Market Sector Update

• California municipal bonds continued to provide solid positive returns during the period, ending the second quarter up 2.26%. Flows into California municipal bonds continue to be strong and with little supply spreads have continued to compress.
• With the Federal Reserve (Fed) indicating it would not be raising rates in 2019, but might cut rates instead, the entire municipal yield curve delivered positive returns. The 22-year-plus part of the curve provided the strongest returns yielding 2.89%.
• For the quarter, the Bloomberg Barclays Municipal Bond Index returned 2.14%, while the Bloomberg Barclays High Yield Municipal Bond Index outperformed high grade by returning 2.73%. The outperformance was driven by coupon return as the yield-to-worst on the high yield index widened three basis points (bps) compared to the municipal bond index.
• Longer term, with the compression of spreads due to the year-to-date rally, 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.
• High yield funds continued the record-setting start to the year with an additional $4.8 billion of inflows in the quarter.

Portfolio Strategy

• The Fund had a positive return for the quarter and outperformed the Bloomberg Barclays High Yield Municipal Index and the Bloomberg Barclays High Grade Municipal Index.
• The Fund’s non-rated exposure currently sits at 22.6%, which is near the maximum desired exposure for the Fund. We do not intend to take the allocation +/-2% its current level.
• The Fund is underweight tobacco with an approximately 7% allocation versus 14% in the Bloomberg Barclays High Yield Municipal Bond Index, which marginally contributed to performance. The Fund’s strategy has always been attractive income with low volatility. While we intend to increase exposure over time, we expect the Fund to remain underweight versus its high yield benchmark.
• 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 11.7% exposure versus 21.3% in the Barclays High Yield Municipal Bond Index. Going forward we expect the Fund to move closer to the benchmark.
• The Fund has relatively small exposure to insured Puerto Rico bonds at 1.10%. These bonds are exempt from both California and federal taxes. However, we continue to stay away from unenhanced exposure in 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 may look at opportunities as the territory restructures its sales-tax-backed bonds, 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, but we feel comfortable adding duration in higher quality names based on the current slope of the yield curve.
• 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 spreads compressed to 2007-levels, we do not feel comfortable chasing yield as spreads are still tight based on historical levels. We will continue to look for one-off opportunities as they present themselves moving forward.

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 are more bearish on the credit market as spreads are on top the lows of 2007 given the strong rally year-to-date.
• We believe the strength in the high yield market should continue in the near term as positive inflows along with low levels of issuance continue to generate positive results.
• Moving into the second half of 2019, we believe the Fed is more likely to cut rates than to raise them. The central bank seems concerned how an ongoing trade war with China and European Union may affect prices and the overall global economy. In addition, any closing of our southern border would certainly be a negative for growth.
• 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 weather the impact of the issues affecting the global economy.
• Despite the gridlock in Washington, with Congress being run by the Democrats, infrastructure is the one thing that might get done at the federal level. If an infrastructure bill does get passed, we expect issuance to increase. However, our expectations are also that taxes in California will continue higher so demand for California municipal bonds should remain strong and we expect minimal impact on the municipal market from a bill.
• 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 Federal tax rate at 37% and the top California tax rate at 13.3%, 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 June 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.

All information is based on Class I shares.

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.