John Cummings Executive Vice President Portfolio Manager read bio	David Blair Senior Vice President Credit Analyst and Portfolio Manager read bio	Bob Fields Senior Vice President Product Manager read bio

As the global economy transitions to a New Normal, the consequences for the municipal bond market are likely to be significant. In the following interview, John Cummings, executive vice president, portfolio manager and head of the municipal bond desk; David Blair, senior vice president, credit analyst / portfolio manager and head of municipal bond research; and Bob Fields, senior vice president and product manager for municipal bond strategies, discuss how diminished revenues among the states and municipalities, together with the downfall of bond insurers and other stresses in the market and the broader economy, are likely to lead to deteriorating credit quality in municipal bonds. Credit analysis is once again vital to municipal investing, while liquidity remains severely diminished. Select high-quality municipal bonds may be an attractive strategy for investors seeking tax-advantaged holdings.

Q: Has the financial crisis had a significant and continuing effect on the municipal bond market?
Fields: Yes, the financial crisis has had a profound effect on both investors and issuers in the municipal bond market. Many different, but related, events have changed the entire landscape, and it is important for investors to understand these changes in order to adjust their expectations for municipal bond investments. In the New Normal economic environment, PIMCO believes growth prospects and returns on assets will likely be lower than they have been in past decades, and the effects of inflation, when it does rise, may be even more threatening to investors. Meanwhile, emerging nations will likely continue to become even stronger drivers of global growth. The New Normal is challenging many long-held assumptions about portfolio allocations and is likely to have continued and profound implications for the municipal bond sector going forward.

Q: What are some of the major challenges facing municipal issuers?
Blair: The economic crisis hit state and local municipalities very hard. States have three major revenue sources: income tax, sales tax and property tax. During previous economic downturns, only one or two of these sources were affected; however, during this crisis, all three revenue sources contracted to a large degree. Income tax revenues were down due to an increase in unemployment and flat or lower household income. Revenues from sales tax have also been affected by the increased savings rate and concurrent decrease in consumer spending. Finally, property tax revenues have been lower due to the housing crisis and the significant drop in home prices across the country. While the effects of the revenue contractions on cities and counties tend to lag behind the effects at the state level, local municipalities face the likelihood that state funding will be curtailed.

States are required to balance their budgets each year and with this significant drop in revenue, it has become very difficult to balance budgets without implementing drastic cuts to social programs or even raising taxes. The stimulus package passed in February 2009 offered some relief to the states, but on balance the severe revenue contraction coupled with the typical challenges state governments must confront have led to increasing headline risk and deteriorating credit prospects. Downgrades are a possibility among the hardest-hit areas.

Q: Is the liquidity in the municipal bond market likely to remain diminished?
Cummings: The liquidity in the municipal bond market was severely diminished by multiple events during the crisis; these permanent changes in the liquidity profile have led to an increased liquidity premium in the municipal bond market. First, we lost several of the major broker-dealers in municipal bonds, including Bear Stearns, Lehman Brothers (where the muni desk was merged into a very small muni desk at Barclays Capital, which acquired some of Lehman’s operations), UBS (which exited the institutional muni business) and Merrill Lynch, through its merger with Bank of America. Second, during the massive deleveraging that took place during the financial crisis, many of the single-strategy municipal hedge funds collapsed and were shut down. The hedge funds and the Wall Street proprietary trading desks were major liquidity providers, in longer-maturity municipal bonds. Finally, property and casualty insurance companies who historically had been active participants in the municipal bond market pulled back as they focused on cleaning up their own balance sheets and raising liquidity.

