Market Sector Update

• The high yield municipal curve performed well during the quarter. Both the long end and short end of the curve had strong performance in the quarter, while the middle part of the curve underperformed. Notably, the 1-year bond returned 1.58%, while 20- and 30-year maturities returned 2.29% and 2.64%, respectively.
• With the Federal Reserve (Fed) cutting interest rates in September, and increasing odds of an October rate cut, the long end of the curve outperformed as concerns of slowing global growth affected the market. On the flipside, we believe the short end of the municipal curve is richly valued relative to Treasuries. We see some attractiveness in the longer part of the curve, but we caution investors to focus on higher-quality bonds. Overall, it is clear the Fed is worried about the negative effects of global trade tariffs, geopolitical risks on the economy and prospects of slower growth. Volatility has increased in the credit markets which has led to an overall negative sentiment, especially as the House of Representatives conducts an impeachment inquiry on President Donald Trump.
• Puerto Rico bonds continued to perform well, returning 6.59% during the quarter, mainly a result of restructuring the island’s sales-tax-backed debt. We continue to be wary of Puerto Rico bonds as the restructuring of the general obligation bonds – constituting the largest amount of debt outstanding – could head to court. The concern is that the 2012 and 2014 debt could be invalidated as unconstitutional, which means it is possible investors could see a total loss on their investments. Recently, the financial regulatory board offered a recovery of 35 cents on the dollar for the 2012 and 2014 debt, which is concerning since the bonds are currently trading at 59.75 cents. Yet to be clarified is whether bondholders reject the settlement, which could result in a protracted litigation possibly ending up in the Supreme Court. While we believe this is unlikely, it is clear the bonds are trading at higher prices than any possible recovery. Except for the sales-tax bonds, we still believe Puerto Rico bonds are “dead money,” meaning investors will receive no income from the bonds for the foreseeable future.
• Debt issuance picked up in the third quarter relative to the first two quarters. However, much of the refinancing activity took place in the taxable market which muted tax-exempt supply. We are confident that supply will rise in the remainder of the year as municipalities take advantage of extremely attractive interest rates.
• The rally in rates during the quarter has led us to become less constructive on the high yield municipal space as new issues come to market with historically low absolute yields and weak collateral for investors. Broadly, we have turned more bearish on the credit market as spreads hover near 2007-lows and we have begun to see an increased level of high-yield deals which are distressed and/or defaulted.

Portfolio Strategy

• The Fund had a low-single-digit return for the quarter, but underperformed relative to its benchmark. The Fund’s underweight in the tobacco sector and Puerto Rico bonds detracted from performance. The Fund’s short duration versus the benchmark also led to underperformance.
• The Fund’s duration is 74% of its benchmark, which is consistent with the previous quarter. We have been actively looking for attractive A- to AA-rated bond opportunities in the new issue market, which we believe offer more relative value with spreads at historically tight levels. This has marginally increased the duration of the portfolio, but we remain defensively positioned from a duration standpoint.
• The Fund has been reducing exposure to non-rated bonds. At the end of the quarter, exposure to non-rated bonds was 22%. Non-rated bond spreads are at record lows, so we feel it is prudent to own more liquid rated bonds to provide us the opportunity to exploit any credit widening.
• In total, the portfolio holds more than 7% of pre-refunded bonds, which affords ample liquidity to exploit investment opportunities as interest rates rise and credit spreads widen. We plan on continuing to hold pre-refunded bonds in the Fund as a source of additional liquidity moving forward. Likewise, with book yields of more than 6% the allocation should allow the Fund to provide a stable and attractive dividend yield.
• We continue to favor revenue bonds over tax-backed debt. We think revenue bonds provide higher yields and better diversification from the general tax and pension issues currently affecting many municipalities. While general obligations have favored well in Chapter 9 bankruptcies, this trend changed post-Detroit and we expect the same outcome in the Title IV filing in Puerto Rico.

Outlook

• We believe the strength in the high yield municipal market should continue in the near term as municipal bond funds continue to see positive inflows and low levels of issuance which have resulted in positive results. However, we expect defaults to pick up materially in 2020 with a slowing economy and poorly structured deals.
• We will continue to look for opportunities with more defensive structures and higher quality bonds as interest rates continue to hover near historically low levels and credit spreads remain tight. We believe it makes sense to remain shorter duration relative to the benchmark as the sector seems fully priced.
• We expect the Fed to cut interest rates another 25 basis points in October. We are concerned about potential global trade wars with China and the European Union and the impact on the global economy. Trade tensions remain a concern, and while a recession this year is unlikely, 2020 could be a different story.
• 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 tax rate at 37% we believe municipal bonds remain highly attractive.
• Going forward, we believe total supply should increase to approximately $400 billion in 2020 – considerably higher than previous years. We believe current demand is strong enough to handle the increase. One growing concern is the consolidation of assets into a select few high yield municipal bond funds – five fund families control 80% of all high yield assets. With that level of concentration, a potential market disruption may cause an issue if investors decided to redeploy capital into other asset classes. We feel if that was to occur we are well positioned to redeploy capital at more attractive spreads and lengthen duration quickly.

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 Sept. 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.

Risk factors: The value of the Fund's shares will change, and you could lose money by investing. 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.