| Fund Background
Fund Background
The Van Kampen Municipal Trust is one of the 17 closed-end
funds sponsored and managed by Van Kampen Investments.
As of July 31, 2007, Van Kampen had approximately $11
billion of closed-end fund assets under management. The
fund was first offered on September 27, 1991, and trades on
the New York Stock Exchange under the ticker VKQ.
As of July 31, 2007, on a NAV total return basis, the fund
returned a -1.61% for the year-to-date period, 3.4% for the
trailing one-year period, 5.81% on an annualized basis for
the trailing five-year period and 7.14% on an annualized
basis since its inception. As of July 31, 2007, the fund had a
12 month trailing yield of 5% as measured by Lipper.
Fund Overview
At the end of July, the fund had approximately $940 million
in assets, with an average credit rating of AA. 66% of the
portfolio was rated AA or better, of which 55% was rated
AAA. Slightly over 10% of the fund was rated below BBB and
that includes about 7.5% that is non-rated. The fund’s nonrated
securities can be rated as low as B internally. This is an
80/20 fund and it holds a maximum of 80% in investment
grade securities.
Fund Performance
By way of background, at the end of the fourth quarter
2006, we made a concerted effort to increase the income
performance capability of the fund, which would hopefully
result in higher dividend payments. To that end, we added
to the fund’s exposure in the tobacco, healthcare and
housing sectors.
At that time, municipal bond spreads were continually moving
in and yields were relatively low. This was due to the increase
of fund flows into not only investment grade funds, but
predominately high yield funds. As a result, high-yield fund
managers were trying to find investments for their portfolios,
but there wasn’t enough high yield paper. Therefore, they had
to invest in BBB rated paper which, drove BBB spreads
substantially tighter than their historical average.
That was the backdrop in which we operated. As mentioned,
we were buying tobacco, which is BBB rated. A lot of
healthcare bonds we purchased were A and BBB rated and
we also bought some AA rated housing bonds. At the end of
the first quarter of 2007 and beginning in the second
quarter, the problems in subprime mortgages wound their
way to the market. We had $388 billion of municipal
issuance last year, which was very easily absorbed by TOBS
and non-traditional buyers/overseer accounts.
At the end of the first quarter or middle of the second quarter,
supply didn’t slow down, but demand started to moderate. That
was when subprime rates started to rise and spreads began
widening. They widened the most in the sectors I previously
mentioned; tobacco, healthcare, but not as much in housing.
Municipal housing issuance remained strong, as the sector
typically represents a very stable credit. By that, I’m referring
to housing bonds issued by states that are normally of the
AA and AAA variety. These types of securities are used for
first time mortgage programs and they have a very strict
limitation on income as well as the amount of each
individual loan a person can obtain. Therefore, they have a
well diversified portfolio within each issuer bucket.
It seems like there has been an increasing drought of
housing bonds issued. This started late in the fourth quarter
and continued to slow down. Then supply started to come
and spreads started to widen again. So the common theme
was spread widening, which started out with the subprime
problems affecting the Treasury market.
In addition, you had a lot of uncertainty regarding the Fed.
Greenspan had retired and, while I wouldn’t say he was
predictable, the market had come to interpret his signals.
Bernanke was somewhat new and the market didn’t know how
to react to what he was doing. They kept thinking, is he going to
cut rates? Is he going to help with the problems in the subprime
market and make it easier for mortgage rates to come down?
To give you a perspective on what eventually transpired, on
December 31st the 30-year segment, what we call the AAA
scale, was at a 4.05% yield. The slope of the two- to three-year
muni scale was about 56 basis points. By end of July, we
had a 30-year yield of 4.37% and the slope had only gone to
60. Slope-wise, we had backed off 32 basis points from 4.05%
to 4.37% and, during that time, you also saw spreads widen.
The 30-year guide was a cheap 4.78% on August 27. At that
point, the curve was as steep as 116. So it almost doubled from
60 at the end of July to its low point of 116 on August 27th.
Today it’s back to about 90 and we’ve rallied somewhat to
4.36%. We went from a low of 4.05% on December 31 to a
high of a 4.78% and back to a 4.36%. However, spreads are still
somewhat wide.
Turning back to the fund’s portfolio, let’s discuss its nonrated
bucket. These securities also widened out. To give you
an idea of where things went, tobacco bonds widened out
from about an 88 spread over AAAs to 150. Non-rated Bonds
widened out about 70 basis points, reaching its tightest point
back in February.