Q: Why is credit analysis such a crucial element for municipal bond investing in the New Normal?
Fields: Credit vigilance will likely be more important in the New Normal than in years past. Historically, the municipal market was fairly homogeneous. According to Thompson Financial, in the last few years prior to the crisis more than 50% of the bonds were insured by a third-party wrapper (insurer) that had AAA ratings. Many retail investors and financial advisors became comfortable picking insured bonds with the highest yields, showing less concern with their underlying credit quality. Now, with the downfall of the monoline bond insurance companies, the market has become much more stratified, with AAA ratings no longer the norm. We feel credit analysis to determine the characteristics and credit quality of each issue is now imperative, due to credit stress in the market and the limited insurance available should a credit concern or event arise.

This means the municipal bond market now appears to be trading more like a credit market than a rates market, which historically had been the case. When the majority of the bonds were rated AAA, the market traded with yields generally priced as a percentage of Treasuries, and the relationship was fairly constant. Since the loss of the majority of bond insurers, the market has moved toward a credit market where A-rated credits trade at a significant spread to BBB-rated credits, and so on. We feel this has placed a premium on credit analysis and the ability to pick stable to improving credits.

Q: What is your outlook for the municipal bond market in 2010 and beyond?
Cummings: Monitoring state budget situations will continue to be important: The outlook for many states continues to deteriorate as revenue declines and budget deficits persist. Due to these continuing strains and the likelihood that the economic recovery is going to be slow, we expect further deterioration in the credit quality of many areas of the municipal bond market. We also expect more credit surprises to the downside along with higher default rates; however, it should be noted that even with this elevated default rate, municipal defaults should still be significantly lower than the taxable credit market. Along with credit quality uncertainty, we expect greater price volatility in the New Normal.

It seems likely that the federal government will have to raise taxes to pay for the massive stimulus programs and help alleviate the large federal deficit. This would likely have a positive effect on the municipal market, as more investors would be seeking tax-advantaged investments.

We expect to see an increase in regulatory supervision in the municipal market as part of a broader New Normal trend; this could potentially hinder liquidity and create administrative obstacles for both issuers and investors.

The Build America Bond program, which was created by the economic Recovery Act of 2009, has proven to be a positive for the municipal bond market. BABs are taxable municipal bonds that receive a 35% interest subsidy from the Federal government. Since it was launched in April of 2009, we have seen over $60 billion in issuance. This program has helped expand the investor base for municipal bonds given the higher yields, while reducing borrowing costs for municipalities due to the interest cost subsidy. The program has also helped reduce supply pressure in longer maturity tax-exempt municipals, which have now been substituted with taxable Build America Bonds. While we expect the program to be extended beyond its 2010 expiration, we can’t be sure for how long.

Q: Given the municipal market outlook, what is PIMCO’s overall strategy in managing municipal bond portfolios?
Cummings: We are focusing on diversified, high-quality issuers with strong credit fundamentals. These include essential service revenue bonds and bonds backed by dedicated taxes; these holdings have dedicated revenues from specific sources that are less likely to be exposed to poor budgeting or political dysfunction.

We are currently underweight or outright avoiding general obligation (GO) municipals in economically distressed areas. Pension obligations and budgetary issues are two red flags we focus on in evaluating GO credits. We also look to avoid local GOs of cities and counties that have excessive employee benefits, as they will most likely have to confront unions to negotiate concessions.

We plan to focus our investments along portions of the curve where we seek to maximize return per unit of risk. Currently this is in the intermediate portion of the curve: between three and eight years. We are much more comfortable with interest rate risk than credit risk.

Q: Given the profound changes in the market, will municipal bonds be an attractive investment option in the New Normal?
Cummings: Overall the municipal bond market has changed significantly. Not surprisingly, the muni market resembles the market of 20 years ago when credit analysis and bond-picking expertise were valued, with the retail investor being the price setter. Although credit quality has deteriorated, municipalities remain strong credits due to their taxing power and underlying goal of providing infrastructure and services to the people of that municipality. They offer relatively attractive yields to investors building tax-advantaged strategies, and in the New Normal they will likely still have room to perform. Their tax-advantaged nature remains the primary driver of demand as investors continue to look to reduce their tax burden.

Thank you, gentlemen.