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Second Quarter Municipal Bond Market Commentary Sheila Amoroso and Rafael Costas, Co-Directors, Franklin Municipal Bond Department	07/01/2006
Key Points: Municipal bonds continued to outperform Treasuries New muni bond issuance is down over last year Puerto Rico bond prices held relatively steady despite a budget crisis and credit downgrade Municipal bonds outperformed Treasuries. In the second quarter, municipal bonds, as measured by the Lehman Brothers Municipal Bond Index, rose 0.03%, as the effects of rising interest rates were mitigated by a weak supply of new issues and strong investor demand for municipal securities.1 Treasury securities, as measured by the Lehman Brothers U.S. Treasury Index, fell by 0.06%, continuing the year-long trend of under performance compared to municipal bonds.1 While the quarter ended with positive results, June was a particularly difficult month for municipal bonds as interest rates rose throughout the municipal yield curve, resulting in negative total returns. Weak municipal bond issuance in 2006. New issuance fell 14% for the first half of 2006, compared to the same period last year, due largely to the diminishing number of refunding opportunities. Last year when issuers sold $408 billion of new municipal bonds, an estimated 32% of them were refunding deals, as many municipalities took advantage of the low interest rate environment. This year, as interest rates have increased, refunding opportunities have decreased and municipalities have been more reluctant to issue long-term debt. Puerto Rico bonds were downgraded following a fiscal crisis. In early May, Puerto Rico announced the shutdown of many of its government departments in response to a budget stalemate between the legislature and the governor's office. While the government promised that reserves had been set aside for bondholders, Moody's still downgraded the government's general obligation (GO) bonds to Baa3 from Baa2. In spite of the fiscal crisis, Puerto Rico bond prices, which generate double tax-free income for residents of all 50 states (due to their status as a U.S. territory), held relatively steady. California Update Moderate growth for California's economy. California's large and diverse economy has been experiencing a sustained trend of moderate growth coupled with healthy tax revenue increases. The governor's recent budget report was quite positive, showing income growth up 6%, while unemployment fell from 6.7% to 5.0% as of May 2006—levels not seen since before the September 11, 2001, terrorist attacks. However, questions of a California real estate bubble and rising commercial real estate vacancies may pose a threat to the state's economy. California credit rating upgraded. In May Standard & Poor's and Moody's upgraded California's GO debt from A to A+ and from A2 to A1, respectively. In June, Fitch also upgraded California's GO debt from A to A+. The credit rating agencies cited California's continuing economic growth, strong state revenues, a higher than expected general fund balance and progress in reducing fiscal imbalances. New York Update New York economic recovery in progress. New York's economy appeared headed toward full recovery, led by New York City, Long Island and the Hudson Valley area economies, with growth supplemented by rebounding healthy profits and bonuses in the finance and insurance industries. The securities markets and real estate in New York City and downstate areas also contributed to the state's economic growth. Recent gains were not consistent across the state, however, and many upstate urban centers remained strained. Additionally, manufacturing continued to lag. Although New York's employment growth typically trails the nation's, as of May 2006, the state's 4.6% unemployment rate was on par with the national rate.2 Closing Statements Regardless of short-term market fluctuations, we view municipal bonds as an attractive source of tax-exempt income, based on their long-term benefits, including: Strong after-tax performance. Historically, municipal bonds have been the second best-performing asset class after stocks on an after-tax basis.3 Relatively low volatility. Historically, municipal bonds have been less volatile than comparable U.S. Treasury bonds.4 Attractive taxable equivalent yields. Municipal bonds may offer taxable equivalent yields that are higher than taxable fixed income alternatives. For example, a hypothetical municipal bond yielding 4.5% would have a taxable equivalent yield of 6.92% for an investor in the 35% federal tax bracket. Therefore, a taxable fixed income investment would have to yield 6.92% in order to equal or exceed the tax-free yield of the hypothetical municipal bond investment.5 At Franklin Templeton, we'll continue to focus on maximizing tax-free income, while adhering to the plain vanilla strategy (no derivatives, no leverage) that has served our shareholders well over the years. A Word about Risk Because municipal bonds are particularly sensitive to interest rate movements, a municipal bond fund's share price and yield will fluctuate with market conditions. Bond prices, and thus a fund's share price, generally move in the opposite direction of interest rates. As the prices of municipal bonds adjust to a rise in interest rates, a fund's share price may decline. This and other risks are detailed in a fund's prospectus.