1st Quarter 2019

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It’s still a seller’s market.

What was setting up to be an attractive rate market going into the last couple weeks of December turned out to be ephemeral. An equity market selloff, the ensuing flight to quality and a capitulating Federal Reserve all conspired to move the 10-year AAA-rated GO municipal bond, as measured by the Thomson Reuters Municipal Market Data (MMD) AAA Curve, from a high of 2.78% in early November to 1.88% at the end of the March 2019 quarter. This was despite heavy tax-loss selling in December that one would expect to push rates higher. Tax-loss selling has reversed itself to a large degree as flows into the muni space have been extraordinary through the first quarter of 2019. Nearly $24 billion flowed into municipal mutual funds in the first three months of the year, marking the best quarter return in five years, according to Investment Company Institute data.

Rebounds across asset classes raise a question: Has the Fed adopted an unspoken third mandate to maintain equity valuations? After the Fed’s capitulation at its December meeting, as well as its dovish language in the most recent statement, maintaining current levels of consumption via the wealth effect has taken on more importance. The change in guidance isn’t only domestic. Stimulus is back on the front burner globally, from the European Central Bank’s “targeted longer-term refinancing operations” aimed at boosting credit growth in the eurozone, to the People’s Bank of China’s pump-priming exertions. The policy accommodation has certainly been a positive for domestic and global equity markets, notwithstanding the rally in fixed income. Case in point, the ICE BofAML U.S. Municipal Master Index returned 2.95% in the first quarter, while the Bloomberg Barclays U.S. Aggregate Bond Index returned 2.94% and the S&P 500 returned 13.65%.

The question for fixed income investors remains: Will rates fall further, or does the Fed raise again? Based on how the five-year Treasury bond and one-month T-Bill are trading at 2.28% and 2.41%, respectively, it would appear that some participants in the bond market are anticipating that the Fed’s next move will be a cut. With the bond and equity markets having differing opinions, one thing is certain: either the bond market is right, or the equity market is right, but not both. Goldilocks is a fairy tale, not a sound investment thesis.

There remains another vexing thought on interest rates and inflation. How is it possible that inflation can be almost non-existent when wage growth and unemployment are both running around 3.4% and the Fed’s balance sheet is $3.7 trillion? Turkey hasn’t had the benefit of a tight labor market and central bank asset purchases, yet somehow found a way to create 20% annual inflation. It wasn’t too long ago when we were told that quantitative easing (QE) would stop once the U.S. unemployment rate reached 6%. Joblessness broke that in September 2014 and all the while QE continued. It seems somewhat odd that college tuition, new car prices, health care and financial asset prices have all risen at rates above core inflation, yet core PCE, the Fed’s favorite measure of inflation, stands at 1.8%. Strange, but true.

Credit spreads, much like triple-A bond insurers, have all but disappeared from the muni market. That is somewhat of an overstatement, but for some time now credit spreads, especially across the plain vanilla investment-grade space, have become virtually commoditized. Pockets of opportunity have existed, but they have been few and far between. One area of opportunity was the pre-paid gas sector at the end of 2018. The widening of corporate high-yield spreads created an opportunity, and the purchases we made at the end of 2018 have performed quite well so far this year. Other credits that are more challenged, such as the states of Illinois and Connecticut and the city of Chicago, have seen a better bid this year as the hunt for yield re-started with a vengeance in the first quarter.

All this leads to our positioning and portfolio actions in the current market environment. Our portfolios have been positioned in the bearish ranges for quite some time, with shorter durations, higher credit qualities and higher cash reserves. As rates climbed through much of 2018, our defensive positioning paid off well. Even with the reduction in rates in the last couple weeks of the year, the shorter the duration, the better. So far this year, it has been the opposite. Rates have fallen through much of the year which has led to longer-duration strategies outperforming shorter-duration strategies. With the reduction in rates, we are comfortable maintaining our current positioning but will look to add additional duration when the opportunity presents itself. The same can be said for credit. We feel as though the worst mistake to make at this point in the cycle would be to take risk when we are not being compensated to do so. Patience is now more of a virtue than before.

Thank you for your continued trust and support.

Performance data shown represents past performance and is no guarantee of future results. Investment return and principal value will fluctuate so shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than quoted. For performance current to the most recent month end, see the mutual funds performance page or call 877-215-1330. The Low Duration and Limited Term funds have a maximum sales charge of 1.50%. The Intermediate Municipal Fund and the Strategic Municipal Income Fund have a maximum sales charge of 2.00%.

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Unless otherwise noted, the source of all data, charts, tables and graphs is Thornburg Investment Management, Inc., as of 3/31/19.

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