MOR Investing — Spring 2009

Relative Value in Municipal Bonds

Like much of the global financial industry, the fixed income market experienced significant volatility throughout 2008, forcing many investors to reevaluate their tolerance for risk in their investments, municipal bonds being no exception. However, municipal bond prices have come under considerable pressure in recent months for various reasons creating, in our view, a particularly attractive buying opportunity for value-minded fixed income investors.

Municipal Bonds and Taxable-Equivalent Yields
Municipal bonds are typically evaluated on the basis of their taxable equivalent yield (TEY), or the yield needed from a taxable bond with comparable risk characteristics to generate the same after-tax return. While interest income from municipal bonds may be fully taxable as ordinary income or subject to the Alternative Minimum Tax, it is generally exempt from taxes at the federal and, in some cases, state levels. Consider, for example, a municipal bond yielding 4.00%. The TEY for a fully-taxable bond for an investor in the 35% tax bracket would be 6.15%, whereas the TEY for an investor in the 20% bracket would be only 5.00%.¹ Therefore, the attractiveness of municipal bonds relative to their taxable counterparts hinges in large part upon the investor’s tax status, and higher-income investors in particular have traditionally gravitated towards this asset class. But current conditions in the municipal bond market have expanded the universe of investors who should consider municipal bonds.

The Municipal/Treasury Ratio
It is best to use a “relative value” framework for assessing the timeliness of a municipal bond investment because, when it comes down to it, fixed income investing is a comparative exercise. One useful metric for identifying relative value in the municipal market is the ratio between the yields from municipal bonds and those from U.S. Treasury securities with similar maturities, or the Municipal/Treasury ratio.

The Municipal/Treasury ratio has traditionally hovered in the 80% range. This can largely be attributed to the differences in the tax treatment as described above. From the standpoint of a prospective municipal bond investor, a ratio significantly higher than this level indicates that municipal bonds, at least by historical measures, are undervalued relative to taxable securities when using Treasuries as a benchmark. Another way of looking at it might be this: the higher the Municipal/Treasure ratio, the lower an investor’s tax bracket needs to be to generate comparable after-tax yields from municipal bonds.

As is illustrated in the table below, the current Municipal/Treasury ratio is substantially greater than the 80% level.

Generally, the Municipal/Treasury ratio tends to be slightly lower (75%-80%) when shorter-dated maturities are compared and slightly higher (80%-85%) for longer-dated maturities because of the inherent uncertainty regarding future tax rates. Current Municipal/Treasury ratios are registering at levels ranging from 85% to 130%, signifying that municipal bonds appear undervalued across the entire maturity spectrum. The central message that can be drawn from this data is clear: at the current yield levels, attractive after-tax returns from municipal bonds are no longer reserved for only those investors in the highest tax brackets.

It should be noted that several factors might provide justification for some of the recent increases in the Municipal/Treasury ratio. A prolonged period of economic weakness may test some municipal issuers’ debt servicing ability since most municipalities derive a significant proportion of revenues from property and sales taxes, both of which may be adversely affected by a continued contraction of real estate values or any increases in unemployment. Additionally, there remains some degree of concern about the financial strength of the bond insurers, making it more important than ever for fixed income investors to be mindful about the credit strength of the underlying issuer.

However, much of the recent price pressure appears to be related to more technical factors, including forced selling by leveraged investors and mutual funds facing shareholder redemptions. This presents an attractive opportunity for income-seeking investors to capture attractive relative returns from municipal bonds, particularly after weighing the possibility of higher tax rates in the future.

Time to Talk Bonds with Your Advisor
Current market conditions have made it possible for fixed income buyers to invest in municipal bonds at what are compelling valuations in relation to taxable bonds of comparable credit quality. For investors seeking to maximize current income while maintaining a defensive posture against the possibility of adverse interest rate changes, we continue to favor higher-coupon premium bond structures as a part of your balanced portfolio. In light of current economic conditions and continued uncertainty regarding the fate of the municipal bond insurers, we suggest you consider municipal bond issues with relatively strong underlying ratings.

Actual yields from individual municipal bonds depend on a number of factors specific to each security and may vary from the levels indicated in the table above. Also, past performance is not indicative of future results. For additional information, please contact your Morgan Keegan Financial Advisor.

¹ The TEY is calculated as follows: TEY = (Municipal Bond Yield) ÷ (1 − Marginal Tax Rate).

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Immediate Annuities Can Provide Lifetime Income

Running out of income is a primary concern for most retirees. Immediate annuities offer a financial alternative to help meet retirement income needs by providing a steady stream of income designed to last through retirement.

What is an immediate annuity?
An immediate annuity is a contract between you and an annuity issuer (an insurance company) to which you pay a single lump sum of money in exchange for the issuer's promise to make payments to you for a fixed period of time or for the rest of your life. Immediate annuities may appeal to you if you are looking for an income you cannot outlive.

