Principal Street High Income Municipal Fund (GSTAX): Q2 2019 Commentary

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General Comments

One of the tenets that we preach at Principal Street is consistency – consistency in our investment approach, consistency in performance, and consistency in distribution yields. If we are doing our jobs well the quarterly letters are also likely to be very consistent, if not a bit repetitive and boring. We apologize in advance.

That stated, we are pleased with our investment strategy, our positioning in the market, and the performance to-date. The operations of the Fund continue to run smoothly, the Fund is growing, and we have found new credits with what we believe is very good value to add to the portfolio. This year continues to be a very attractive time to own tax-exempt high yield. The macroeconomic backdrop is largely positive – certainly regarding inflation and the direction of rates – and midway through 2019 the Fund and the asset class are chalking up strong returns, with what we believe to be a clear horizon for the remainder of the year. We believe that the Fund’s attributes – higher yields, the potential for capital appreciation, its low correlation to other asset classes, and its strong relative value in the fixed income universe – make it an attractive addition to many portfolios. We discuss all of this in more detail below.

Market Review

What a difference a few months make! The market sentiment has shifted rapidly after the Fall 2018, which at the time was wary of the prospect of additional Fed rate hikes (following three rate increases in 2018) and the specter of higher inflation, not to mention the mid-term elections. We were, however, circumspect, if not naysayers, of the robust economic scenario that would lead to higher inflation and higher rates. And, of course, the scenario that began to unfold at the end of the 4th quarter 2018 has gained momentum through the 2nd quarter 2019 – mixed but weaker economic data, no inflation to speak of, falling Treasury yields, and the prospect that the Fed will actually lower rates later this year. Combined with the value in our market, the tight supply, and the voracious demand, the high-yield tax-exempt market has performed very well year-to-date, and as we stated above, we believe that its performance should continue for the remainder of 2019.

During the 2nd quarter, the Bloomberg Barclays High Yield Municipal Bond Index generated a return 2.73%, following the 1st quarter’s return of 3.83%. A very good year thus far. The investment grade tax-exempt market (as represented by the Bloomberg Barclays Municipal Bond Index) was up 2.14% during the same period, following the 1st quarter’s return of 2.90%. Overall, the high yield tax-exempt market was largely fueled by declining interest rates in the period triggered by the latest intimations from the Federal Reserve that appears to be positioning for a rate decrease. We believe this decrease will occur and that the Fed will be both deliberate and modest in its actions. The market continues to enjoy a tailwind from the favorable combination of low supply and high demand. This dynamic again helped to bolster prices in our market. With these strong market technicals and solid credit selections, we have avoided any dramatic adverse swings in performance.

As we have espoused for several years, we continue to believe that the low-yield environment is here to stay for the foreseeable future and that finding meaningful yield is increasingly difficult. We continue to believe in the attributes of the Fund – namely yield, diversification and low correlation. The yields generated, both on a relative and absolute basis, are very significant in the current lowyield environment. This is an environment we think will persist over the near and mid-term, and that the yields generated with our credit selections can remain very relevant. The yields compared to Treasuries and Corporates, both on an absolute and taxable-equivalent basis, remain very attractive, and the important municipal / Treasury ratio is currently about 92%, an indication that tax-exempt prices remain attractive.

Certainly an important attribute for the projects in which we invest is the low correlation to other asset classes. The majority of our investments are tangible brick and mortar, essential need projects that are secured by senior liens and in our view have strong underlying collateral value and very solid enterprise value. These projects typically continue to operate regardless of other market, world or political events. For example, a private pay assisted living facility in Florida is usually not influenced by global trade policy, immigration policy, or tax policy. We believe that much of our asset class’s resilience can be attributed to this low correlation.

