The following is excerpted from the latest Crane Data's Money Fund Intelligence newsletter. This month MFI interviews managers of Western Asset Management's Municipal Money Market Funds. We speak with Robert Amodeo, Portfolio Manager and Head of the Municipal Group, and Charles Bardes, a Portfolio Manager on the Tax-Exempt Money Market Mutual Funds. The two have been running money funds with the unit since its days as Salomon Brothers Asset Management (in the late '80's/early '90's), which then became Citigroup Asset Management and eventually was acquired by Western parent Legg Mason. Our Q&A involving tax-exempt money fund issues follows.

MFI: What has been the biggest challenge recently vs. historically? Amodeo: Our investment philosophy and process are unchanged as they served our shareholders well during the most volatile markets yet everything around us has changed.... Historically, money market funds were a product that didn't concern too many people. But today investors ask you to be an active manager, you have to have good credit, you need to be proactive in your positioning. You need to anticipate rating actions, which seems to be coming through the pipeline a little faster than they have in years prior. So, an active manager will be able to perform well in this marketplace. But if you subscribe to the old "gut feel" rules, say 10 years ago, the industry won't allow you to survive.

MFI: Do potential bank downgrades impact the tax-exempt market? Amodeo: Absolutely, it is in particular the letters of credit, or the standby purchase agreements [that are impacted]. It's the liquidity within the marketplace that's backed by those large banks which are now moving toward Tier 2. So, whereas in the past you may have been able to diversify the portfolios to twelve names, now there will be less names in that top tier. Or you would have to move to just names that perhaps you have overlooked in years prior.

MFI: Is the majority of the municipal supply dependent on those types of [demand and liquidity] features? Bardes: Yes, in fact one of the concerns we had prior to the recent Moody's action was the Basel III recommendations, which essentially wouldn't be going fully into effect until 2015. But there was a lot of concern about whether banks would be averse to capital requirements and whether they would be willing to write more letter of credit business renewals especially. For 2010 and 2011, we really didn't see that much of a drop off in renewals and such. There were some issuers that did take advantage of either bonding out or issuing SIFMA index notes or other types of instruments, as opposed to variable rate demand notes, but we didn't see it affecting supply as much. Now the landscape has changed a little bit, once again. A couple of banks that were counted on to be there now are facing potential downgrades.

Amodeo: The challenge for tax-exempt investors is to be able to differentiate the liquidity aspect of the variable rate demand note from the mechanics of the note itself. VRDNs seem to be under attack on a regular basis but the mechanics of the instrument work very well when backed by strong liquidity provider.

MFI: Is the Moody's threat a big deal? How much of an impact could it have on the market? Amodeo: Well for us we've remained proactive. We moved our portfolios away from these potential downgrades into other names [to] get ahead of it. Like we have in prior cycles and prior years of potential downgrades, we don't want to sit there and wait for it to take place. We really want to be proactive. For us, it won't have much of an impact at all.

MFI: Is it similar to when the municipal bonds insurers all got downgraded? Amodeo: Yes, and in many ways we were ahead of that as well. We know from experience that [you've got to] be proactive in this marketplace, so that when you are looking for replacement parts you want to be ahead of the crowd. The landscape you just described is very similar to the one we are confronting now.

MFI: Is the lack of supply a major problem in this market? Bardes: No, not today. It's fine. We are able to, kind of move pieces around in the last month or so.... We've been finding ample replacement parts for those securities we've divesting of.

MFI: Are crossover [taxable] buyers impacting the market? Amodeo: Yes, they drove municipal yields lower. Municipal bonds or variable rate demand notes appeared cheap, not only on a tax-adjusted basis but in a nominal sense. That drew the attention of these institutions that normally would avoid the tax-exempt securities because they cannot benefit from the tax-exempt income. So, they came marching in with their large balance sheets and really soaked up a great deal of supply ... and drove yields to lower levels, levels comparable to the taxable arena.... The taxable arena cheapened up a little bit recently, so they put back some VRDNs as their traditional securities appeared more attractive. (Look for more excerpts in coming days or see our April MFI for the full interview.)

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