Characteristics of immediate annuities

• A steady stream of payments for either a fixed period of time (such as 10 years) or for the rest of your life.
• The issuer assumes all investment risk.
• Generally, you only pay income taxes on the part of each payment that represents earnings or interest credited to your account.
• You relinquish control over the money you invest in the immediate annuity. While there are some exceptions, usually you receive fixed payments with little or no variation in the amount or timing of each payment.
• If you chose a life only payment option, you may not live long enough to receive the return of all of your investment, since payments cease at your death with this option.

How does an immediate annuity work?
As the name implies, an immediate annuity begins to pay you a stream of income immediately. The amount of income you receive is based on a number of factors, including your age at the time of purchase, your gender, whether payments will be made to only you or to you and another person, and whether payments will be made for a fixed period of time or for the rest of your life.

What are your payment options?
Most immediate annuities include a number of payment options that can affect the amount of the payment you receive. The more common payment choices are:

• Life only. Payments are based on your age and continue until you die, at which time they cease.
• Installment refund/cash refund. If you die prior to receiving at least the return of your investment in the immediate annuity, the beneficiary you name in the policy will receive an amount equal to the difference between what you invested and what you received.
• Life with a period certain. With this option, the issuer does not guarantee the return of your investment; rather, it guarantees a minimum period of time during which payments will be made.
• Joint and survivor. This option provides payments for the lives of two people, typically you and your spouse. When either of you dies, payments continue to be made for the life of the survivor.
• Period certain. This option provides a guaranteed payment for the fixed period of time you specify (e.g., 5, 10, 15, 20 years). If you die prior to the end of the chosen period, your beneficiary will continue to receive payments for the remainder of the fixed period.

Other factors to consider
First, be sure that the payment option you select will address your income needs.

Second, if you are considering a life only payment option, be aware that it may take many years before you receive at least the return of your investment from the immediate annuity.

Third, consider whether there are better alternatives for providing income.

You expect to live for a long time. If you're healthy and have longevity in your family, an immediate annuity may be an investment to consider. Contact your Morgan Keegan financial advisor to learn more about immediate annuities.

This information is for illustrative and discussion purposes only. Morgan Keegan does not provide legal or tax advice. You need to contact your legal and tax advisors for additional information and advice before making any investment decisions.

Prepared by Forefield Inc. © Copyright 2009 Forefield Inc.

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New Rule for 529 Plan Investors

Under current federal law, 529 college savings plans are permitted (but not required) to allow investors to change the investment options on their existing contributions once per calendar year. (This is different than changing investment options on future contributions, which most plans allow at any time.) Industry observers have criticized this "once-per-year" rule as too inflexible, especially in a down market year like 2008.

The IRS has recently published a notice addressing this issue. For 2009, according to the IRS, 529 college savings plans may allow investors to change the investment options on their existing contributions twice per year instead of once per year. Check with your Morgan Keegan financial advisor to see if your 529 plan offers this new investment flexibility before you make any changes.

Also, keep in mind that most 529 plans allow you to change the investment options on your existing contributions whenever you change the beneficiary of the account.

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FINRA-Protecting You

Morgan Keegan & Company, Inc. is a member of the Financial Industry Regulatory Authority (FINRA). As such, we are required to disclose the availability of BrokerCheck, an online tool that provides information on FINRA registered securities firms and brokers. To access BrokerCheck or download a brochure, go to www.finra.org. For questions regarding BrokerCheck, FINRA provides a toll-free hotline, 1-800-289-9999, available Monday through Friday from 8 a.m. until 8 p.m., Eastern Time.

Learn More About SIPC

Morgan Keegan & Company, Inc. is a member of the Securities Investor Protection Corporation (SIPC). You may obtain information about SIPC, including a SIPC brochure, by visiting www.sipc.org or calling 202-371-8300.

News for CMO Investors

An informational brochure on CMOs and other mortgage-related securities is available from your Morgan Keegan financial advisor. Call your advisor for a complimentary copy.

An Important Message for Margin Account Holders

Customers with margin accounts that have a debit balance may lose the right to vote some or all of the securities. Securities that are pledged as collateral for a margin loan may then be lent by the Firm carrying the debt (Morgan Keegan) to itself or to others. The authorization for this lending of securities is set forth in the Morgan Keegan New Account Client Agreement and Disclosure Statement. If those shares are loaned, the right to vote the shares go with the shares. Therefore, if you carry a margin debit balance you may not be able to vote all of those shares. Further, you may receive proxy materials that reflect a right to vote a different, smaller number of shares than you may own in your margin account.

If you have any questions on these matters, please contact your Morgan Keegan Financial Advisor.

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