Morningstar Advisor - February/March 2009 - 39

Associate director of fund analysis Lawrence Jones, vice president of equity research Haywood Kelly, bond specialist Eric Jacobson, and fund analyst Miriam Sjoblom contributed to this report. Municipal Bonds r Municipal markets were depressed by a crisis of confidence in the creditworthiness of municipalbond insurers, the failure of auction-rate securities markets, and significant sales of municipal bonds by highly leveraged market participants, involving so-called “tender-option bonds.” r Hedge funds that had taken advantage of the TOB structure unwound them in droves when plummeting markets and margin calls demanded that they sell their most-liquid positions. r As hedge funds and Wall Street departed the market and retail investors grew increasingly skittish, demand for the securities waned, putting pressure on prices. r Muni valuations relative to comparable maturity Treasuries are incredibly cheap, as are other measures of value, such as their yield comparisons to agency-backed mortgage securities. r Actual defaults in sector are incredibly rare. r Stick to high-quality munis for now. Nonrated and below-investment-grade sectors get hurt the most in a downturn. Consumer Stocks r In a consumer-led recession, the market naturally clobbers consumer stocks. r Given the U.S. housing crisis and generally high consumer debt levels, we agree that many areas of consumer—especially retail—will see a shakeout. Mortgage-Backed Securities r Headlines concerning agency balance sheets alarmed investors worldwide. r Investors dumped agency mortgages in droves and have remained on the sidelines, if for no other reason than the need to raise cash. r Bear market is hammering shares of several wide-moat consumer names that we think have very bright long-term futures. r We are focusing on a combination of lowerrisk firms that have dominant brands and slightly higher-risk firms with better long-term growth opportunities. r Yields of mortgages guaranteed by Fannie, Freddie, and Ginnie Mae are well above historical norms—even when adjusted for the theoretical value of their embedded refinancing options. r Fannie, Freddie, and Ginnie Mae mortgages carry what is effectively a government promise of protection. r Good values also exist in the nonagency mortgage-backed securities market, which is much less secure (with the lack of government guarantees) and has seen severe price declines. r Fidelity Intermediate Municipal Income FLTMX: Mark Sommer adds value through sector rotation, issue selection, and yield-curve positioning. r Franklin Federal Tax-Free Income A FKTIX: Sheila Amoroso buys and holds bonds offering competitive yields and trading at reasonable prices. r Vanguard Long-Term Tax-Exempt VWLTX: Fund’s cost advantage gives the offering a leg up in the muni world, where costs matter more than just about anywhere else. r Avon Products AVP: The firm’s restructuring efforts, international diversification, and strong returns on invested capital should allow its cash flows to hold up even in difficult times. r PepsiCo PEP: With its brands, product innovation, and a direct-store-delivery network, PepsiCo is the gold standard for the consumer-products industry. r CarMax KMX: Stock has gotten crushed, but we still think the company has a long runway of growth ahead of it. r PIMCO Total Return PTTRX: Bill Gross built a big position in agency guaranteed mortgage-backed securities and held firm against negative news. r TCW Total Return Bond TGLMX: Jeffrey Gundlach navigated through trouble by purchasing high-credit-quality mortgage-backed issues. r FPA New Income FPNIX: Bob Rodriguez and Tom Atteberry bought agency mortgage-backed issues, sticking to high-quality issues, because preservation of capital is foremost in their minds. MorningstarAdvisor.com 39

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Morningstar Advisor - February/March 2009

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