestment rate and value of the bond.

Money managers are rarely “buy and hold” market participants and are seeking relative value

and total return. Yield may not represent the actual return of the bond over a time horizon

prior to redemption. Therefore, using the average yield of a bond fund (market weighted

average of the yields of the bonds in the fund) is not indicative of past returns of the fund.

Peer Group Comparison

Peer group comparison became popular in the 1990s as a way to judge relative

performance between fund managers. Funds are generally classified by their investable

universe: maturity/duration of the securities, quality of the bonds, state specific, and sectorconcentration are a few examples of how funds can be compared. Investors looking for a

fund would be able to select their criteria and filter a list of who the leading fund managers

are by total return based on those conditions. This method became popular among plan

sponsors and consultants to help evaluate money managers for their clients. However, there

are problems using this analysis in the municipal bond market. One is the lack of a central

exchange and uniform bond pricing. Differences in the top and median quartile of a peer

group comparison might be as few as a handful of basis point in a year, which could be

explained through the pricing method of the securities (different data pricing service, matrix

pricing, MSRB reported trades, internal trader marks, stagnant prices, etc.). This can also be

misleading, as companies would have an interest in using higher security prices when

representing performance numbers and are rarely checked by any regulatory agency to

confirm their returns. Second, funds with different benchmarks or management styles could

be in the same peer group. If these factors are unknown, comparisons of portfolios with

generally different overall holdings (allowable securities) and methodology (active, passive,

top/bottom, etc.) could mean comparing apples with oranges.

Total Return

Total return is the current standard and best measure of historical performance. For an

individual security, total return takes into account the percentage change in its market price

(price return) and the value of the accrued interest (income/coupon return). For a portfolio,

the total return is calculated as the market weighted average total return of each bond. In a

mutual fund, this would be the change in the Net Asset Value, or NAV (price return), and

the amount of the distribution (income/coupon return). The use of total return as aperformance measurement allows for historical comparisons, current analytics, and future

scenario analysis.

Indexing

Indexing, or the use of a market benchmark, was first created and implemented in the fixed

income markets in the 1970s. Their popularity did not generate widespread interest in the

municipal marketplace until 1993, when the SEC mandated mutual funds to include a

market benchmark in their prospectus to provide investors information about fund




18 October 2010 25

characteristics and risks. By using an index, total return became the standard for risk/

reward comparison for funds. Creating peer groups amid mutual funds with the same

benchmark allowed for comparable evaluations; analytics became available that previously

were used only by the equity markets. Fixed income portfolio management and

performance evaluation started to be more than a monthly function as market information

became more frequent. Today, it is rare for a managed municipal portfolio or fund not to

have some benchmark to which it adheres.

Asset/Liability Management

Asset/Liability Management (ALM) has evolved from its traditional practice in industries

such as banks and insurance companies, who have expected but distinct payout schedules

based on their accounting or actuarial assumptions; it has also used by corporations and

entities with pension liabilities, defined benefit plans, medical liabilities, or other post-

employment benefits. ALM initially addressed the problem of liabilities that were priced at

book value using accrual accounting, whereas the assets funding them were marked to

market, creating a mismatch between assets and liabilities (e.g., the S&L crisis in the 1980s).

ALM handles the danger of depleting capital to narrow the difference between assets and

liabilities when the values do not move in tandem (asset/liability risk). ALM’s goal is tomaintain or create a surplus of assets beyond liabilities.

To analyze asset/liability risk, the techniques of gap analysis and duration matching were

developed (although they do not necessarily solve it). Since the capital of most financial

institutions is small relative to the firm’s assets or liabilities, small percentage changes in

assets or liabilities can translate into large percentage changes in capital. This leveraged risk

is affected by interest rates, earning power, and the ability to take on additional debt.

Scenario analysis models that projected future performance and conditions were scrutinized

in order to reflect the movement of both assets and liabilities more accurately.

The success of their investment portfolios is based on the capability to make mandatory

payments on a timely basis, not on a comparison with a generic market benchmark or a

peer group. Currently, falling interest rates, used for liability discounting, have caused the

present value of liabilities to increase. More and more non-financial institutions and state

pension programs are receptive to custom indexing for help in their asset/liability

management; pensions and retirement healthcare programs are among the largest (if not

the largest) assets, and many are underfunded after a decade of poor performing assets.




