4th Quarter 2017

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Raise your hand if you believe the municipal bond market represents a screaming buy. We count a total of just four hands—out of the hundreds (perhaps dozens) of readers. Despite the questionable scientific accuracy of this informal poll, it highlights the disconnect between the instincts of most municipal bond participants and the broader investment decisions that have permeated the municipal market throughout the year.

All year investors have feared a shock—any kind of shock—that would send the municipal market roiling. Early in 2017, those fears revolved around the prospect of increased supply due to infrastructure spending plans, deterioration of the credit quality of the entire health-care sector in the face of massive health-care reform, as well as tax reform that would evaporate demand as all of our marginal tax rates fell with interest rates moving higher based on optimistic visions of economic growth. And yet, in spite of all of those concerns, investors broadly bought longer, lower-quality bonds, taking on more and more risk for less and less incremental yield.

All the while these fears lurked just beneath the surface, it still seems as though the strategy of many municipal bond participants relies on taking outsized risk, praying they can hit the sell button faster than the next guy, should volatility rear its head.

Still skeptical? Let us give you an example. In late May, the State of Illinois announced that they were on the precipice of failing to pass a budget for the third year in a row. Given that it was the third time, it shouldn’t have been that surprising. But, investors, with their hands ever hovering over the sell button, panicked. All of a sudden spreads on Illinois paper blew out by almost 150 basis points (1.5%) in the span of 12 hours. It is worth noting that Thornburg had no direct exposure to the State of Illinois, largely because we didn’t believe the price reflected the credit risk. After the spread blowout, however, we added it to the portfolio. Within a week or so, Illinois announced the passage of a budget. A budget that, by the by, did nothing to address the fundamental credit issues in the state. And just like that, spreads on Illinois tightened and investors’ hands returned to their natural position just above the sell button. For what it is worth, we sold our position at the new higher prices.

So it continued in the fourth quarter of 2017. Tax reform came to fruition and sent the market reeling. News reports surrounding the elimination of the advanced refunding provision as well as a possible elimination of private activity bonds pushed issuers to the market in record numbers. Much like the Illinois case, investors initially reacted with fear, then confidence, then fear, and finally ended the year with some confidence.

Where do we go from here? The reactions to tax reform, and it’s effect on the supply side of the market, in our minds, is overblown. While it is certainly true that refunding bonds have been a major driver of supply over the past several years, it is important to remember that the economic benefit of refunding debt is predicated on lower interest rates. To the extent that we believe rate pressure is shaded higher, the market likely would have seen substantially less advanced refunding issuance, in the near term, regardless of tax reform.

The elimination of the SALT (State and Local Tax) deduction could potentially impact demand in high-tax states. Several of those states already trade at extremely high prices, and the others have potentially serious credit issues. Spread widening in places like New Jersey are likely to drown out any price pop from investors looking to save a little on their tax bill.

Demand is perhaps more interesting. The decrease in corporate tax rates significantly reduces the value of the tax exemption to banks, insurance companies, and other corporate municipal buyers. Should they rotate assets out of the tax-exempt space and into the taxable fixed income space, the municipal market could lose as much as 15% of the demand. This is far from the majority, but certainly enough for downward price pressure.

Pair this with renewed discussions around infrastructure spending, the continued unwinding of the Federal Reserve balance sheet, and the prospect for several more rate increases and there are quite a few opportunities for volatility—especially in a market where investors seem skittish and eager to react to any perceived negative news.

Are municipal bonds a screaming buy? We are not going to raise our hands. Risk is overpriced, and there are political and economic events on the horizon that could lead to a lot of action around the sell button. That said, there is always a reason to own municipal bonds. Asset allocation, portfolio diversification, and low long-term correlation to other asset classes still provide strong reason to invest in municipal bonds. One day we will pound the table, or the television, or the keyboard demanding you over allocate to this asset class. In the meantime, at Thornburg we will continue to focus on risk and reward. On days when everyone is selling out of fear, we are going to look to be buying, and on days when everyone is buying, we are content to sit on our hands.

As always, we appreciate your continued trust in us.

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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Before investing, carefully consider the Fund’s investment goals, risks, charges, and expenses. For a prospectus or summary prospectus containing this and other information, contact your financial advisor or visit our literature center. Read them carefully before investing.

Unless otherwise noted, the source of all data, charts, tables and graphs is Thornburg Investment Management, Inc., as of 12/31/17.

Investments carry risks, including possible loss of principal. Portfolios investing in bonds have the same interest rate, inflation, and credit risks that are associated with the underlying bonds. The value of bonds will fluctuate relative to changes in interest rates, decreasing when interest rates rise. This effect is more pronounced for longer-term bonds. Unlike bonds, bond funds have ongoing fees and expenses. Investments in lower rated and unrated bonds may be more sensitive to default, downgrades, and market volatility; these investments may also be less liquid than higher rated bonds. Investments in derivatives are subject to the risks associated with the securities or other assets underlying the pool of securities, including illiquidity and difficulty in valuation. Investments in the Fund are not FDIC insured, nor are they bank deposits or guaranteed by a bank or any other entity.

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