Market Sector Update

• The high yield municipal curve (Bloomberg Barclays High Yield Municipal Index) reversed the strong performance over the last several quarters returning -6.88% for the first quarter. Returns were negative across the curve with longer maturities losing the most. For comparison, the 5-year part of the curve lost 5.86% while the 22+ year part of the curve returned -13.39%.
• The onset of COVID-19 and social distancing has dramatically changed the economic outlook from where it was last quarter. The Federal Reserve (Fed) cut the federal funds rate to zero and has reopened its bond buying program with the expectation of more to follow. Discussions indicate it could potentially include municipal bond purchases, but is yet to be determined.
• Estimates are that unemployment could increase to high-single-digits or low-double-digits. Some economic impact is expected to be offset by the recently passed stimulus bill, but the effects are likely to be limited until consumers return to normal daily life.
• The municipal bond market experienced unprecedented volatility in the quarter, particularly in March. Broadly, we believe the municipal market presents better buying opportunities than we have seen in some time, specifically in higher quality bonds where we see attractiveness in the longer part of the curve. We felt that high yield credit was deteriorating coming into the year and believe the economic slowdown will cause elevated levels of distress.
• Puerto Rico bonds returned -2.52% for the quarter, and the bankruptcy judge has ordered the postponement of deadlines in the bankruptcy due to COVID-19. We continue to be wary of Puerto Rico bonds given the ongoing uncertainty about timing and amount of recoveries. 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. With the Fund’s focus on generating high levels of tax-exempt income, Puerto Rico bonds are not an appropriate investment at this time.
• Debt issuance for the first quarter was in line with the first quarter of 2019, but saw a notable decline in the last few weeks of the quarter. Much of the refinancing activity took place in the taxable market, which was a continuation of the trend that started in the second half of 2019. While supply is very limited for the time being, we could see a notable increase in the second half of the year as the effects of effects of COVID-19 start to subside and the Fed keeps interest rates near zero.

Portfolio Strategy

• The Fund had a low-single-digit negative return, but outperformed relative to its benchmark and its peer group. The Fund’s short duration versus the benchmark and focus on higher quality credit led to outperformance as high yield underperformed investment grade.
• The Fund’s duration is 55% of its benchmark, which reflects duration on the index extending faster than the Fund in the recent selloff. We have been actively looking for attractive A- to AA-rated bonds, which we believe will recover more quickly than high yield and will outperform if spreads continue to widen. We will be more aggressive in lengthening duration going forward. We expect duration to be closer to, but still short of, benchmark duration by midyear.
• The Fund has been reducing exposure to non-rated bonds. At the end of the quarter, exposure to non-rated bonds was 22.9%. Non-rated bond spreads were at record lows coming into the year and we feel it is prudent to own more liquid, rated bonds in an effort to exploit any credit widening.
• In total, the portfolio holds more than 5.5% of pre-refunded bonds, which has afforded and will continue to afford ample liquidity for investment opportunities with higher interest rates and wider credit spreads. 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 may help the Fund 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 fared well in Chapter 9 bankruptcies, this trend changed after Detroit’s bankruptcy and we expect the same outcome in the Title IV filing in Puerto Rico.

Outlook

• While the selloff in municipal bonds has provided what we believe are more attractive investment opportunities, we remain cautious on the high yield space as new issues brought to market in recent quarters came with weak covenants and collateral for investors.
• We saw an acceleration of both distressed and defaulted deals in 2019 and coming into the year believed this trend was likely to continue. The recent economic slowdown is likely to exacerbate this trend. We will continue to monitor high-yield issues for more attractive entry points and are hopeful that recent events will lead to investors receiving better protection on newly underwritten deals.
• We believe investors will continue to search for tax-exempt yield. Ratios between U.S. Treasuries and municipal bonds are near historical highs, which should provide for more attractive investment opportunities.
• We believe that recent weakness in the high-yield municipal market should continue in the near term as municipal bond funds continue to see outflows and distressed or defaulted credits increase. Due to the number of poorly structured deals, we expect defaults to increase materially in 2020 and recoveries could be less than historical results.
• We expect the Fed to be “on hold” for the foreseeable future as rates are at zero. In light of the stimulus that has been provided and is yet to come, there is a risk that inflation could increase once the economy starts to recover.
• Going forward, we believe total supply should increase but the total for the year will be dependent on how soon and how quickly the economy starts to recover. We believe current demand is strong enough to handle the increase and the potential for the Fed to start buying municipal bonds would provide further support. We will continue to monitor the breakdown between taxable and tax-exempt bonds.
• One concern we have had is the consolidation of assets into a select few high yield municipal bond funds – as of last year, five fund families controlled 80% of all high yield assets. That concentration has contributed to the recent volatility in the municipal market and will continue to cause higher than normal volatility. We feel 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 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.

All information is based on Class I shares.

The Bloomberg Barclays High Yield Municipal 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.

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 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.