Quarterly Update

Jul. 2018

William D. Black, Managing Director, Senior Portfolio Manager | Jul. 2018

High Yield Municipals Gain Despite Rising Rates

Returns on Puerto Rico bonds boost overall index

Supply and demand characteristics support outperformance

Continued strong economy, positive technical factors should help sector throughout 2018

Performance in the High Yield Municipal asset class has been strong this year even though the Federal Reserve has raised rates twice and signaled its intention to raise them twice more. As of June 30, returns for the S&P Municipal Bond High Yield Index were 4.32% for the first half and 2.99% for the second quarter. These results are appreciably better than those for many other fixed income asset classes.

Several factors have contributed to this positive performance. First, a belief by investors that the recoveries on Puerto Rico bonds may be stronger than expected has led prices for bonds such as those issued by the Puerto Rico Aqueducts and Sewers Authority (PRASA) to rise dramatically, boosting overall index returns for the year. (We are not confident about further gains coming from Puerto Rico bonds in the index, as demographics and the underlying economy are likely to continue to weigh on the commonwealth’s finances.)

A second factor that has supported prices is continued demand for yield in the face of limited supply of high yield municipal bonds. Finally, a strong economy has allowed the revenue streams that pay the debt service on these predominantly project-backed bonds to remain strong.

We believe that for the remainder of 2018, demand for high yield municipals will continue to support the sector, and a growing economy will continue to support credit quality, allowing outperformance versus other fixed income sectors to continue. Borrowers are likely to take advantage of the high level of demand by demanding not just lower rates but weaker covenants and bond structures. This makes for an environment in which investors will benefit from thorough research and a high degree of selectivity.

Key Points

Returns on Puerto Rico bonds boost overall index

Supply and demand characteristics support outperformance

Continued strong economy, positive technical factors should help sector throughout 2018

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Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

There are inherent risks with equity investing. These risks include, but are not limited to, stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. Investing in international markets carries risks such as currency fluctuation, regulatory risks, and economic and political instability. Emerging markets involve heightened risks related to the same factors, as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.

Concentrating assets in the real estate sector or REITs may disproportionately subject a portfolio to the risks of that industry, including the loss of value because of adverse developments affecting the real estate industry and real property values. Investments in REITs may be subject to increased price volatility and liquidity risk; concentration risk is high.

Investments in Master Limited Partnerships (MLP) are susceptible to concentration risk, illiquidity, exposure to potential volatility, tax reporting complexity, fiscal policy, and market risk. Investors in MLPs are subject to increased tax reporting requirements. MLP investors typically receive a complicated schedule K-1 form rather than Form 1099. MLPs may not be appropriate investments for tax-advantaged accounts because of potential negative tax consequences (Unrelated Business Income Tax).

There are inherent risks with fixed-income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer-duration fixed-income securities and during periods when prevailing interest rates are low or negative. The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT), and taxable gains are also possible. Investments in below-investment-grade debt securities, which are usually called “high yield” or “junk bonds,” are typically in weaker financial health and such securities can be harder to value and sell, and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.

Investments in emerging market bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more developed foreign markets. Emerging market bonds can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Returns include the reinvestment of interest and dividends. Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk. Past performance is no guarantee of future performance.

Index Definitions

The Standard & Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.

The MSCI ACWI ex USA Index captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries (excluding the US) and 24 Emerging Markets (EM) countries*. With 2,154 constituents, the index covers approximately 85% of the global equity opportunity set outside the US.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. & Canada. As of June 2007, the MSCI EAFE Index consisted of the following 21 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

The STOXX Europe 50 index provides a blue-chip representation of supersector leaders in Europe covering almost 50% of the free-float market capitalization of the European stock market. The index covers 50 stocks from 18 European countries: Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom.

The MSCI China Index captures large and mid cap representation across China H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). With 447 constituents, the index covers about 85% of this China equity universe. Currently, the index also includes Large Cap A shares represented at 2.5% of their free float adjusted market capitalization.

The MSCI Emerging Markets Index captures large and mid cap representation across 24 Emerging Markets (EM) countries*. With 1,138 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

The S&P Municipal Bond High-Yield Index consists of bonds in the S&P Municipal Bond Index that are not rated or are rated below investment grade. The S&P Municipal Bond Index measures the performance of bonds issued by state and local municipalities in the U.S. and its territories. All bonds in the index are exempt from U.S. federal income taxes, but some are subject to alternative minimum tax (AMT).

Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.

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