Market Sector Update

• California municipal bonds continued to provide solid positive returns, up 1.71% in the third quarter. Flows into California municipal bonds continued to be strong and helped offset an increase in supply with spreads continuing to remain tight. The entire municipal yield curve delivered positive returns with the 22-year-plus part of the curve providing the strongest returns yielding 2.64%. Performance was aided by the Federal Reserve (Fed) cutting the federal funds rate by 25 basis points (bps) twice in the quarter. The market is pricing in a 72% chance of one more cut of 25 bps or more by year end.
• We believe the strength in the high yield market should continue in the near term as positive inflows should be sufficient to offset slightly higher levels of issuance and continue to generate positive results.
• High yield funds continued the record-setting start to the year with another $4.9 billion of inflows. For the quarter, the Bloomberg Barclays Municipal Bond Index returned 1.58% while the Bloomberg Barclays High Yield Municipal Bond Index outperformed high grade returning 2.84%. The outperformance of high yield was driven by coupon and price return as the yield-to-worst on the high yield index tightened 19 bps compared to the Municipal Bond Index. When comparing the AAA versus BBB, spreads widened inside of three years and tightened on the balance of the curve.
• Longer term, with the compression of spreads due to the rally year-to-date we continue to be cautious when looking at spread product. Spreads continue to be tight in a historical context and new investment options continue to offer very little collateral for investors. With the Fed’s concerns about future growth, we feel it is more important to focus on quality as we believe spreads will widen if the economy slows.

Portfolio Strategy

• The Fund had a positive return for the quarter, but underperformed the Bloomberg Barclays High Yield Municipal Bond Index. However, due to the higher amount of spread product in the Fund, it outperformed the Bloomberg Barclays Municipal Bond Index.
• The Fund’s non-rated exposure sits at 21%, which is near the maximum desired exposure. We do not intend to add non-rated exposure as spreads are historically tight and we feel it is prudent to own more liquid, higher-rated bonds in order to take advantage of potential future spread widening in lower rated credits.
• The Fund is underweight tobacco with an approximately 7.2% allocation versus 14.0% in the Bloomberg Barclays High Yield Municipal Bond Index. The underweight position was a drag on performance in the quarter as tobacco bonds returned a positive 3.98% or 114 bps higher than the benchmark total return. The Fund’s strategy has always been to seek attractive income with low volatility. While we intend to increase exposure over time, we expect the Fund to remain underweight tobacco bonds versus benchmark.
• We have been measured in investing cash which sits at approximately 13.4%. We will continue to invest based on current market fundamentals with the intent of reducing the cash position to less than 5%. With spreads compressed to 2007 levels, we do not feel comfortable chasing yield as spreads are still tight based on historical levels.
• We are less cautious on California hospitals and evaluate the borrowers carefully. We intend to focus on the higher quality systems while staying away from smaller sole regional providers. The Fund is underweight the hospital sector with 13.7% exposure versus 21.6% in the Bloomberg Barclays High Yield Municipal Bond Index. Going forward we expect the Fund to move closer to the benchmark, as it did in the most recent quarter.
• The Fund has 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 they offer a high likelihood of offering no income for investors. We may look at opportunities as the territory’s sales tax-backed bonds are restructured, however it would not represent more than 1% of total net assets.
• 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. If recent high-profile defaults in general obligations has 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 bonds with more defensive structures as interest rates continue to hover around historically low levels and credit spreads continue to be tight. We are shorter duration than the benchmark, however, with the relative cheapening of the long end over the last quarter we feel comfortable adding duration in higher quality names.

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 continued low supply. However, early projections indicate issuance may be up in 2020 compared to recent years. We are more bearish on the credit market as spreads are near 2007-lows given the strong rally year-to-date.
• Moving into the fourth quarter of 2019, we expect the Fed to cut rates one more time before the end of the year. We remain concerned about how the ongoing U.S. trade war with both China and the European Union will affect prices and the overall global economy. The impact of tariffs on the Fed’s decisions requires constant review, while the presidential impeachment inquiry by the House of Representatives adds another level of uncertainty that could negatively impact markets.
• With the Fund’s duration at 89% of the Bloomberg Barclays High Yield Municipal Bond Index and adequate levels of cash, we feel appropriately structured to potentially weather the impact of the issues affecting the global economy.
• We have held the view that despite the gridlock in Washington, infrastructure is the one thing that might get done at the federal level. However, the impeachment inquiry and the presidential election in 2020 make it seem less likely that this will occur. If an infrastructure bill does get passed, we expect issuance to increase even more. However, we also expect that taxes in California will continue to increase, so demand for California municipal bonds is likely to remain strong and we expect minimal impact on the municipal market from a bill.

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, 2019, 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.

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.