Tax-Exempt Outlook and 2Q Summary

July 21, 2010

We expect good relative performance from the tax-exempt market through the early summer. Favoring tax-exempt municipal bonds are the persistent low yields on money market instruments, the diminished supply due to the success of taxable Build America Bonds (BABs), the high level of reinvestment demand, the approach of higher income tax rates in 2011, and yields that are relatively attractive compared with US Treasuries. Yet with municipal yields near all-time lows, we remain relatively neutral in our portfolios' maturity structure. We strive to add yield and value through our independent credit research effort with a focus on essential-purpose revenue and dedicated tax issues.

In the second quarter, US Treasury bonds — the performance leaders of 2008 and the laggards of 2009 — returned to the spotlight as top performers. The flight-to-quality trade re-emerged with the global debt crisis, a sluggish domestic economy, and a rebirth of deflationary concerns. Yields on US Treasury notes and bonds fell across the maturity spectrum, with 7- and 10-year notes showing the largest declines during the quarter (0.86% and 0.89%, respectively).

Municipal bond yields also eased in the second quarter, albeit reluctantly, as comparisons between state budgetary imbalances and sovereign debt problems gave municipal investors pause. The result was inconsistent liquidity in the secondary municipal bond market. Nevertheless, yields did decline overall, especially in the 2- to 11-year range, as attention slowly turned to the attractive yields relative to US Treasuries and the expectation that July would bring both reduced new issue supply and new reinvestment demand from large maturities, calls, and interest payments.

From a credit perspective, state finances remain dismal, with only modest recent improvement as the recovery has been slow. Exacerbating the gloomy outlook is the loss of Federal Recovery Act funds, which should keep conditions tight for fiscal 2011 and possibly beyond. The news was not entirely bleak, however. Although Illinois seems to have surpassed California in its inability to come to grips with continuing financial imbalances, New Jersey by contrast has made initial strides in tackling its budget problems.

The bad news: Illinois has resisted going beyond one-time measures to address its structural imbalance. This lack of political will indicates further deterioration ahead in an already weak financial position. The state economy, with a diverse base and above-average wealth, is not the primary culprit. A clear sign of Illinois's problems is the largest unfunded pension liability of any state.

The good news: New Jersey recently passed a budget with spending at its lowest level since 2006 but only nominal increases in revenue. Acknowledging the concern of driving residents and businesses out of the state due to the heavy tax burden, New Jersey made significant cuts in aid to municipalities and higher education rather than increase revenues. The state also recently adopted comprehensive reforms that should benefit the pension system over the next decade.

Certain investment gurus (none recognized as experienced municipal specialists) have warned of an impending crisis in municipal finance. While we expect an increase in the number of defaults over previous downturns, the default rate for essential-service issues will remain low, and we do not foresee an epidemic in the overall market as most entities are well run with broad powers to raise revenues or make expenditure cuts. The defaults that occur should be isolated events with some combination of the following characteristics:

How should investors react? Our strategy of thorough, independent credit research, an emphasis on essential-purpose revenue and dedicated tax issues, and increased geographic diversification has served EWM clients well and avoided downgrade risk for the past 1 1/2 years. We do not expect the Federal Reserve to raise the Federal Funds rate until 2011; in our opinion, the overall level of interest rates should remain low, but volatile, for the balance of 2010. A number of factors should support the tax-exempt market over the short to intermediate term. Nevertheless, with municipal bond and cash yields near historic lows, we will stay fully invested but prefer to take advantage of wellresearched, individual undervalued opportunities provided by the market's inconsistent liquidity than to make undue, aggressive duration bets.

Download: Tax-Exempt Outlook and 2Q Summary (PDF)

Important Notice: Evercore Wealth Management, LLC ("EWM") is registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940. EWM prepared this material for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. This material should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. EWM may make investment decisions for its clients that are different from or inconsistent with the analysis in this report. EWM clients may invest in categories of securities or other instruments not covered in this report. EWM obtained this information from multiple sources believed to be reliable as of the date of publication; EWM, however, makes no representations as to the accuracy or completeness of such third party information. EWM has no obligation to update, modify or amend this information or to otherwise notify a reader thereof in the event that any such information becomes outdated, inaccurate, or incomplete. Specific needs of a client must be reviewed and assessed before determining the proper allocation for a client and must be adjusted to market circumstances. The securities/instruments discussed in this material may not be suitable for all investors. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. Any opinions and analysis herein reflect our judgment at this date and are subject to change as there are changes in relevant economic, legal or political circumstances. Upon request, we will furnish a list of all securities recommended to clients during the past year. This material does not purport to be a complete description of our investment services. This material may not be sold or redistributed without the prior written consent of EWM.