Elsewhere, A rated hospital bonds widened about 30 or 35
basis points. However, since the end of August they made 10
or 15 of that back. BBB- rated hospitals widened by 50 to 60
basis points during this period and they tightened up roughly
10 or 20 basis points. Non-rated securities had backed up
over 60 or 70 basis points and they haven’t really tightened
too much. There was a snap-back at the end of August
where you could buy a non-rated new issue anywhere from
a B+ to B- internal equivalent rating at about 650. Today,
they’re probably 615-620. But the whole theme here has
been spread widening.
This widening was a purely technical phenomenon. Overall,
credit quality in the portfolio has never been stronger. The
healthcare industry is experiencing one of its best times ever.
There have been Medicare and Medicaid increases to the
hospitals that help their bottom line. The continuing care
retirement community (CCRC) bonds we purchase are non-rated
and they’re also very strong.
In the tobacco industry, manufacturers that are paying into
the master settlement agreement (MSA), which backs all the
tobacco bonds, have never been stronger either in terms of
earning and their balance sheets. The litigation environment
in tobacco, which kept us out of the sector until 2005, is very
favorable for investors. Most of the litigation that was
brought against the tobacco manufactures and even against
the MSA has been turned down in court.
It’s important to point out that the fund’s recent performance
is completely unrelated to credit quality deterioration. In fact,
the credits themselves have been very, very strong. In
addition, despite the effects of the housing slowdown, the
economy is still fairly strong. But bottom line: the portfolio
itself has never been stronger and I look forward going
forward to it turning around and righting itself.
Portfolio Positioning
Last year, municipal supply was about $388 billion. Year-to-date,
we’re at $290 billion. As a reference point, over the first
eight months of 2006, new supply was approximately $239
billion, so we’re roughly $50 billion ahead of last year’s pace.
Of course, last year was a record for refunding. With rates
backing up, a lot of refundings that were in the works for
this year have been put on the sidelines because the interest
savings aren’t there anymore.
When all is said and done, we could easily eclipse $400
billion and may set a new record in 2007. The market has
priced in a 25 basis point cut by the Fed at its meeting in
September and about half the market assumes there will be
another 50 basis points in cuts. Some are calling for as many
as four cuts by the end of the year, with the fed funds rate
falling to 4.25%. I’m not personally in that camp.
Listening to the Fed’s comments and reviewing the releases
from their recent meetings, they seem to be pretty adamant
that the easy credit environment is what got our economy
and subprime mortgages to the point where they are today.
Therefore, easing interest rates too much and making money
easy again is not the solution.
I don’t think the current Fed believes it’s their responsibility
to bail out the market because of the issues related to
subprime mortgages. They’re still worried about employment
and inflation. However, I think last week Friday’s job numbers
was an eye-opener for the Fed because no one thought we’d
have a negative number for the month.
We’ve also seen oil reach a record $80 a barrel. Part of this
was because of hurricane season fears in the Gulf. I don’t
think the Fed has enough inflation information right now to
go full bore with big cuts. I think if you saw a 50 basis point
cut in September it might signal to the market that the Fed is
really worried about what’s going on and that’s the last
impression they want to give the market.
As a matter of fact, former Fed Chairman Greenspan clarified
some of his previous comments and said he supported what
Bernanke has done. In addition, he said if he was in the same
position, he probably would not have done anything
differently. If we’re right and get a slow easing of rates, we
think the curve may steepen a little bit more. Obviously, if the
short end of the curve is going to rally, we think municipals
will outperform.
At the end of August, the municipal market was weak and
you could buy a AAA municipal bond at 100% of the same
comparable Aaa 30-year Treasury bond. If you were not
concerned about AAA- or AA-rated housing bonds that are
subject to the AMT, they got as cheap as 112%. History has
shown that anytime you can buy municipal bonds at 100%
or cheaper of the comparable Treasury yield, you will always
do better. It may take time, but when that happens, you are
looking at a compelling opportunity, because municipals have
historically been roughly 85% of comparable Treasury yields.
In terms of the fund’s portfolio, during the recent rally we
pared back a little bit on its exposure to tobacco. There’s a
$500 billion Ohio tobacco deal coming to market next
month. Already this year we’ve had two major deals that
caused a repricing of the tobacco market and their spreads
to widen out. One was New Jersey tobacco during the first
quarter of 2007 and the other was Michigan tobacco in
August. In particular, we sold some of our lower 5% coupon
yielding tobacco bonds. Looking ahead, we’re going to set
some money aside to buy into the Ohio tobacco deal, which
will probably reprice the tobacco market again.
