1st Quarter 2018

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The Federal Reserve Board (Fed) increased short-term interest rates at its March 2018 meeting, Chairman Jerome Powell's first move as the new Fed president. The increase puts the new Federal funds rate target at 1.50% to 1.75%. In so doing, the Fed stated: "The economic outlook has strengthened in recent months." While the assessment of the economy may be true, it's hard to tell from the stock market's performance during the quarter. The Dow Jones Industrial Average reached an all-time high of 26,617 on January 26, and a low for the quarter of 23,533 on March 23. The CBOE Volatility Index (VIX) had an average reading of 12.5%, for the 12-months ending December 31, 2018, and reached a high for the quarter of 37.3% on February 5, 2018. After a long absence, volatility has returned to the stock market. This has served as a reminder to investors about the importance of a well-diversified portfolio of stocks, bonds, and cash.

The following table highlights the returns of various market indices for the quarters ending December 31, 2017, and March 31, 2018.

Table of Indices returns

The topic of tax reform consumed municipal market participants in the fourth quarter of 2017, with several proposals being bandied about that would significantly impact the supply/demand dynamics of the market for years to come. Ultimately, the legislation was not as radical as initially feared. On the supply side of the equation, issuers lost the ability to advance refund debt. Much like a homeowner refinancing an existing mortgage to save on interest costs, an issuer would refinance debt when interest rates were low to provide some present-value savings. While many thought this would have a large impact on supply, we did not agree. Advance refunding is highly correlated to the current level of interest rates, and many issuers had already accomplished any possible refunding over the previous several years.

Instead, we found the impact of tax reform on the demand side of the equation to be far more interesting. Overlooked was the reduction of the corporate tax rate from 35% to 21%, and the fact that corporations evaluating municipal bonds versus other fixed income securities on a tax-equivalent basis would now require a higher hurdle rate to buy municipal securities. We felt that the impact this may have on two specific buyers of municipals, banks, and property and casualty insurance companies, which own roughly 20% to 25% of outstanding municipal bonds, could lead both to re-evaluate owning municipal bonds. While we do not believe this to be an Armageddon-type of scenario; we expect it to be more like a weight leaning on the market for the next 12 to 18 months.

Other demand-side impacts are the limitations on the deductibility of state and local taxes (SALT), which led many market observers to postulate that the demand for municipal bonds in high tax states will increase. Again, we did not share the same opinion. The demand for California bonds has already driven prices to a level where we feel there is little value when compared to other municipal securities on a tax-equivalent basis.

Demand for municipal securities in other high-tax states, such as Connecticut, Pennsylvania, and New Jersey, is not as cut and dry because there is significant credit risk associated with each. Nevertheless, these concerns caused the supply of municipal bonds to spike in November and December as issuers rushed to market to hedge against the potential threat of tax reform. Some investors viewed this period as an opportunity to buy extra municipal bonds in anticipation of a January rally, which never materialized. We did not view the market the same way and kept our funds positioned at the lower end of their relative risk spectrums (i.e., lower duration, higher credit quality, and higher reserve positions). The last fear facing the municipal bond market is the long-advertised infrastructure plan. While the plan has experienced several failed launches, and what is known suggests it will have little impact on the supply of municipal bonds, we are still monitoring the details of the proposal for potential impacts to our portfolios.

The headlines for the municipal market at the end of March 2018 certainly look scary. On April 2, 2018, Bloomberg posted the following headlines (not holdovers from April Fools' Day): "Muni Bonds Headed for Biggest First Quarter Loss Since 1996" and "Muni Bond Issuance Plummeted 29% in 1Q; BofAML Topped League." Given a basic understanding of supply and demand effects on pricing, the two headlines may seem hard to reconcile. The last six months has really been the tale of two markets. Chart 1 illustrates the changes that occurred in yields for AAA general obligation bonds during the fourth quarter of 2017 and the first quarter of 2018.

Changes in AAA General Obligation Municipal Yield Curve

The fourth quarter of 2017 saw yields of shorter maturity bonds increase more than the yields of longer maturity bonds, leading to a flattening of the yield curve. At the time, many analysts and pundits harped that the phenomenon portends a future recession. In the first quarter of 2018, the market watched as yields of longer maturity bonds increased more than yields of shorter maturity bonds, leading to a steepening of the yield curve. The steepening of the curve is an indication that market participants have a growing concern about increases in inflation—the enemy of the fixed income investor.

A welcome by-product of the changes in yields is the improvement in "real yields"; a metric that measures value in the fixed income market. Real yields, which is calculated as the yield of a given bond less an inflation measure, such as Core PCE, have improved throughout the first quarter. The real yield of a five-year AAA municipal bond ended 2017 at 0.18%, which is significantly less than the long-term average of 1.08%. As of March 31, 2018, the real yield on a five-year AAA municipal security stood at 0.47%, a significant increase from the fourth quarter of 2017, but still well below the long-term average. Table 2 highlights the real yields for AAA general obligation bonds of select maturities.

Despite the changes in yields during the quarter, credit spreads have remained unchanged. Credit spreads remain at levels not seen since before the credit crisis of 2008. Chart 2 on the previous page highlights credit spreads between a 10-year AAA general obligation bond and a 10-year BBB revenue bond.

In volatile markets, it is good to remember the benefits of Thornburg's core laddered municipal strategies. The ladder structure works to provide an increased dividend, while limiting net asset value volatility. The cash that is organically generated by the ladder structure, through bond maturities and interest payments, can be reinvested in higheryielding securities, while the remaining assets roll down the yield curve and are priced to shorter maturities. All of this works to aid in the recovery of any initial NAV losses in a rising-rate environment while delivering a high level of tax-exempt income.

Thank you for the continued trust in our people and our process.

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%.

Important Information
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 thornburg.com. Read them carefully before investing.

Unless otherwise noted, the source of all data, charts, tables and graphs is Thornburg Investment Management, Inc., as of 3/31/18.

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.

The views expressed are subject to change and do not necessarily reflect the views of Thornburg Investment Management, Inc. This information should not be relied upon as a recommendation or investment advice and is not intended to predict the performance of any investment or market.

Class I shares may not be available to all investors. Minimum investments for the I share class may be higher than those for other classes.

Diversification does not assure or guarantee better performance and cannot eliminate the risk of investment losses.

Income earned from municipal bonds is exempt from regular federal and in some cases, state and local income tax. Income may be subject to the alternative minimum tax (AMT).

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