Market Sector Update

• The municipal market posted negative returns in the quarter. However, returns across the credit spectrum and the yield curve were not uniform. Higher quality returns were more negative the further one moved out on the curve, while performance was enhanced by bearing additional credit risk; A-rated, BBB-rated, below investment grade, and nonrated bonds posted positive returns with higher returns realized the further one moved down the credit spectrum. Credit spreads continued to tighten with the magnitude of compression incrementally greater the further out on the credit curve, while the yield curve steepened significantly. California municipal bonds returned -0.67%, underperforming the Bloomberg Barclays Municipal Bond Index.
• Mutual fund flows into the asset class continued to be robust, as well as high levels of reinvestment flows from bond maturities, bond calls and coupon income. Tax-exempt new issue supply was not enough to satisfy the insatiable investment demand.
• As yields on the highest quality bonds hovered near all-time low levels, investors moved further out on the credit spectrum, including high yield, in search of higher absolute yields. Credit spreads on BBB-rated bonds declined 37 bps while spreads on high yield bonds compressed 61 bps. President Joe Biden's American Rescue Plan, which included over $500 billion in aid to states, cities, public transit, education and airports, has materially enhanced the credit profile of many municipal issuers. Creditor protections in many lower quality new issues continue to be relaxed substantially. In the current yield-seeking environment, investors are showing little concern for bearing this increased credit risk, which is now lower for some as a result of the massive stimulus funding.
• Defaults in the municipal bond asset class continue to be rare and tend to be highly concentrated in the high yield space. We are beginning to see distressed situations in the high yield space with more frequency; to date, these have been heavily concentrated in the continuing care retirement communities, speculative project finance, student housing, and hotel/convention center sectors. This will need to be monitored closely, and we will continue to exercise high levels of surveillance on our below investment grade and non-rated holdings. However, we expect the overall municipal market default rate to remain significantly lower than the corporate default rate, as has been the history between these markets.

Portfolio Strategy

• The Fund posted a positive total return for the quarter, outperforming its peer group while underperforming both the benchmark and the Bloomberg Barclays 65% High Grade/35% High Yield Composite. The portfolio's duration is slightly shorter than its benchmark, and the portfolio is defensively structured with a higher quality emphasis.
• At quarter-end, exposure to non-rated bonds was approximately 22%. While admittedly off the low spread level observed in early 2020 (pre-COVID-19 pandemic), high yield spreads are currently well below both 5-year and 10-year averages.
• The Fund is underweight tobacco with an 8.23% allocation versus 12.3% in the Bloomberg Barclays Municipal High Yield 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.
• 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.
• Persistent credit surveillance will be critical in this environment.

Outlook

• We remain confident in our belief that investment grade municipal bond defaults will continue to be much lower than any other fixed income alternatives except U.S. Treasuries. The massive stimulus infusion from the American Rescue Plan has been a large credit positive for the overall municipal bond market. The State of California will receive approximately $26.2 billion in direct aid and localities are expected to receive an additional $14.97 billion.
• We continue to take a long-term approach with credit selection. We will not compromise the overall credit quality of the Fund by chasing lower quality opportunities with poor bondholder protections and deteriorating credit profiles.
• The Municipal Liquidity Facility (MLF) expired at year-end. While not widely utilized, it should be noted that the Federal Reserve is no longer in a position to be the lender of last resort in a crisis.
• At this juncture, the municipal bond market is very expensive relative to taxable fixed income alternatives. There is euphoria as a result of the massive stimulus funds provided by the American Rescue Plan. Expected corporate and personal income tax rate increases on the horizon are also adding to the exuberance. Large investor flows into a negative supply market is also a tailwind. However, credit spreads are rapidly approaching the all-time lows observed last spring, and are well inside both 5-year and 10-year averages. While the market has recently decoupled from the U.S. Treasury market, we do not believe that this situation will be sustainable in the long run. Continued pressure on U.S. Treasury market yields will eventually have to be acknowledged by the municipal bond market, as has been the historical relationship between these markets.
• One concern we have is the heavy concentration of assets in a select few high yield municipal bond funds. As of last year, five fund families controlled 80% of all high yield assets. That level of concentration has been a contributor to high levels of volatility in prior stressed market episodes, and we believe that this is a risk that needs to be monitored closely moving forward.

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 March 31, 2021, 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 65% High Grade/35% High Yield Composite is an unmanaged composite comprised of 65% investment grade municipal bonds (Bloomberg Barclays Municipal Bond Index) and 35% non-investment grade municipal bonds (Bloomberg Barclays Municipal High Yield Index).

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.