The fund does have some inverse floaters; most of them are
3:1, but none higher. When the market traded off, we didn’t
collapse any inverse floaters trust. However, we did unwind
some to take a little volatility out of the portfolio. The
tobacco sector remains somewhat volatile and, until the $5
billion Ohio deal bonds clears, this volatility could continue.
As I mentioned, we’re seeking to add more yield to the
portfolio. Therefore, you’ll probably some more purchases of
BBB- and non-rated healthcare bonds. Again, the credit
quality of those bonds has never been better, even on a nonrated
bond down to our –D internal rated issues. We will not
add any new inverse floaters to the portfolio. If anything, as
rates come back down again, we may try to unwind our
floaters and go back to our normal bread and butter—just
straight municipal bonds.
Leverage
The fund’s leverage is approximately 35%, which is typical
of our peer group. In terms of duration, for most of this
period the fund had been somewhat neutral to a little bit
short of the benchmark. We’re currently a little bit
long—about 103%- 104%—and we’re using three year Treasury
contracts to hedge back duration. Our leverage strategy was
obviously impacted by the dramatic volatility in the market,
as we saw movements that haven’t occurred in five or six
years.
Again, just to remind you of those moves, from December 31
to August 27 we went from 4.05% to 4.78% and then back
down to 4.36%. Obviously, with leverage, the move from 405
to 478 didn’t help us. But moving from 478 to 436 did help
us generate extra return. Hopefully, the increased income
that we generate from the inverse floaters will more than
compensate for the volatility in the fund over time. As I said
before, as rates come back down and we can unwind some
of these floaters back to where we put them on at, we’ll
decrease the fund’s volatility and its duration .
Q&A
Question: When you’re speaking of comparables, you’re
speaking of AAA municipals against Treasuries, I assume.
Answer: That’s correct, yes.
Question: I noticed that during the last two days this and
other closed-end municipal funds were down sharply. Is
there any particular reason for this?
Answer: From the bottom on August 27, I think the fund is
up $0.50-$0.60 and we’ve had $0.08, $0.10, and $0.12
increases in a single day. During the last few days, for
whatever reason, it seems like the market may have gotten
ahead of itself.
You are seeing a little bit of backup in tobacco, roughly10 or 15
basis points in recent days. This impacted the fund, as it has
about a 6% allocation to tobacco bonds. I also have several
inverse flow tobacco trusts which magnified the movement
and I think that’s the majority of the recent price decline.
Our non-rated bonds have also widened a little bit. I’m
hoping it’s just temporary, but again, we haven’t seen this
volatility for years and all of a sudden we had a snap back.
For whatever reason, the quicker you snap back, people say,
“wait a minute, we’re getting ahead of ourselves.” The buyers
just aren’t there to bid the market up anymore and you get
some natural pullback.
Question: In which scenario do you buy inverse floaters?
Answer: The last inverse floaters we put on was around
March. When the market trade is off and, let’s say I put a 5%
coupon in and at 416 of the inverse floater trust, they're now
worth 5%. I didn’t trade new ones per se, but I closed out an
old one and put a new one on at 5%. As a result, I picked up
40 basis points of yield to that particular trust and, on the
2:1 basis, picked up 80 points. On a 3:1 floaters, we obtain
120 basis points.
Question: Do put inverse floaters on because you anticipated
short rates moving?
Answer: No, the reason we put the floaters on is to increase
income to the portfolio. The way that works is if you buy a
million bonds at 5% yielding 4.60%, now you can take that
million and you can put it into a trust. At 3:1 leverage,
instead of paying for a million dollars worth of bonds, you
only have to pay for $250,000. Because it’s 3:1 instead of
running 4.60%, you’re going to earn about 6.5%-7% on the
$250,000. Then, theoretically, you take the extra $750,000
and invest it elsewhere.
So it’s not so much making a market call, we were trying to
add yield to the portfolio and to decrease the discount,
which we did, and increased the market return on the series
which we did. Unfortunately, it happened at the expense of
the NAV of the portfolio.
Question: Then the credit spreads went against you?
Answer: Exactly. Again, it had nothing to do with the credits
themselves. It was more a function of what buyers were in
the market and what supply they're able to absorb given all
that supply last year. At the same time, you had funds that were getting outflows, so they slow down. You had overseas
investors who came into the market for the first time last
year and they stopped buying. You had a lot of inverse
floated trusts, that were inverse floated at 7:1, 8:1, 9:1 and
10:1. As the market price came down they had to liquidate
because they were running out of cushion. So you had all
those bonds come back into the markets and no one to buy
them. This kept putting pressure on the prices. It has nothing
to do with credit whatsoever.
