Market Sector Update

• California municipal bonds returned 2.87% for the quarter, compared to -0.49% in the prior quarter and 2.26% in the second quarter of 2019. The negative returns that resulted from the COVID-19-induced selloff in the first quarter were completely erased and the high-grade market has seen an almost full recovery to pre-COVID-19 levels.
• Positive flows into California municipal bonds during the quarter, while still negative year to date (YTD), contributed to performance. The entire municipal yield curve delivered positive returns with the 5-year spot and 7-year spot delivering the best returns at 3.26% and 3.31%, respectively. High-yield funds had continued outflows during the quarter bringing YTD outflows to $7.7 billion.
• For the quarter, the Bloomberg Barclays Municipal Bond Index returned 2.72% while the Bloomberg Barclays High Yield Municipal Bond Index outperformed high grade at 4.55%. The outperformance of high yield during the quarter was driven by the reach for yield and materially wider spreads coming into the quarter. The high-yield index is still underperforming relative to the investment-grade index YTD at -2.64% versus 2.08%, respectively. This reflects the significant underperformance of high yield in the first quarter.
• Longer term, we continue to be cautious when looking at spread product. There has been a notable increase in monetary defaults, draws on debt service reserve funds, and covenant violations. We expect continued pressure in the high-yield space as the ongoing effects of COVID-19 continue to take their toll on lower quality borrowers and previously implemented federal support programs have less of an impact. Spreads on BBB credits remain wider than recent year and may present more attractive buying opportunities if supported by the underlying fundamentals.

Portfolio Strategy

• The Fund had a positive low-single-digit return, but underperformed relative to the Bloomberg Barclays High Yield Municipal Bond Index and slightly outperformed the Bloomberg Barclays Municipal Bond Index.
• The Fund’s non-rated exposure sits at 19.2%, which is near the maximum desired exposure. We do not intend to add to the allocation as we expect continued credit pressure and increased defaults. We feel it is prudent to own more liquid, higher-rated bonds until there is more clarity on the progression of COVID-19.
• The Fund is underweight tobacco with a 6.0% allocation versus 13.5% in the Bloomberg Barclays High Yield Municipal Bond Index. The underweight position was a drag on performance in the quarter as tobacco bonds returned 12.8%, making it the best performing sector in the index. While we intend to increase exposure over time, we expect the Fund to remain underweight tobacco bonds versus the benchmark.
• We have been measured in investing cash which sits at approximately 8.7%. We will continue to invest based on current market fundamentals with the intent of reducing the cash position to less than 5%.
• We have become more cautious on California hospitals and are evaluating the borrowers carefully due to the impact they are seeing from COVID-19. The Fund is underweight the hospital sector with 9.1% exposure versus 20.1% in the Bloomberg Barclays High Yield Municipal Bond Index. This contributed to Fund performance versus the benchmark as hospital returns were 0.4% for the quarter. Going forward, we expect the Fund to move closer to the benchmark’s weight.
• We have been bearish on senior living as we felt it was getting overbuilt in anticipation of increased retirees. While we could not have predicted the recent pandemic, underweighting this sector proved to be beneficial as many senior living credits are starting to have monetary and technical defaults.
• 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 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 are seeking opportunities in lower quality investment-grade bonds to take advantage of wider relative spreads. The Fund’s duration is shorter than the benchmark. However, with the entire municipal curve cheap relative to Treasuries, we feel comfortable adding duration as municipals continue to tighten.

Outlook

• We 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, a “second wave” of COVID-19 could cause a return to outflows which would lead to selling pressure on the asset class. We remain bearish on the non-investment grade credit market as we believe there will be a continued increase in defaults from the ongoing, pandemic-induced economic challenges.
• We believe the high-yield market could outperform the investment-grade market in the near-term as the reach for yield continues, actions by the Federal Reserve and federal government cause high grade valuations to rise, and the supply/demand imbalance supports more tightening. However, we do not believe the underlying fundamentals support a sustained rally in high yield over the medium term.
• The Fund’s high level of cash provides sufficient liquidity to take advantage of more attractive yields and to be selective buyers if others are forced sellers.
• Due to COVID-19, the upcoming presidential election, social unrest, and overall economic uncertainty, we believe there is likely to be continued volatility in the municipal market, similar to many other asset classes. However, we think it is times like this that the Fund’s focus on fundamental credit analysis, producing high levels of tax-exempt income, and maintaining lower than average volatility are critical.

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, 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.