2015 Dec Barlcays Muni Primer Dated 2010

MUNICIPAL RESEARCH
18 October 2010
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 ones 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 Capitals municipal indices can be employed to measure a
portfolios relative total return performance and to enhance a fund managers 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 longterm 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.
PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 28
Peter De Groot
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peter.de-groot@barcap.com
Andrew Chan, CFA
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andrew.chan2@barcap.com
Jormen Vallecillo
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jormen.vallecillo@barcap.com
www.barcap.com
Barclays Capital | Municipal Market and Index Primer
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 TaxExempts ......................................................................................................................................................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
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 investors 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 2010s pace above 2009s 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)
Agency
Index, 871
Treasury
Index, 180
Figure 2: Indices by Avg Mkt Value per Bond $mn (June 30, 2010)
Credit Index,
3978
MBS Index,
1313
MBS Index,
$3,838.62
Credit Index,
$841.30
ABS Index,
$366.75
Municipal
Index,
$26.90
ABS Index,
114
Agency
Index,
$1,318.78
Treasury
Index,
$26,326.13
Municipal
Index, 46446
Source: Barclays Capital
18 October 2010
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 important
factors 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 bonds 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 new
issuance: 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 Moodys Investors Service (Moodys) or AAA by Standard & Poors (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 Local
Government 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 taxexempt 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 issuers interest payment expenses or change the debt maturity schedule.
18 October 2010
Figure 3: Municipal Index Rating Distribution (June 30, 2010)

BAA
OAD 9.94
12.32%
AAA
OAD 6.77
30.43%
Figure 4: Municipal Index Sector Distribution (June 30, 2010)

Prerefunded
OAD 3.28
9.53%
Insured
OAD 9.04
11.75%
Housing
1.82%
Hospitals
7.01%
Education
5.77%
Industrial
A
OAD 9.00
20.88%
AA
OAD 8.59
36.37%
General
Obligation
OAD 6.77
15.83%
REV
OAD 9.26
54.76%
Special Tax
7.59%
3.59%
Power
5.61%
Resource
Recovery
0.24%
Transport
11.75%
Water &
Sewer
Lease Rev 6.29%
4.42%
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, and
taxing 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.
18 October 2010
Figure 5: Holders of Municipal 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%
Insurance
companies
16.5%
Funds (MM,
Mutual,
Closed end,
ETF)
34.4%
Governmentsponsored
enterprises
1.0%
Household
sector
43.6%
Source: Federal Reserve Board, Flow of Funds Accounts, March 2010
Figure 6: Holders of Corporate Debt (December 31, 2009)

Finance
companies
1.8%
REITs
0.2%
Brokers and
dealers
1.3%
Governmentsponsored
enterprises
2.7%
Households
19.4%
Federal,
State, and
Local
Government
1.5%
Funds (MM,
Mutual,
Closed, ETF)
12.1%
Pension
Funds
(private and Insurance
Companies
public)
19.5%
6.2%
Funding
corporations
6.5%
Banks
8.4%
Foreign
20.5%
Source: Federal Reserve Board, Flow of Funds Accounts, March 2010
An investor interested in purchasing a municipal bond must be able to compare the taxexempt yield of a municipal bond to the after-tax yield earned in the taxable debt security
arena. 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 & Poors, 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.
18 October 2010
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 as
inflation 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.
Tobacco
Securities 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 assetbacked (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
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 10year 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 has
encouraged 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-dated
bonds 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 Ricos 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
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 Hillcrests financial condition worsened and it was eventually
bought out; its bonds were defeased to the call.
18 October 2010
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 reorganization
were 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 together
insure 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 countys 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
10
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 Systemand 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 $120140mn 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 Moodys February 2010 Special
Comment report, Moodys-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, Moodys 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
11
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
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%
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%
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%
10
Source: Moodys U.S. Municipal Bond Default and Recoveries, 1970-2009, February 2010
Figure 8: Average Cumulative Default Rates, 1970-2009, General Obligation

