Confidential

Vanguard Municipal Market OutlookPhiladelphia FPA

May 17, 2011

Mike KobsSenior Portfolio ManagerMuni Bond Group

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• General Overview of the Municipal Market

• Review of Current Market Conditions

• Vanguard’s position on default risk and public pension underfunding

• Municipal Bond Market Outlook

• Q&A

Municipal Bond Market Presentation

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• Issuers are typically state and local governments and not-for-profit entities

• Most municipal debt provides a tax-advantage for investors

• Borrowing cost advantage for issuers

• Relatively high credit quality

• Large number of independent issuers/credits

• Municipal securities are exempt from registration with the SEC

Unique Characteristics of theU.S. Municipal Securities Market

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• “General Obligation” Notes and Bonds–Backed by the full faith and credit of a state or local

government–All sources of revenue, unless specifically limited, will

be used to pay debt service on the bonds

• “Revenue” Notes and Bonds– Issued to finance specific revenue-generating projects

or utility systems–Secured solely by the revenues from the financed

project or system

How are U.S. Municipal Borrowings Secured?

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• $2.925 Trillion outstanding

• 50,000+ Issuers

• 1.18 million cusips

How big is the Municipal Bond Market?

Source: MSRB 2010 FactBook

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Core Inflation Momentum FactorsMunicipal Bond Market- Credit Quality and Sectors

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Municipal Bond Market- New Issuance Supply

Source: The Bond Buyer

2002

2004

2006

2008

2010

0

100

200

300

400

500

Issuance ($Billion)

Issuance ($Bil-lion)

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Other8%

Broker/Dealers1%

Commercial Banks

8%

P&C Insurance14%

Mutual Funds15%MM Funds

18%

Households36%

Municipal Bond Market- Holders of Municipal Debt

Source: Federal Reserve Board, Flow of Fund Accounts

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Core Inflation Momentum FactorsMunicipal rates have risen from historical low levelsJan-00

Jul-00

Jan-01

Jul-01

Jan-02

Jul-02

Jan-03

Jul-03

Jan-04

Jul-04

Jan-05

Jul-05

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

AAA Municipal Yield Levels

7-Day 5-Year 25-Year

Perc

ent

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Core Inflation Momentum FactorsCredit Quality Spreads

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Core Inflation Momentum FactorsMunicipals look attractive versus high quality alternatives

10-Year Comparison

5/6/2011

Muni Corporate

QualityCredit Spread AAA (MMD) Yield Tax Eq Yield*

Credit Spread UST Yield Vs Corp Vs Tsy

AAA 17 2.74 2.91 4.48 29 3.18 3.47 1.01 1.30

AA 56 2.74 3.30 5.08 99 3.18 4.17 0.91 1.90

A 154 2.74 4.28 6.58 131 3.18 4.49 2.09 3.40

BBB 211 2.74 4.85 7.46 170 3.18 4.88 2.58 4.28

*35% Federal Tax Bracket

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Core Inflation Momentum FactorsHistorical Municipal Default Statistics

Moody's (1)

S&P (2)

Fitch (3)

0.00% 0.20% 0.40% 0.60% 0.80% 1.00% 1.20% 1.40% 1.60%

CorporateMunicipal

.89% [238 defaults (1999-2009)]

.04% [10 defaults (1999-2009)]

1.54% [1,604 defaults (1986-2008)]

.02% [10 defaults (1986-2008)]

1.57% [1,707 defaults (1970-2009)]

.01% [54 defaults (1970-2009)]

1. Moody’s Investors Services, U.S. Municipal Bond Defaults and Recoversies, 1970-2009 (February 2010); Moody’s Investors Service Corporate Default ad Recovery Rates, 1920-2009 (February 2010). Percentags based upon average one year default rate.

2. Standard & Poors, 2009 Global Corporate Default Study and Ratings Transitions (March 17,2010); Standard & Poor’s; U.S. Municipal Ratings Transitions and Defaults, 1976-2009 (March 17,2010); Standard & Poor’s; U.S.

3. Fitch Ratings Inc. U.S. Public Finance Transition and Default Study (1999-2009), March 25,2010; Fitch Ratings Global Corporate Finance 2009 Transition and Default Study.

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• Over the Counter Market

• 100’s of dealers

• 1.2% of securities outstanding trade daily on average, most of these trades are in denominations of less than $100,000 par value

• Evaluations are done daily by two pricing services: Thompson/JJ Kenny and IDC Muller

• Pricing convention is on a Yield to Worst basis

Municipal Market Trading Conventions

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• Steep Yield Curve

• Cheap relative to Treasuries

• Wider Credit Spreads

• Headline Risk

• Regulatory Rhetoric

Current Market Conditions

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Steep Yield Curve

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

Municipal Yield Curve3/31/2011 "AAA" MMD Curve

Years to Maturity

Yield

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Cheap relative to Treasuries

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 201165%

75%

85%

95%

105%

115%

125%

135%

145%

155%

165%

Ratio of 10-Yr Muni to 10-Yr Tr(1990-Present, Monthly)

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Core Inflation Momentum FactorsState and Local Government Challenges

• Pensions – the biggest long term challenge due to constitutional and statutory protections (estimates up to $3 trillion unfunded liability depending on discount rates selected)

• OPEB – huge promise to retirees with estimates up to $700 billion unfunded liability, generally pay-as-you-go; can be altered by legislature

• Medicaid – on the way to becoming largest line item in state budgets

• Education – continuing to be squeezed, particularly with the loss of ARRA funding

• Debt – much discussion of default, but debt burden remains within historical norms

> 18 ConfidentialSource: Rockefeller Institute

> 19 ConfidentialSource: Rockefeller Institute

> 20 ConfidentialSource: Rockefeller Institute

> 21 ConfidentialSource: Rockefeller Institute

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Core Inflation Momentum FactorsMunicipal interest cost is manageable

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Core Inflation Momentum FactorsUnfunded Actuarial Liabilities from Pensions and OPEBs

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Core Inflation Momentum FactorsDebt levels have risen but are within historical norms

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Core Inflation Momentum FactorsMunicipal Market Outlook

• Yield Curve – Flattening as Fed Tightens

• Credit Spreads – Wider than historical averages, differentiation in credit

• Headline Risk – As the budget process moves forward, difficult decisions about cutting services and raising revenues will be played out in the press

• Legislation Risk – Many initiatives to replace the tax-exemption in Munis will play out in the media and generate volatility depending on what form gains traction

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Core Inflation Momentum FactorsQ&A

• What concerns your clients about the Municipal Market?