Market Sector Update

• The high yield municipal curve continued its strong performance into the fourth quarter. The middle of the curve had solid performance while the long end was weaker, although still positive. Notably, 5-year and 10-year bonds returned 1.56% and 1.20%, respectively, while 30-year maturities returned only 0.67%.
• With the continued strength in the economy and de-escalation of a prolonged trade war, the Federal Reserve (Fed) indicated it is most likely “on hold” for 2020 with respects to the federal funds rate. We believe the Fed is less concerned about the negative effects of global trade tariffs, and it seems comfortable with current monetary policy given the continued strength in the domestic economy which is supported by steady consumer sentiment and low unemployment.
• In December, the House of Representatives impeached President Donald Trump. As a result, we saw increased volatility in the credit markets yet the municipal high income credit markets have continued to outperform investment grade. While the House prepares to send formal impeachment charges to the Senate, we believe the Senate will not vote to convict.
• Broadly, we believe the entire municipal curve is richly valued relative to U.S. Treasuries. We see some attractiveness in the longer part of the curve, but we believe the focus should be on higher quality bonds as the quality of high yield credit is deteriorating.
• Puerto Rico bonds returned 1.31%, losing steam relative to the previous quarter, as bankruptcy continues at a snail’s pace. 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 65 cents on the dollar. 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 salestax 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 accelerated in the fourth quarter relative to the first three quarters. Much of the refinancing activity took place in the taxable market which muted tax-exempt supply. As interest rates remain historically low, we are confident that supply will rise into 2020 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.
• We saw an acceleration of both distressed and defaulted deals in 2019. We believe this trend is likely to continue through 2020. Broadly, we have turned more bearish on the credit market as spreads hover near 2007-lows and the quality and necessity of many deals are highly speculative.

Portfolio Strategy

• The Fund had a positive return, but underperformed relative to its benchmark. The Fund’s short duration versus the benchmark led to underperformance, while reducing exposure to higher risk credits hurt performance because credit has continued to outperform.
• The Fund’s duration is 78% of its benchmark, which reflects our moves to extend duration from the previous quarter. We have been actively looking for attractive A- to AA-rated bonds 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 defensive from a duration standpoint while slowly lengthening.
• The Fund has been reducing exposure to non-rated bonds. At the end of the quarter, exposure to non-rated bonds was 20%. 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% for 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 after Detroit’s bankruptcy and we expect the same outcome in the Title IV filing in Puerto Rico.

Outlook

• We believe investors will continue to search for tax-exempt yield. However, it is important to note that ratios between U.S. Treasuries and municipal bonds are reaching record levels. At some point, the tax advantage of municipal bonds may diminish, resulting in increased demand for taxable bonds. We believe the current euphoria can only last so long.
• 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, which has resulted in positive results. International investor demand has allowed many tax-exempt bonds to be refinanced with taxable debt, which offers cost savings to the issuer. Due to the number of poorly structured deals, we expect defaults to increase materially in 2020.
• We expect the Fed to be “on hold” for 2020. If the strength in the economy continues, we believe inflation should increase, resulting in higher rates.
• Going forward, we believe total supply should increase to approximately $400 billion in 2020, which is considerably higher than previous years. We believe current demand is strong enough to handle the increase. Of the $400 billion in issuance, one dynamic to monitor will be the breakdown between taxable and tax-exempt bonds.
• 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 Dec. 31, 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.