Market Sector Update

• California municipal bonds returned -0.49% for the first quarter, compared to 0.69% in the prior quarter and 2.81% in the first quarter of 2019. Negative performance year to date was a result of the intense selloff in the last few weeks of the quarter, as a result of the impacts of COVID-19. Returns in March alone were -3.49%. Flows out of California municipal bonds also contributed to selling pressures in March. The entire municipal yield curve delivered negative returns with the exception of the 1-2 year range, which was barely positive.
• High-yield funds started the year with continued record-setting inflows with $5 billion at the end of February. The trend dramatically reversed in March and the quarter ended with net outflows of $6.2 billion.
• For the quarter, the Bloomberg Barclays Municipal Bond Index returned -0.63% while the Bloomberg Barclays High Yield Municipal Bond Index underperformed high grade returning -6.88%. The underperformance of high yield was driven by selling pressures and spread widening as coupon return was approximately the same for investment grade and high-yield indices.
• Longer term, we continue to be cautious when looking at spread product. We expect continued spread widening and an increase in defaults in the non-investment grade space as the economic impacts of COVID-19 take their toll on lower quality borrowers.
• Spreads on higher quality (BBB and above) have widened to levels not seen for the past five years, which provides more attractive investment opportunities, but remain below peaks reached during the Global Financial Crisis that began in 2007 and during the Taper Tantrum in 2013. Actions by the Federal Reserve (Fed) to lower the federal funds rate and roll out programs to buy municipal bonds could put a ceiling on high-quality spreads.

Portfolio Strategy

• The Fund had a negative return but outperformed the Bloomberg Barclays High Yield Municipal Bond Index and underperformed the Bloomberg Barclays Municipal Bond Index.
• The Fund’s non-rated exposure sits at 20.8%, which is near the maximum desired exposure. We do not intend to add to the allocation as we expect continued spread widening and increased defaults. We feel it is prudent to own more liquid, higher-rated bonds as we believe rates have become more attractive and expect the investment grade space to recover more quickly than non-investment grade. Additional liquidity will help us potentially take advantage of further spread widening in lower rated credits once we feel compensated for the increased risk.
• The Fund is underweight tobacco with a 5.8% allocation versus 13.2% in the Bloomberg Barclays High Yield Municipal Bond Index. The underweight position contributed to performance in the quarter. While we intend to increase exposure over time, we expect to remain underweight versus the benchmark.
• We have been measured in investing cash, which sits at approximately 9.8%, at the end of the quarter. We will continue to invest based on current market fundamentals with the intent of reducing the cash position to less than 5%. We feel comfortable putting additional cash to work in investment-grade names but remain cautious on non-investment grade credit.
• We have become more cautious on California hospitals, due to the impact they are seeing from COVID-19. We intend to focus on the higher quality systems while staying away from smaller, regional sole-providers. Increased federal support could be a benefit to hospitals longer term, despite the near-term challenges. The Fund is underweight the hospital sector with 9.2% exposure versus 22% in the Bloomberg Barclays High Yield Municipal Bond Index, which contributed to outperformance. Going forward, we expect the Fund to move closer to the benchmark.
• We have been bearish on senior living based on our view it was overbuilt in anticipation of increased retirees. Underweighting the sector proved to be beneficial as many senior living credits were down more than 10% for the quarter.
• The Fund has relatively small exposure to insured Puerto Rico bonds (1.0%) which are exempt from both California and federal taxes. 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 there is 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 likely 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 and believe recent stock market declines could increase pension funding pressures.
• We are seeking opportunities in higher quality bonds in an effort to take advantage of recent spread widening. The Fund’s duration is shorter than the benchmark. However, with the long end of the curve relatively cheap versus the short end, we feel comfortable adding duration in higher quality.

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 historically lower default rates. However, elevated outflows could continue in the near future which would put additional selling pressure on the asset class. We remain bearish on the non-investment grade credit market as spreads have room to widen further and we believe there will be increased defaults from the recent economic shutdown.
• We believe the high-yield market will underperform the investment-grade market in the near-term as recent economic events will put more pressure on lower quality borrowers. Actions by the Fed and federal government are more likely to benefit the high-grade market, which is the reason for our continued defensive stance.
• The Fund’s high level of cash provides sufficient liquidity to take advantage of more attractive yields and to be selective buyers when others are forced sellers.

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, 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 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..