Rating
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%
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%
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: Moodys U.S. Municipal Bond Default and Recoveries, 1970-2009, February 2010
18 October 2010
12
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:
18 October 2010
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
13
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
Municipal Bond Index
General Obligation
State
Local
Revenue
Pre-refunded
Insured
Education
Transportation
Hospital
Resource Recovery
Housing
Water & Sewer
IDR/PCR
Special Tax
Power
Lease
18 October 2010
14
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
PRIMARY SECONDARY EDUCATION
MULTI-FAMILY HOUSING
HIGHER EDUCATION
SINGLE-MULTI FAMILY HOUSING
STUDENT LOANS
NEW PUBLIC HOUSING
LIBRARY, MUSEUMS
CMO BACKED HOUSING
OTHER EDUCATION
OTHER HOUSING
GOVERNMENT/PUBLIC SERVICE
INDUSTRIAL/ECONOMIC DEVELOPMENT
GOVERNMENT PUBLIC BUILDINGS
INDUSTRIAL DEVELOPMENT
FIRE STATION EQUIPMENT
POLLUTION CONTROL
CORRECTIONAL FACILITIES, COURTS
SOLID WASTE RESOURCE RECOVERY
GENERAL PURPOSE PUBLIC IMPROVEMENTS
ECONOMIC DEVELOPMENT
POLICE STATION EQUIPMENT
OFFICE BUILDINGS, LAND PARTNER
REDEVELOPMENT, LAND CLEARANCE
MALL, SHOPPING CENTERS
LAND PRESERVATION
OTHER INDUSTRIAL/ECONOMIC DEVELOPMENT
OTHER GOVERNMENT PUBLIC SERVICE

HEALTH CARE
RECREATION
HOSPITALS
CIVIC CONVENTION CENTERS
HOSPITAL EQUIPMENT LOANS
STADIUMS/SPORTS COMPLEX
NURSING HOMES
THEATERS
LIFECARE RETIREMENT CENTERS
PARKS, ZOOS, BEACHES
OTHER HEALTH CARE
OTHER RECREATION
TRANSPORTATION
UTILITY
AIRPORTS
ELECTRIC PUBLIC POWER
SEAPORTS, MARINE TERMINALS
WATER & SEWER
TOLL ROADS, STREETS, HIGHWAYS
GAS
BRIDGES
TELEPHONE
TUNNELS
SANITATION
PARKING FACILITIES
FLOOD CONTROL, STORM DRAIN
MASS RAPID TRANSIT
COMBINED UTILITIES
OTHER TRANSPORTATION
OTHER UTILITY
OTHER
VETERANS
AGRICULTURE
IRRIGATION
18 October 2010
15
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 monitor
changes 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

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 size
Used to report index performance (returns)
Statistics (Forward) Universe

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, market
values, etc.)
18 October 2010
16
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 the
price 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
17
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, with
an 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; added
several 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
18
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 Moodys 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 after
December 1, 2009, with accreted value of over $7mn will be allowed into index. Prerefunded bond rating will not be forced to AAA and must have an index rating of
investment grade to be in main index.
April 2010 Moodys 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. Potential
total 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
19
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 few
enhanced 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
20
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, a
portfolio 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 shortintermediate 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 companys portfolio managers 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
21
Figure 12: Index Results for June 30, 2010

