Market Sector Update

• California municipal bonds had a solid quarter returning a healthy 1.45%. With the turmoil in the equity market, the government shutdown and the prospects of a prolonged China trade war, municipal bonds benefited from a flight to quality. The 7- to 10-year part of the curve showed the strongest returns yielding 1.77 and 1.38%, respectively.
• We believe the strength in the municipal high yield market should continue in the near term as positive inflows along with low levels of issuance should continue to generate positive results.
• Municipal high yield flows turned negative for the quarter with $2.236 billion leaving the asset class. This was the main reason for the significant underperformance in the tobacco sector. Likewise, this resulted in spreads widening although they are still tight on a historical basis. On a ratings basis, AAA versus BBB spreads widened from 63 basis points (bps) to 94 bps.
• Longer term, even with the widening in spreads during the quarter we continue to be cautious when evaluating opportunities. As stated previously, spreads continue to be tight in a historical context and new investment options continue to offer little collateral for investors. With the three major issues referenced above, we feel it is more important to focus on quality as we believe spreads may continue to widen. We feel that higher quality California paper should benefit greatly if the turmoil in the government and equity markets persists.

Portfolio Strategy

• The Fund outperformed the Barclay’s High Yield Municipal Index for the quarter. Due to the higher amount of higher spread holdings in the Fund, we underperformed the Bloomberg Barclays High Grade Municipal Index.
• The Fund’s non-rated exposure currently sits at 25% which is a maximum for the Fund in our view. We do not intend to take the percentage higher.
• The Fund is underweight tobacco with an approximate 8% allocation versus 16.34% in the Bloomberg Barclays High Yield Municipal Bond Index. The underweight position helped in the quarter as tobacco bonds returned a negative 3.87%. With the weakness in the sector we are looking for attractive issues trading at a discount and offering attractive yields. The Fund’s strategy has always been attractive income with low volatility, but we do intend to increase exposure over time.
• We have been measured in investing cash which sits at approximately 7%. We will continue to invest in a thoughtful manner based on current market fundamentals with the intent of reducing the cash position to less than 5%. Even with the widening in spreads from 63 bps to 94 bps during the quarter, we do not feel comfortable chasing yield as spreads are still tight on a historical basis. Likewise, with a 78 bps spread on the 10 versus 30-year AAA municipal curve, we feel more comfortable slowly adding duration in the portfolio.
• We are less cautious on California hospitals and evaluate the borrowers carefully. We intend to focus in the higher quality systems while staying away from smaller sole-regional providers. The Fund is underweight the hospital sector with 8.02% exposure versus 13.48% in the Bloomberg Barclays Municipal Bond Index. Going forward, we expect the Fund to be at the benchmark level.
• The Fund has relatively small exposure to insured Puerto Rico bonds (1.21%), which is exempt from both California and federal taxes. However, we continue to stay away from the territory. With the Fund’s primary mission of creating high levels of tax-exempt income for clients, we would be remiss to chase these bonds as they offer a high likelihood of offering no income for investors.
• We continue to favor revenue bonds over tax-backed debt. We believe revenue bonds provide higher yields and a broader allocation to help insulate from general tax and pension issues currently affecting many municipalities. If recent high-profile defaults in general obligations have taught us any lesson, then it is that revenue bonds with strong collateral recovery fare much better in the event of a default.
• We are seeking 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 remain shorter duration than the benchmark, however with the slope of the yield we feel comfortable adding duration in higher quality names.

Outlook

• We still believe the California municipal market is attractive versus other fixed income asset classes based on strong demand due to high taxes and continued low supply. In our view, debt issuance for 2019 will be higher than most estimates, possibly up 20% to more historical norms.
• We believe California municipal bonds should have a solid year; however the tougher call to make for 2019 is whether strong demand continues into the new year. While we think demand will remain strong we do not expect it to be as strong of a market in 2019 as 2018.
• Several variables could upend our call. First, a prolonged trade war with China could result in higher consumer prices causing inflation and driving yields higher, which may lead to investors leaving the asset class. Second, the recent government shutdown may affect growth moving forward, but the duration of the shutdown is unknown. Last, the fourth quarter equity market sell off was a positive and negative for municipal bonds. The positive is we expect only one Fed rate hike in 2019 which should help alleviate pressure on market. However, if the equity market is cheap enough then investors may decide to reallocate capital.
• With the Fund’s duration at 100% of the Bloomberg Barclays Municipal Bond Index and adequate levels of cash, we feel appropriately structured to weather the impact of the many issues in government and the global economy.
• With the elections over and Congress being led by Democrats, infrastructure is the one thing that might get done in Washington. If a bill does get passed, expect issuance to increase even more. Our expectations are that taxes in California are only going higher so the demand will remain strong.

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 Dec. 31, 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.

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.