3rd Quarter 2018

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The third quarter of 2018 began tranquilly in the municipal bond market, as it typically does, given the historical lack of new issue munis during the late summer months. In the second quarter and up to mid-September, yields on munis barely moved and the shape of the municipal yield curve stayed fairly constant. This condition was exacerbated by the market’s continual digesting of the tax reform passed at the end of 2017. The supply of new issue municipal bonds fell about 7% for the third quarter and about 16% for the nine months ended September 30, 2018.

The exclusion of an issuer’s ability to advance refund existing outstanding debt was in part responsible for this. Demand for municipal bonds was also impacted by other aspects of the tax reform. The reduction of the corporate tax rate from 35% to 21% made municipal debt less attractive for those corporates that buy municipal bonds and other types of fixed income securities on a tax-equivalent basis. This primarily impacted property and casuality insurance companies and banks, which together traditionally owned 20% to 25% of outstanding municipal bonds. Mutual fund cash flows were still positive, but much lower than in the same period last year. The Investment Company Institute (ICI) reported flows of almost $5.5 billion in the third quarter of 2018 versus $10 billion for the same period in 2017.

This proved to be the calm before the storm. Following the Federal Reserve’s September 0.25% hike in its short-term target rate and hawkish comments from a number of Fed governors, things began to change. Curiously enough, this happened against a backdrop of very strong economic activity. Gross domestic product (GDP) registered 4.2% annualized growth in the second quarter. Core PCE (Personal Consumption and Expenditure Index), the Fed’s preferred inflation measure, achieved the central bank’s 2% target for the second month in a row. Finally, the unemployment rate was 3.7%, the lowest level since December 1969. One of the benefits of the strong economy is that municipal credit conditions continue to improve across the U.S. A broad measure of economic health, published by Bloomberg, shows that only three states had suboptimal economic improvement between second quarter 2017 and second quarter 2018 (latest data available). Those were Alaska and North and South Dakota. All the other states showed economic improvement of up to 6.3% over that period.

This increase in volatility did not end in September as it has bled into October and included the stock markets. Pundits, fearful of a flat yield curve and concerned with the spread between the yield of a two-year Treasury and that of a 10-year Treasury at 0.20%, prognosticated that an inverted yield curve was on the horizon, potentially foreshadowing a recession. But the yield curve has since steepened and the two-year to 10-year Treasury spread increased to 0.31% at the time of this writing, indicating a booming economy and higher rates. The path of interest-rate prognostication is littered with the dashed careers of the certain. As total return managers, we avoid the perils of interest-rate predictions and instead focus on relative value metrics. This is not a perfect system and had led us to be early both in adding risk and reducing in our portfolios. Still, we feel this is the best way, in the long run, to manage the assets entrusted to us.

Over the past two-and-a-half years, we have positioned our strategies in the lower- end of their relative risk spectrums. This has led to lower durations (a measure of price sensitivity to changes in interest rates), higher credit quality, and higher reserve positions. We have done so because many of the risk metrics in the market have indicated that investors are not being adequately compensated to take risk. Be it credit risk or duration risk, investors have been willing to accept lower increments of yield for larger increments of risk. Global central banks are largely responsible. The coordinated effort to drive down interest rates to extremely low levels to counteract the Financial Crisis has had repercussions for investors. In particular, it has forced investors further out the risk spectrum to essentially stretch for income. As central banks “normalize” interest rates, which is exactly what the Fed is doing, lower risk alternatives will become more attractive to investors.

The risk/reward dynamics, and the value metrics that we follow, have become very disconcerting of late. Credit spreads, which are the difference between AAA general obligation bonds and BBB revenue bonds and represent the additional compensation an investor receives for investing in lower-quality bonds, are back to 2006–2007 levels. This is not enticing when viewed in the context of changes to the new issue market. In 2007, roughly 60% of new issue bonds were insured by AAA municipal bond insurers; today, it is only 5%. The slope of the yield curve, which is the additional yield an investor receives for investing in longer maturity bonds, is flat, suggesting that the additional compensation an investor is receiving for extending maturity again is not enticing. Lastly, real yields, which is the nominal yield on a bond less an inflation measure, are less and less attractive the longer the maturity of the bond.

For the reasons cited above, all of our portfolios are positioned at the lower end of their relative risk spectrums: lower duration, higher credit quality, and higher reserve positions. The current situation is reminiscent of 1994, one of the worst bear markets for fixed income on record. Throughout 1994, the Fed increased the Fed funds rate, which increased both short- and long-term interest rates, and led short-duration portfolios to outperform long-duration portfolios. In 1995, the opposite occurred, and long-duration portfolios outperformed short-duration portfolios. More interesting, at the end of the two-year period, long-duration portfolios outperformed short duration portfolios. The lesson is not about which strategy should be owned, but about how investors should avoid knee-jerk reactions and stay the course.