1 Year (1-2)
3 Year (2-4)
5 Year (4-6)
7 Year (6-8)
10 Year (8-12)
15 Year (12-17)
20 Year (17-22)
Long Bond (22+)
GO Bond Index
State GO
Local GO
1 Year GO (1-2)
3 Year GO (2-4)
5 Year GO (4-6)
7 Year GO (6-8)
10 Year GO (8-12)
15 Year GO (12-17)
Long Term GO (17+)
Revenue Bond Index
Electric
Hospital
Housing
IDR/PCR
Transportation
Education
Water & Sewer
Resource Recovery
Leasing
Special Tax
Pre-refunded Index
1 Year Preref (1-2)
3 Year Preref (2-4)
5 Year Preref (4-6)
7 Year Preref (6-8)
8+ Yr. Preref
Insured Bond Index
Long Insured
California Exempt
New York Exempt
AMT Index
Zero Coupon Index
Conventional Muni
Non-Investment Grade
Managed Money Index
Short Term (1-5)
Sht/Interm (1-10)
Intermediate (1-17)
Long (10+)
Number
Issues
Price
Return
Coupon
Return
MTD
Total
Return
Past
3m
Past
6m
Yearto-Date
Since
Inception
46,514
3,487
6,135
5,076
4,647
8,608
8,918
5,164
4,479
12,724
5,863
6,861
881
1,660
1,513
1,469
2,740
2,595
1,866
23,836
2,134
2,647
1,153
640
4,823
3,061
3,393
160
2,294
3,531
3,976
1,283
1,646
629
223
195
5,978
628
6,237
5,843
2,321
1,290
42,910
3,341
19,550
3,267
8,598
15,203
10,952
-0.32
-0.27
-0.07
-0.05
-0.07
-0.06
-0.41
-0.65
-0.60
-0.32
-0.35
-0.29
-0.32
-0.06
-0.02
-0.04
-0.06
-0.40
-0.87
-0.37
-0.20
-0.07
-0.19
-1.29
-0.32
-0.33
-0.28
-0.79
-0.35
-0.51
-0.04
-0.28
-0.01
0.24
0.16
-0.08
-0.35
-0.39
-0.56
-0.23
-0.21
-1.12
-0.31
-0.04
-0.35
-0.20
-0.08
-0.19
-0.51
0.38
0.37
0.38
0.36
0.37
0.37
0.38
0.39
0.41
0.37
0.38
0.36
0.37
0.36
0.35
0.36
0.36
0.37
0.39
0.39
0.39
0.43
0.42
0.45
0.38
0.38
0.38
0.39
0.40
0.37
0.37
0.36
0.40
0.36
0.34
0.32
0.38
0.39
0.39
0.38
0.43
0.00
0.39
0.53
0.36
0.35
0.35
0.36
0.37
0.06
0.09
0.29
0.31
0.29
0.31
-0.03
-0.25
-0.19
0.05
0.03
0.07
0.04
0.30
0.33
0.32
0.30
-0.02
-0.48
0.02
0.18
0.36
0.23
-0.83
0.06
0.06
0.10
-0.40
0.04
-0.14
0.32
0.08
0.36
0.60
0.50
0.23
0.03
-0.01
-0.17
0.15
0.22
-1.12
0.08
0.49
0.02
0.15
0.27
0.16
-0.13
2.03
0.55
1.21
1.68
2.27
2.68
2.11
2.12
2.43
2.19
2.31
2.03
0.50
1.20
1.75
2.42
2.89
2.34
2.50
2.10
1.92
2.53
2.35
1.03
2.29
2.10
2.09
1.27
2.21
2.00
1.37
0.49
1.30
1.93
2.53
2.66
1.95
2.17
2.30
2.07
2.46
3.06
1.99
3.10
2.04
1.04
2.03
2.12
2.05
3.31
0.87
1.51
2.46
3.55
4.12
3.41
3.64
4.49
3.35
3.52
3.12
0.75
1.45
2.45
3.53
4.24
3.47
4.51
3.68
3.19
4.91
4.35
2.78
3.91
3.30
3.36
2.24
3.70
3.46
1.44
0.61
1.26
1.93
2.90
3.06
3.15
3.90
4.16
3.37
4.76
4.69
3.20
7.29
3.04
1.25
2.78
2.96
3.20
3.31
0.87
1.51
2.46
3.55
4.12
3.41
3.64
4.49
3.35
3.52
3.12
0.75
1.45
2.45
3.53
4.24
3.47
4.51
3.68
3.19
4.91
4.35
2.78
3.91
3.30
3.36
2.24
3.70
3.46
1.44
0.61
1.26
1.93
2.90
3.06
3.15
3.90
4.16
3.37
4.76
4.69
3.20
7.29
3.04
1.25
2.78
2.96
3.20
9.61
2.43
4.30
6.88
8.14
9.58
10.23
11.80
14.99
8.86
9.04
8.61
2.36
4.35
6.97
7.98
9.48
9.95
12.78
11.28
9.59
13.78
11.09
19.75
11.06
9.60
9.28
8.38
9.93
10.28
3.89
1.53
3.36
5.53
6.23
8.63
9.14
12.79
11.69
9.40
13.35
17.14
9.23
21.90
8.78
4.22
6.58
7.67
10.04
18 October 2010
22
Figure 13: Index Results for June 30, 2010