18 October 2010 26

Tax Treatment of Market Discount, Original Issue Discount,and De Minimis for Tax-Exempts

The potential for rising yields in the municipal market has highlighted the importance of

the tax treatment of price appreciation. A market discount might occur when a security is

purchased in the secondary market at a price lower than par. In the most typical scenario,when a par bond is purchased in the secondary at a price below par, the accreted market

discount is taxed at ordinary income. In the case in which the discount on the purchase

price is within a small (de mimimis) amount, the price appreciation at sale or redemption is

taxed at a more favorable (capital gains) rate. Original Issue Discount (OID) occurs when a

bond is issued at a price below its redemption value; an OID bond is taxed differently.

Market Discount

For a non-OID bond, the accreted market discount can be calculated using the straight line

amortization. This method involves amortizing the difference between the purchase price

of a bond at discount and its face value over the number of years until maturity of the

bond on a constant basis.

Example 1: If a 10y par bond is purchased at 90 dollars, its total market discount of 10

points is accreted at one point per year until maturity. After two years, the bond’s accreted

market discount is two points and added to the original purchase price of the bond, for a

total of 92 dollars.

Taxation of Market Discount

The accreted market discount is typically taxed as ordinary income at the time the bond

is redeemed at maturity. If the bond is sold before maturity, the gain when it is disposed is

treated as ordinary interest income up to the amount of the accrued market discount, and

any gain above that is taxed at the capital gains rate. If the bond is bought at a market

discount and held to maturity, the gain that the investor receives is completely taxed at

ordinary income. Referring to the bond in the prior example:

Example 2: If the 10y par bond purchased at 90 is held to maturity, the entire market

discount of 10 points, one point per year, is taxed as ordinary income in the year the bond

is redeemed.

Example 3: If the 10y par bond originally purchased at 90 dollars is sold after two years at

93 dollars, not all of the 3 point gain is taxed at ordinary income. The two points of accreted

market discount over the two years is treated as ordinary income, but the other one point

would be considered a capital gain.

De minimis

The de minimis rule applies if there is only a small amount of market discount. De minimis

is calculated as 0.25% of the face value of a bond multiplied by the number of complete

years from the bond’s purchase date and its maturity date. If the market discount is less

than the de minimis amount, the market discount is considered to be zero, and the accreted

market discount is treated as a capital gain upon disposition or redemption.

Example 4: If the investor purchases the 10yr par bond at a discount for a dollar price above

97.50 (de minimis allows for 0.25*10 = 2.50 from par), the gain that the investor receives

between the bond purchase price and redemption is taxed at the capital gains rate. For

example, should the investor buy a 10y bond at a price of 98, within the 2.5 point de




18 October 2010 27

minimis amount deducted from par, for tax purposes, the 2 point discount would be treated

as a capital gain at sale or redemption.

Original Issue Discount

This arises when a bond is issued at a price below its redemption value. Since OID

represents the interest paid by the issuer, for municipal bonds, it is treated as tax-exempt

interest, whereas market discount is not.

Market Discount on an OID

Still, market discount can apply to an OID bond if the bond is purchased below the price of

the bond’s issue price plus accrued OID. This is not calculated through straight line

amortization but rather using the constant interest rate method which corresponds to the

economic accrual of interest based on the yield of an OID bond at the time it is issued.

Market discount is the gain that is experienced of the bond’s issue price plus accrued

OID over the purchase price. The de minimis rule applies to an OID bond just as in the

same manner as a par bond, with the market discount considered to be zero if it is within

the de minimis limit and taxed on a capital gains basis.

Taxation of an OID

For tax-exempt municipal OID bonds, accrued OID is not subject to ordinary income tax

but is required to be reported in the same manner as any other tax-exempt bond interest.

For taxable OID bonds, accrued OID is recognized annually as taxable interest income. Note,

though, that accrued OID on municipal bonds is potentially subject to the alternative

minimum tax in the same manner as other municipal bond interest.

An important fact to take into consideration is that even though OID municipal bonds are

tax exempt, the market discount of an OID municipal bond is still taxed, as in the

following example:

Example 5 – An OID bond purchased outside of de minimis allowance and held to maturity:

A 20y, zero-coupon municipal bond was issued at an original issue price of 36.0 (issue yield

5.15%). After ten years, the accrued OID plus original issue price is 60.0 and a purchaser

buys the bond at 50.0 and holds it to maturity. The purchaser bought the bond below the

de minimis allowance of 2.5 points (10 years x .25) or 57.5 price, so the market discount will

be taxed at the ordinary income tax rate. The bond has a total accretion of 50 points. 40

points of the accretion is tax-exempt, as it is due to the accrued OID, but the 10 points that

the purchaser gained must be treated as ordinary income.