As Mark Twain once said: “History does not repeat itself, but it does rhyme.” Recent events serve as a reminder of the importance of patience in volatile times and of investing in strategies that properly align with one’s investment horizon. It should also serve as a reminder of the importance of well-diversified portfolios. Our strategies have held up well relative to their competition, though we are not immune to losses. We urge our investors to be patient and allow our actively managed ladder structure to deliver the benefits it has over the last 34 years.

We thank you for your continued support. We are dedicated to providing our investors with attractive risk-adjusted returns on a tax-efficient basis. Rest assured that when we find we are being well compensated to take incremental risks, we will do so for our investors’ benefit.

Important Information

 As of 9/30/18 1 Yr 3 Yr 5 Yr 10 Yr Inception 1/1/1985
Limited Term Municipal Composite (Net) -0.22% 1.07% 1.71% 3.11% 4.77%
Limited Term Municipal Composite (Gross) 0.04% 1.34% 1.98% 3.50% 5.60%
Bloomberg Barclays 5-Year Municipal Bond Index -0.60% 1.16% 1.85% 3.37% N/A**
ICE BofA Merrill Lynch 1-10 Year Municipal Index -0.29% 1.21% 1.82% 3.17% N/A**
Performance data for the Limited Term Municipal Strategy is from the Limited Term Municipal Composite, inception date of January 1, 1985.

As of 9/30/18 1 Yr 3 Yr 5 Yr Inception 4/1/2014
Low Duration Municipal Composite (Net) 0.42% 0.72% 0.69%
Low Duration Municipal Composite (Gross) 0.77% 1.07% 1.06%
ICE BofA Merrill Lynch 1-3 Year Municipal Securities Index 0.29% 0.70% 0.76%
Performance data for the Low Duration Municipal Strategy is from the Low Duration Municipal Composite, inception date of April 1, 2014.

As of 9/30/18 1 Yr 3 Yr 5 Yr 10 Yr Inception 11/1/1991
Intermediate Term Municipal Composite (Net) 0.16% 1.71% 2.70% 4.17% 4.67%
Intermediate Term Municipal Composite (Gross) 0.58% 2.14% 3.14% 4.69% 5.40%
ICE BofA Merrill Lynch 3-15 Year Municipal Index -0.35% 1.86% 2.85% 4.41% N/A**
Performance data for the Intermediate Term Municipal Strategy is from the Intermediate Term Municipal Composite, inception date of November 1, 1991.

As of 9/30/18 1 Yr 3 Yr 5 Yr Inception 5/1/2009
Strategic Municipal Income Composite (Net) 0.69% 2.00% 3.59% 5.87%
Strategic Municipal Income Composite (Gross) 1.37% 2.73% 4.35% 6.75%
ICE BofA Merrill Lynch Municipal Master Index 0.24% 2.33% 3.75% 4.52%
Performance data for the Strategic Municipal Income Strategy is from the Strategic Municipal Income Composite, inception date of May 1, 2009.

Each composite above represents all assets under management in fully discretionary, fee based accounts. Returns are calculated using a time-weighted and asset-weighted calculation including reinvestment of dividends and income. Returns are annualized for periods greater than one year. Individual account performance will vary. The performance data quoted represents past performance; it does not guarantee future results. Portfolio returns net of fees may include management, advisory and/or custodial fees. Thornburg Investment Management Inc.’s fee schedule is detailed in Part 2A of its ADV brochure. Portfolio returns gross of fees do not reflect the deduction of management fees. Performance results of the firm's clients will be reduced by the firm's management fees. For example, an account with a compounded annual total return of 10% would have increased by 159% over ten years. Assuming an annual management fee of .75%, this increase would be 142%.

**Index not yet incepted.

Unless otherwise noted, the source of all data, charts, tables and graphs is Thornburg Investment Management, Inc., as of 9/30/18.

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.

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

The performance of any index is not indicative of the performance of any particular investment. Unless otherwise noted, index returns reflect the reinvestment of income dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing. Investors may not make direct investments into any index.

Portfolio construction will have significant differences from that of a benchmark index in terms of security holdings, industry weightings, asset allocations and number of positions held, all of which may contribute to performance, characteristics and volatility differences. Investors may not make direct investments into any index.

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