Market Sector Update

• The municipal market posted strong returns in the quarter with highest returns in the below investment grade (high yield) credit space. Credit spreads continued to tighten with the magnitude of compression incrementally greater the further out on the credit curve, while the yield curve flattened meaningfully. California municipal bonds returned 1.69%, slightly under-performing 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. High absolute yields compared to the taxable fixed income market also brought in many crossover buyers, i.e. insurance companies, banks and foreign accounts.
• 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 48 bps while spreads on high yield bonds compressed 55 bps. This reach for yield is occurring while many issuer credit metrics are deteriorating with each passing day. Creditor protections in many lower quality new issues are also being relaxed substantially, while many others are thinly capitalized projects, unproven technologies, or both. In the current yield-seeking environment, investors are showing little concern for bearing this increased credit risk.
• In our view, there is not a sector in the municipal bond space that will be able to avoid the negative drag brought about by the COVID-19 pandemic. We are beginning to see distressed situations in the high yield space with more frequency. To date, this has been heavily concentrated in the following sectors: CCRC (continuing care retirement community), lifecare/nursing, student housing projects, dirt deals, as well as financing for projects with unproven technologies that attempt to turn a waste product into a viable commodity.

Portfolio Strategy

• The Fund posted a positive total return for the quarter, performing in-line with the peer group while underperforming both the benchmark and the Bloomberg Barclays 65% High Grade/35% High Yield Composite. The portfolio 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 20%. While admittedly off the low spread level observed earlier in the year (pre-COVID-19 pandemic), high yield spreads are currently well below both 5-year and 10- year averages.
• Persistent credit surveillance will be critical in this environment.
• 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 tend to have higher recovery rates in the event of a default.
• The Fund is underweight tobacco with a 7.61% allocation versus 12.3% in the Bloomberg Barclays Municipal High Yield Index. This represents a 0.61% increase in the Fund’s weighting. The underweight position was a drag on performance as high yield tobacco bonds returned 13.93% in the fourth quarter. 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.

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. However, we expect to see downgrades in the investment grade space, as we believe there is not a sector or issuer that can completely avoid the negative impact of the pandemic. We expect an acceleration of both distressed and defaulted issues in the high yield space and believe this trend is likely to continue and even accelerate. However, we believe that the default rate will remain lower than the taxable high yield space with higher recovery rates, as has been the history between the two asset classes. We will continue to monitor high yield issues for more attractive entry points, but with current high yield spreads very tight relative to both 5-year and 10-year averages, we believe that it is prudent to not chase the market. We will continue to strive to avoid any issuer that will be impacted severely.
• 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 investments with poor bondholder protections and deteriorating credit profiles in this very uncertain environment.
• 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.
• State and local governments, as well as almost all revenue bond sectors in the market are facing unprecedented shocks to their revenue streams, although California appears to have bucked the trend, at least in the near term. In May, California girded for a $54 billion budget gap. It now projects a $15 billion surplus for next year after it reaped a $26 billion windfall from raking in more tax revenue and spending less than expected. It remains to be seen whether this trend will continue or is a one-time windfall.
• The outcome of the Senate runoff election in Georgia on January 5th is critical. If the Republicans hold the Senate, then we would not expect much fiscal assistance to the municipal bond market. However, if the Democrats take control of the Senate, then a large fiscal assistance package to state and local governments could be forthcoming. This could pressure the high yield space also as investors may rotate into higher quality bonds.

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 Dec. 31, 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 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-i nvestment 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.