When the market discount is considered zero (purchased within the de minimis allowance),

the difference between the purchase price and the bond’s accrued OID plus original issue

price is taxed at capital gains rate.

Example 6 – An OID bond purchased within the de minimis allowance and held to maturity:A 20y, zero-coupon municipal bond, issued at an original issue price of 36.0 (issue yield

5.15%). After ten years, the accrued OID plus original issue price is 60.0. This time, the

purchaser buys the bond at 58.0, within the de minimis allowance of 2.5 points (10 years x

0.25) or 57.5 price. The bond has a total accretion of 42 points. 40 points of the accretion is

tax-exempt, as it is due to the accrued OID, but the 2 points that the purchaser gained is

treated as capital gains.

If a bond’s market discount is not zero (purchased outside of the de minimis allowance)

and the bond is sold prior to maturity, the gain/loss on the bond is calculated based on




18 October 2010 28

the difference between the sale price and the revised purchaser price (equal to the

original purchase price + the accrued OID of the original issue at time of sale). A portion

of the gain is taxed as ordinary income due to the market discount. That amount is the

difference between the revised purchaser price and the price of the bond using the

purchasing yield at the time of sale; the rest is taxed at capital gains rate.

Example 7 – An OID bond purchased outside of the de minimis allowance and sold prior tomaturity: A 20y, zero-coupon municipal bond issued at an original issue price of 36.0 (issue

yield 5.15%). After ten years, the accrued OID plus original issue price is 60.0. The

purchaser buys the bond at 50.0, outside the de minimis allowance price of 57.5. The

purchaser later sells the bond for 80.0 after five more years. The bond has an accrued OID

plus original issued price at the time of sale of 77.5. The 17.5 points in accrued OID (77.5-

60.0) over the five years is tax exempt. It is added to the purchasing price of 50.0 for an

adjusted cost basis of 67.5. The gain on the bond is 80.0-67.5 = 12.5 points. To understand

the taxation of the 12.5 points, calculate the portion due to market discount. The bond

holder’s purchase yield of 7.05% is used to find the 72.3 price at time of sale and is

compared with the adjusted cost basis of the bond. The difference, 72.3-67.5 = 4.8, is due to

the market discount and subject to ordinary income tax (note that the bond was purchased

originally with a 10 point market discount). The rest of the gain, 12.5-4.8 = 7.7, is taxed atthe capital gains rate.



Analyst Certification(s) We, Peter J. De Groot, Andrew Chan and Jormen Vallecillo, hereby certify (1) that the views expressed in this research report accurately reflect our personalviews about any or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly orindirectly related to the specific recommendations or views expressed in this research report.

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entered into only with such persons. Barclays Capital is authorized and regulated by the Financial Services Authority ('FSA') and member of the LondonStock Exchange.Barclays Capital Inc., US registered broker/dealer and member of FINRA (www.finra.org), is distributing this material in the United States and, inconnection therewith accepts responsibility for its contents. Any U.S. person wishing to effect a transaction in any security discussed herein should do soonly by contacting a representative of Barclays Capital Inc. in the U.S. at 745 Seventh Avenue, New York, New York 10019.Non-U.S. persons should contact and execute transactions through a Barclays Bank PLC branch or affiliate in their home jurisdiction unless localregulations permit otherwise.This material is distributed in Canada by Barclays Capital Canada Inc., a registered investment dealer and member of IIROC (www.iiroc.ca).Subject to the conditions of this publication as set out above, Absa Capital, the Investment Banking Division of Absa Bank Limited, an authorised financialservices provider (Registration No.: 1986/004794/06), is distributing this material in South Africa. Absa Bank Limited is regulated by the South AfricanReserve Bank. This publication is not, nor is it intended to be, advice as defined and/or contemplated in the (South African) Financial Advisory andIntermediary Services Act, 37 of 2002, or any other financial, investment, trading, tax, legal, accounting, retirement, actuarial or other professional adviceor service whatsoever. Any South African person or entity wishing to effect a transaction in any security discussed herein should do so only by contactinga representative of Absa Capital in South Africa, 15 Alice Lane, Sandton, Johannesburg, Gauteng 2196. Absa Capital is an affiliate of Barclays Capital.In Japan, foreign exchange research reports are prepared and distributed by Barclays Bank PLC Tokyo Branch. Other research reports are distributed toinstitutional investors in Japan by Barclays Capital Japan Limited. Barclays Capital Japan Limited is a joint-stock company incorporated in Japan withregistered office of 6-10-1 Roppongi, Minato-ku, Tokyo 106-6131, Japan. It is a subsidiary of Barclays Bank PLC and a registered financial instruments firmregulated by the Financial Services Agency of Japan. Registered Number: Kanto Zaimukyokucho (kinsho) No. 143.