Question: Does your leverage float or do you have it locked
in for a certain period of time?
Answer: The fund’s leverage is set, some weekly and some
30-day auctions. On the bonds themselves that are put into
an inverse floated trust, BMA resets them every week.
Question: In theory, if the fed funds rate comes down 100
basis points, your income and portfolio should go up and
maybe you’ll raise the dividend down the road?
Answer: In terms of the direction of the interest rate,
correct. If they start to ease the fed funds rate, the curve
should rally, which means interest rates come down. That
helps the fund, as it’s 35% LIBORed already. Anytime you go
back after that to reset, whether it’s 7-day or 30-day resets,
theoretically the price should go down, which is more
income to pay out to the portfolio.
The inverse floaters themselves in the portfolio could reset
once a week. If BMA comes down, there’s also more income
for the portfolio, but theoretically again, it goes back to our
whole premise for doing this. If we can increase the income
earning potential of the portfolio down the road, it can result
in a dividend increase for the fund.
Question: Could you comment on the Davis versus Kentucky
case that’s going on with regards to bonds being priced
accordingly. Is there any indication which way the decision
is leaning?
Answer: There has really been no change in the price of
bonds. Let me go back and give you an example. Florida used
to have the intangibles tax and it was slowly weaned away,
so Florida bonds have adjusted because of that. They’re still
trading at a slight premium to, let’s say Illinois paper which
is a national paper, but doesn’t have the demand it
used to have. The only reason that it still carries somewhat
of a premium is because of the people that live there like
buying paper they’re familiar with.
In terms of the Davis versus Kentucky case, worse case
scenario, high tax states such as California, New York, and
Pennsylvania would be the most adversely affected. By that,
I mean there would really be no reason for a California
resident to just want to own California paper because they’re
familiar with the area or the school district. So the price of
California paper would probably migrate more towards the
national level. You’d have a few differences, based on things
such as the rating and the spot on the curve, but you’d have
some pretty similar yields on all bonds.
Bottom line—nobody here thinks it’s going to pass. We think
the Supreme Courts will not change it as they’re going to
allow states to have tax preferences on their in-state bonds. It
wasn’t looking like that for a while, but there have been so
many estates of governors, cities, counties, etc. that have all
spoken up. It would cost California or Pennsylvania, to name a
few, if their bonds become cheaper, as it obviously raises their
financing costs. At the end of the day, I don’t think that’s what
anybody wants to happen, least of all the municipal market.
Performance data quoted represents past performance, which
is no guarantee of future results and current performance may
be lower or higher than the figures shown. For the most recent
month performance figures, please visit the performance section of our site or
contact your financial advisor. Investment returns will
fluctuate and trust shares, when sold, may be worth more or
less than their original cost. NAV per share is determined by
dividing the value of the trust’s portfolio securities, cash and
other assets, less all liabilities and preferred shares, by the
total number of common shares outstanding. Total return
assumes an investment at the beginning of the period,
reinvestment of all distributions for the period in accordance
with the trust’s dividend reinvestment plan, and sale of all
shares at the end of the period.
Views and opinions expressed are those of Tom Byron as of
September 13, 2007 and are subject to change at any time, due to
changes in the market or economic conditions. Portfolio data
referred to in the call is as of July 31, 2007 and is subject to change.
The comments should not be construed as recommendations, but
as an illustration of broader themes. There is no assurance that
the closed-end fund will achieve its investment objective. Like
stocks, a closed-end fund’s share price will fluctuate with market
conditions and other factors.
At the time of sale, your shares may have a market price that is
above or below the net asset value and may be worth more or less
than your original investment. Accordingly, it is possible to lose
money investing in the trust. Investments in securities rated
below investment grade present greater risk of loss to principal
and interest than investment in higher-quality securities. Income
from the trust may subject certain individuals to the Federal
Alternative Minimum Tax.
The information presented contains forward-looking statements.
You are cautioned not to place undo reliance on forward-looking
statements, which speak only as of the date on which they are
made and which reflect management’s current estimates,
projections, expectations, or beliefs, and which are subject to risks
and uncertainties that may cause actual results to differ materially.
Leverage. Should the fund employ leverage, the portfolio may
experience increased volatility.
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