Market Sector Update

• The California municipal market had a negative return for the quarter. With the Federal Reserve (Fed) slowly raising rates and relatively benign inflation data, the long end of the Bloomberg Barclays Municipal Bond Index returned negative 22 basis points (bps). The 7- to 10-year part of the curve showed the strongest returns yielding 1.50% and 1.11%, respectively.
• 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.
• Puerto Rico backed bonds continue to be the strongest performing sector – returning 8.68% during the period. Much of the debt is now owned by nontraditional investors as municipal bond mutual funds have greatly reduced exposure to the territory. Much of the debt is now owned by nontraditional investors as municipal bond mutual funds have greatly reduced exposure to the territory. We believe Puerto Rico bonds are dead money meaning investors will receive no income from the bonds for the foreseeable future.
• Longer term, with the rally in rates through 2017 and into 2018, we are less constructive on the California high yield municipal space as new issues come to market with historically low absolute yields and weak collateral for investors.

Portfolio Strategy

• The Fund’s absolute return was slightly negative, in line with the Bloomberg Barclays Municipal Bond Index.
• The Fund is underweight tobacco with an approximate 8% allocation versus 17.42% in the Bloomberg Barclays High Yield Municipal Bond Index. The underweight position detracted as tobacco bonds were slightly positive for the quarter. We continue to believe our underweight is prudent at this time based on the tightness of credit spreads. Several tobacco refundings are on the calendar and we will continue to look at opportunities to add names at discounts to par.
• We have been measured in investing cash which sits at approximately 10%. 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%. With credit spreads at levels last seen in 2007, we feel it is prudent to not chase yield. Likewise, with a spread of only 14 bps between 10- and 30-year treasuries, we do not believe we are being compensated to add duration.
• The team continues to see the greatest opportunity in land-secured bonds, also known as Mello-Roos/Community Facility District (CFD) bonds. We also see opportunities in charter school bonds, which have experienced less price volatility than CFD bonds. We believe both types of bonds offer compelling risk/reward profiles.
• We are cautious on California hospitals and evaluate the borrowers carefully. The Fund is underweight the hospital sector with 7.93% exposure versus 13.43% in the Bloomberg Barclays Municipal Bond Index. We believe hospitals carry the most ratings downgrade risk of any sector due to multiple versions of proposed health care reform. This could lead to a rollback of Medicaid expansion, which may strain operating performance in the sector.
• 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 better diversification from general tax and pension issues currently affecting many municipalities. Historically, General Obligations have fared well in Chapter 9 bankruptcies, however that trend was turned on its head post-Detroit and we expect the same outcome in the Title IV filing in Puerto Rico.
• 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 as we view the sector as fully priced.

Outlook

• We still believe the California municipal market is attractive versus other fixed income asset classes based on strong demand and continued low supply. In our view, debt issuance for the remainder of 2018 will be higher than most estimates, but will remain lower than historical norms. We are more bearish on the credit market as spreads are hovering around the lows of 2007.
• We expect one more rate hike in 2018 as inflation climbs closer to the Fed’s 2% threshold. We are concerned how a possible trade war with both China and the European Union would affect prices and the overall global economy. We will monitor how tariffs might tip the Fed’s hand and whether it will be forced to review current interest rate policy.
• With the Fund’s duration at 86% of the Bloomberg Barclays Municipal Bond Index and adequate levels of cash, we feel appropriately structured to weather the impact of a long trade war. It is important investors realize prudent managers diversify across sectors and always limit the amount of exposure to those variables as well as any individual bond.
• Per the upcoming elections, infrastructure is one issue that has bipartisan support. The method in which Congress achieves the funding may impact the inventory municipal bond market. For example, Build America Bonds and single state grants all may take inventory and normalize supply and demand in a high demand market.
• We believe investors will continue to search for tax-exempt yield even after the tax legislation was passed. We view the tax cuts as favoring lower income brackets, but with the top tax rate at 37% we believe municipal bonds remain highly attractive.

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, 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.