Barclays Bank PLC, Hong Kong Branch is distributing this material in Hong Kong as an authorised institution regulated by the Hong Kong MonetaryAuthority. Registered Office: 41/F, Cheung Kong Center, 2 Queen's Road Central, Hong Kong.Barclays Bank PLC Frankfurt Branch is distributing this material in Germany under the supervision of Bundesanstalt für Finanzdienstleistungsaufsicht(BaFin).This material is distributed in Malaysia by Barclays Capital Markets Malaysia Sdn Bhd.This material is distributed in Brazil by Banco Barclays S.A.Barclays Bank PLC in the Dubai International Financial Centre (Registered No. 0060) is regulated by the Dubai Financial Services Authority (DFSA).Barclays Bank PLC-DIFC Branch, may only undertake the financial services activities that fall within the scope of its existing DFSA licence.Barclays Bank PLC in the UAE is regulated by the Central Bank of the UAE and is licensed to conduct business activities as a branch of a commercial bankincorporated outside the UAE in Dubai (Licence No.: 13/1844/2008, Registered Office: Building No. 6, Burj Dubai Business Hub, Sheikh Zayed Road, DubaiCity) and Abu Dhabi (Licence No.: 13/952/2008, Registered Office: Al Jazira Towers, Hamdan Street, PO Box 2734, Abu Dhabi).Barclays Bank PLC in the Qatar Financial Centre (Registered No. 00018) is authorised by the Qatar Financial Centre Regulatory Authority (QFCRA).Barclays Bank PLC-QFC Branch may only undertake the regulated activities that fall within the scope of its existing QFCRA licence. Principal place ofbusiness in Qatar: Qatar Financial Centre, Office 1002, 10th Floor, QFC Tower, Diplomatic Area, West Bay, PO Box 15891, Doha, Qatar.This material is distributed in Dubai, the UAE and Qatar by Barclays Bank PLC. Related financial products or services are only available to ProfessionalClients as defined by the DFSA, and Business Customers as defined by the QFCRA.This material is distributed in Saudi Arabia by Barclays Saudi Arabia ('BSA'). It is not the intention of the Publication to be used or deemed asrecommendation, option or advice for any action (s) that may take place in future. Barclays Saudi Arabia is a Closed Joint Stock Company, (CMA License

No. 09141-37). Registered office Al Faisaliah Tower | Level 18 | Riyadh 11311 | Kingdom of Saudi Arabia. Authorised and regulated by the Capital MarketAuthority, Commercial Registration Number: 1010283024.This material is distributed in Russia by Barclays Capital, affiliated company of Barclays Bank PLC, registered and regulated in Russia by the FSFM. BrokerLicense #177-11850-100000; Dealer License #177-11855-010000. Registered address in Russia: 125047 Moscow, 1st Tverskaya-Yamskaya str. 21.This material is distributed in India by Barclays Bank PLC, India Branch.This material is distributed in Singapore by the Singapore branch of Barclays Bank PLC, a bank licensed in Singapore by the Monetary Authority ofSingapore. For matters in connection with this report, recipients in Singapore may contact the Singapore branch of Barclays Bank PLC, whose registeredaddress is One Raffles Quay Level 28, South Tower, Singapore 048583.Barclays Bank PLC, Australia Branch (ARBN 062 449 585, AFSL 246617) is distributing this material in Australia. It is directed at 'wholesale clients' asdefined by Australian Corporations Act 2001.IRS Circular 230 Prepared Materials Disclaimer: Barclays Capital and its affiliates do not provide tax advice and nothing contained herein should beconstrued to be tax advice. Please be advised that any discussion of U.S. tax matters contained herein (including any attachments) (i) is not intended orwritten to be used, and cannot be used, by you for the purpose of avoiding U.S. tax-related penalties; and (ii) was written to support the promotion ormarketing of the transactions or other matters addressed herein. Accordingly, you should seek advice based on your particular circumstances from an

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2015 Dec Barlcays Muni Primer Dated 2010