Market Sector Update

• The high yield municipal market performed well during the second quarter of 2018. With the Federal Reserve (Fed) slowly raising rates and relatively benign inflation data, the long end of the high municipal curve returned better than 3%. We believe the strength in the high yield market should continue in the near term as positive inflows, along with low levels of issuance, will continue to generate positive results.
• The second quarter of 2018 saw strength across the entire curve with the strongest returns in 3-year maturities, which returned 5.56%. The strongest returns continue to be Puerto Rico bonds, which returned 12.08% for the quarter. Puerto Rico debt now only makes up 3.35% of the Bloomberg Barclays High Yield Municipal Index, as downgrades have resulted in their bonds failing out of the index. Much of the debt is now owned by nontraditional investors as municipal bond mutual funds have greatly reduced exposure to the territory. We believe that Puerto Rico bonds are dead money - meaning investors will receive no income from the bonds for the foreseeable future. With the Fund’s primary mission of creating high levels of tax exempt income for clients, we feel we would be remiss to chase something with a very high likelihood of offering no income for investors.
• The Fund being underweight tobacco negatively contributed to performance for the quarter as bonds continued to approach par. With several tobacco refundings on the calendar we will continue to look at opportunities to add names we like at discounts to par.
• With the rally in rates through 2017 and into early 2018 we have become less constructive on the high yield municipal space as new issues are coming to market primarily with historically low absolute yields and weak collateral for investors.
• Going forward we still believe the municipal market is attractive versus other fixed income asset classes based on strong demand and continued low supply. We do feel like debt issuance for the remainder of 2018 will be higher than most estimates; however, we also believe it will remain lower than historical norms. We have turned more bearish on the credit market as spreads are hovering around the lows of 2007.

Portfolio Strategy

• The Fund has been reducing exposure in non-rated bonds. As of end of the second quarter exposure to non-rated bonds was below 35%. With non-rated bond spreads at record lows we feel it is prudent to own more liquid rated bonds in order to provide us the opportunity to exploit any credit widening. It is important to note that about 4% of the non-rated bonds we hold are pre-refunded, meaning although non-rated, these bonds are highly liquid. Currently the portfolio holds over 11% of pre-refunded bonds, which affords ample liquidity to exploit opportunities as they arise. We will continue to hold over 11% of the portfolio in pre-refunded bonds as a source of additional liquidity moving forward. It is important to note that the book yields of most of these bonds are well north of 6%, allowing us to maintain a strong and stable dividend.
• We continue to favor revenue bonds over tax backed debt as revenue bonds, in our view, provide higher yields and better diversification from general tax and pension issues currently affecting many municipalities. Historically, General Obligation bonds have favored well in Chapter 9 bankruptcies. This was turned on its head, however, post-Detroit and we expect the same outcome in the Title IV filing in Puerto Rico.
• We are cautious with California hospitals and evaluate these borrowers carefully. The Fund is underweight the hospital sector, with 7.33% exposure versus a 13.52% weighting in the Bloomberg Barclay’s Municipal Bond Index. We believe that hospitals carry the most ratings downgrade risk of any sector due to multiple versions of proposed healthcare reform that could lead to a rollback of Medicaid expansion, which will strain operating performance in the sector.
• Going forward, we will look for opportunities in bonds with more defensive structures, as interest rates continue to hover around historically low levels and credit spreads continue to be tight. We feel at this time it makes sense to remain shorter duration than the Benchmark, as we view the sector as fully priced.

Outlook

• Moving forward we expect two more rate hikes in 2018 as inflation climbs closer to the Fed’s 2% threshold. We are certainly concerned how a possible trade war with both China and the European Union would affect prices and the overall global economy. It will be important to monitor how tariffs might tip the Fed’s hand one way or another, and whether they will be forced to review current interest rate policy. Certainly, this is an evolving threat which we must continue monitor closely. With the Fund matching 75% of the duration of the Bloomberg Barclays High Yield Municipal Index, we feel we are appropriately structured to weather any storm a long trade war may cause. It is important investors realize prudent managers diversify across states and sectors and always limit the amount of exposure to those variables, as well as any individual bond.
• We believe investors will continue to search for tax-exempt yield. We view the tax cuts that took effect earlier this year as favoring lower income brackets and, with a top tax rate of 37%, municipal bonds are still highly attractive. Although we see demand for municipal bonds staying consistent with normal levels, one big outlier would be additional issuance caused by a large infrastructure spending bill getting passed in Congress and signed by the President. That being said, we believe that supply in the municipal market will remain at normal levels, which should present opportunities for investors. In our view, municipal bonds will continue to be one of the most attractive fixed income asset classes from a relative valuation standpoint.

The opinions expressed are those of the Fund’s managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through June 30, 2018, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. Past performance is not a guarantee of future results.

The Bloomberg Barclays Municipal Bond Index is an unmanaged index comprised of securities that represent the long-term municipal bond market. The Bloomberg Barclays Municipal High Yield Index is an unmanaged index made up of bonds that are non-investment grade, unrated, or rated below Ba1 by Moody’s Investors Service with a remaining maturity of at least one year. It is not possible to invest directly in an index.

Diversification does not guarantee a profit or protect against loss in a declining market. It is a method to manage risk.

Effective duration is a calculation used to approximate the actual, modified duration of a callable bond. Effective duration is calculated using the long position holdings of the portfolio.

Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. The Fund may include a significant portion of its investments that will pay interest that is taxable under the Alternative Minimum Tax (AMT). Exempt-interest dividends the Fund pays may be subject to state and local income taxes. The portion of the dividends the Fund pays that is attributable to interest earned on U.S. government securities generally is not subject to those taxes, although distributions by the Fund to its shareholders of net realized gains on the sale of those securities are fully subject to those taxes. The municipal securities market generally, or certain municipal securities in particular, may be significantly affected by adverse political, legislative or regulatory changes or litigation at the Federal or state level. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers. Because the Fund invests predominantly in California municipal securities, events in California are likely to affect the Fund’s investments and its performance. As with California municipal securities, events in any of the U.S. territories, such as Puerto Rico, Guam and the U.S. Virgin Islands, where the Fund is invested may affect the Fund’s investments and its performance. These events may include economic or political policy changes, tax base erosion, constitutional limits on tax increases, budget deficits and other financial difficulties, and changes in the credit ratings assigned to municipal issuers of California or U.S. territories.