Market Sector Update

• California municipal bonds returned 1.01% for the third quarter, compared to 2.87% in the prior quarter and 1.71% in the third quarter of 2019. The negative returns that resulted from the COVID-19 induced selloff in the first quarter are just a memory with year-to-date (YTD) returns of 3.40%.
• Flows into California municipal bonds continued the positive momentum from the prior quarter, albeit still slightly negative YTD, which contributed to positive performance. The entire municipal yield curve delivered positive returns with the 7-year spot and long end delivering the best returns at 1.47% and 1.41%, respectively.
• High yield funds had small inflows during the quarter, a reversal from the prior two quarters, bringing YTD outflows to negative $6.1 billion.
• The Bloomberg Barclays Municipal Bond Index returned 1.23%, while the Bloomberg Barclays Municipal High Yield Index outperformed high grade with a return of 3.09%. High yield’s outperformance was driven by the continued reach for yield. The high yield index is still underperforming the investment grade index YTD reflecting the significant underperformance of the high yield index in the first quarter when returns were negative 6.88% compared to the investment grade index being down 0.63%.
• Longer term, we continue to be cautious when looking at spread product. There has been a notable increase in monetary defaults, draws on debt service reserve funds and covenant violations. We expect continued pressure in the high-yield space as the ongoing effects of COVID-19 continue to take their toll on lower quality borrowers. Spreads on BBB credits remain wider than past years and present more attractive buying opportunities when supported by the underlying fundamentals.

Portfolio Strategy

• The Fund had a positive return for the quarter, which underperformed the Bloomberg Barclays Municipal High Yield Index, but outperformed the Bloomberg Barclays Municipal Bond Index. The Fund’s non-rated exposure is 20.4%, which is near the maximum desired exposure. We do not intend to add to the allocation. We feel it is prudent to own more liquid, higher-rated bonds until there is more clarity on the progression of COVID-19.
• The Fund is underweight tobacco with a 7.0% allocation versus 13.2% in the Bloomberg Barclays Municipal High Yield Index. This represents a 1.0% increase in the Fund’s weighting as multiple deals in the new issue market provided good buying opportunities. The underweight position had limited impact on performance as tobacco bonds returned 2.79%, slightly underperforming the index. The Fund’s strategy is to seek attractive income with low volatility. We intend to increase exposure over time but expect to remain underweight tobacco versus the benchmark.
• We were moderately aggressive in investing cash this quarter, which sits at approximately 5.8%, as lingering effects from the first quarter selloff provided better buying opportunities. We will continue to invest based on current market fundamentals with the intent of reducing the cash position to less than 5%. With spreads remaining wide compared to recent years, we feel comfortable putting additional cash to work in lower quality investment grade names but remain cautious on non-investment grade credit as we believe pressure persists on weaker borrowers.
• We added to the waste services and airports sectors. We believe waste services are an essential service that should hold up well regardless of the impact of COVID-19. While air travel has been hit hard recently, most airports have significant liquidity to weather the storm and trade at wider spreads.
• The Fund continues to have a relatively small exposure to insured Puerto Rico bonds (1.0%) which are exempt from both California and federal taxes. However, we continue to stay away from unenhanced exposure to 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 we believe there is a high likelihood of offering no income for investors. Additionally, COVID-19 has had a significant impact on the territory due to its already weak financial position and ongoing negotiations indicate bondholder recoveries may be materially lower than previously expected.
• We continue to favor revenue bonds over tax-backed debt. We believe revenue bonds provide higher yields and better diversification from general tax and pension issues currently affecting many municipalities, exacerbated by the ongoing decline in economic activity. We think another stock market selloff could further increase pension funding pressures. If recent high-profile defaults in general obligations have taught us any lessons, revenue bonds with strong collateral fare much better in a recovery in the event of a default.
• We are seeking opportunities in lower quality investment grade bonds to take advantage of wider relative spreads. The Fund’s duration is shorter than the benchmark, but we feel comfortable adding duration as the Federal Reserve (Fed) has indicated it will keep rates at zero for the foreseeable future.

Outlook

• We still believe the California municipal market is attractive relative to other fixed income asset classes based on strong demand due to high taxes and historically lower default rates. However, we think the prolonged impact of COVID-19 could eventually cause a return to outflows which would lead to selling pressure on the asset class. We remain bearish on the non-investment grade credit market as we believe there will be a continued increase in defaults from the ongoing, pandemic-induced economic challenges.
• We believe the high yield market could outperform the investment grade market in the near-term as the reach for yield continues, actions by the Fed and federal government have caused high grade credits to be rich again, and the supply and demand imbalance supports more tightening. However, we do not believe the underlying fundamentals support a sustained rally in high yield over the medium term.
• Due to COVID-19, the upcoming U.S. Presidential election, social unrest, and overall economic uncertainty, we think heightened volatility in the municipal market is likely to persist in the fourth quarter. The Fund’s level of cash provides enough liquidity to take advantage of more attractive yields and to be selective buyers if others are forced sellers.

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 Sept. 30, 2020, 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.

All information is based on Class I shares.

The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.

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. 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. 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.