Number
Issues
Durat. MDur.
To
To
Worst Worst
Mod.
Adj.
Durat.
Quality
Cpn
Time
To
Worst
Mat.
Price
Yield
To
Worst
Market
Value
Index
Agg.
46,446
5.72
5.60
8.28
AA2/AA3
4.98
7.53
13.51 100.67
3.41
1,249,231
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
100.00 100.00
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
8.87
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
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
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
2.73
7 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
GO Bond Index
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
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
160
4.17
4.08
7.00
A1/A2
4.91
5.33
11.88 102.38
3.76
3,009
0.44
0.24
Leasing
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
8.27
Revenue Bond Index
Resource Recovery
3,487
6.42
6.29
8.95
AA2/AA3
4.83
8.04
14.53
87.93
3.61
103,272
15.10
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
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
Insured Bond Index
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
4.67
Zero 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
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
35.93
18 October 2010
23
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 sector
concentration 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 a
performance 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
24
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 postemployment 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). ALMs goal is to
maintain 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 firms 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
25
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 bonds 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 bonds 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
26
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 bonds 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 bonds 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 bonds 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 bonds 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
27
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 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. 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 (77.560.0) 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
holders 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 at
the capital gains rate.
18 October 2010
28
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 personal
views 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 or
indirectly related to the specific recommendations or views expressed in this research report.
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MUNICIPAL RESEARCH

Municipal Market and Index Primer

Barclays Capital | Municipal Market and Index Primer

Barclays Capital | Municipal Market and Index Primer

Municipal Bond Market

Source: Barclays Capital

Source: Barclays Capital

Barclays Capital | Municipal Market and Index Primer

Barclays Capital | Municipal Market and Index Primer

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

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

Source: Barclays Capital

Source: Barclays Capital

Barclays Capital | Municipal Market and Index Primer

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

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

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

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

Barclays Capital | Municipal Market and Index Primer

Municipals over the Past Decade and into 2010

Barclays Capital | Municipal Market and Index Primer

Tender Option Bond Programs

Barclays Capital | Municipal Market and Index Primer

The Taxable Municipal Market

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

Barclays Capital | Municipal Market and Index Primer

Barclays Capital | Municipal Market and Index Primer

Municipal Bond Defaults

Barclays Capital | Municipal Market and Index Primer

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

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

Barclays Capital | Municipal Market and Index Primer

Barclays Capital Municipal Index Design Principles

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

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

No secondary insured or private placement bonds

No partially prerefunded CUSIP where no new CUSIPs are issued

Barclays Capital | Municipal Market and Index Primer

Figure 9: Municipal Bond Index Hierarchy

Municipal Bond Index

Water & Sewer

Source: Barclays Capital

Barclays Capital | Municipal Market and Index Primer

Figure 10: MuniView Classifications

PRIMARY SECONDARY EDUCATION

SINGLE-MULTI FAMILY HOUSING

NEW PUBLIC HOUSING

CMO BACKED HOUSING

GOVERNMENT PUBLIC BUILDINGS

FIRE STATION EQUIPMENT

CORRECTIONAL FACILITIES, COURTS

SOLID WASTE RESOURCE RECOVERY

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