Quarterly Performance Review

The Principal Street High Income Municipal Fund Institutional Class returned 2.10% in the 2nd quarter, while the Fund’s benchmark, the Bloomberg Barclays High Yield Municipal Bond Index, returned 2.73%, an underperformance of 63 basis points (bps). The underperformance to the Index can be partly attributed to the fact that an Illinois multi-family project dropped on a trade that we believe was made from panic, not current credit information. The bond continues to its pay debt service and we believe that the credit may remain sound despite its price. Also, the index generated performance for two broad sectors that we do not participate in, namely tobacco zero coupon bonds and a variety of Puerto Rico credits, both of which we have eschewed due to the poor credit profile. We believe that the index has become skewed due to the significant percentage of Puerto Rico and Master Settlement Tobacco bonds that are represented in the Index and we are reticent to overweight the Fund in any one sector, particularly a sector in which we do not have faith in the credit fundamentals. We continue to adhere to our disciplined investment approach that we believe will help us avoid problem credits and will provide solid returns over the longer term, even at the risk of temporarily underperforming during different periods in market. Although part of our portfolio management is to be aware of the index, we are in no way an index fund, instead providing active management in project revenue bonds that we believe will provide stability in the portfolio. Additionally, we do not employ leverage in the Fund, which we believe adds unwanted volatility to the equation.

At the end of the period, the Fund had $109.5 million of assets under management and 70 credits. The Fund continues to experience modest growth and we have added credits accordingly.

Our investments generated attractive income as many of the bonds we own continued to benefit from a stronger economy. At the end of the period, the Fund had a 30-day SEC yield (subsidized) of 5.49%, which equates to a taxable-equivalent yield of 8.71% at the highest federal tax bracket of 37%. We believe this yield continues to be very attractive on both a relative and absolute basis.

We continue to overweight healthcare, especially the senior care sector. As a general rule, we love the demographics and market strength for senior care, and we take comfort that we can be overweight in the sector due to the independence of each project from one another and the private pay model that the projects employ. The private pay component – unlike skilled nursing and hospitals – mitigates the common denominator of Medicare and Medicaid, which we believe can be detrimental in the event of reimbursement cuts. We have also added a number of industrial, manufacturing, and recycling facilities to the portfolio. This is a broad sector that we believe possesses solid value and tremendous opportunity for carefully selected credits.

Overall, we believe the Fund maintains a solid foundation that has generated both tax-free income and total return.

Core Tenents and Positioning 

We are monitoring many moving pieces, and all of this makes it very difficult to predict the course of the economy and interest rates. We return, as always, to some of our core tenets to guide us, and these do remain consistent. We believe:

  • In the credit fundamentals for both the portfolio and the high yield market in general;
  • That the Fund is well-positioned and that our focus on project revenue debt has been and should continue to be a winning formula for generating attractive tax-exempt income and capital appreciation;
  • That investors continue to search for meaningful yield, and that both the Fund and the asset class have the ability to provide that;
  • That the asset class represents some of the best value in the fixed income universe, a bold claim that has been reinforced by the attractive income generated by the Fund;
  • That over time, demand should continue to exceed supply on the long end of market (where the Fund invests), propelling prices higher;
  • That the Fund continues to offer low correlation to other asset classes and significant diversification, which may offer stability when other markets are more volatile.

Inherent in these core tenets is that we continue to ascribe to the following assumptions:

  • Treasury market will continue to trade in a narrow band;
  • The Fed is likely to lower rates during the course of 2019;
  • Inflation will not play a major role in 2019, remaining in the 2% -2.5% range;
  • The projects in the Fund, many of which are essential need, should operate well and continue to generate a high stream of federally tax-free income.

Although some of the individual components adjust slightly over time, these principles should sound very familiar, given that it has been our working thesis for many years. Taken in tandem with our stringent investment process, this has proven to be an effective combination for generating consistent and reliable federally tax-free income and capital appreciation since the Fund’s inception. We believe our credit selection continues to be the engine that drives performance and have experienced few defaults.

We have the ability to analyze difficult credits that may represent good value, and to bring the expertise to work through problem credits that may develop over time. Naturally we try to avoid problems with our credits but possessing the tools to work through a problem is an important asset.

Tax-Free Income Versus Total Return

Although we are very sensitive to the fact that no investor wants to incur losses, we believe that all investors need to understand that both the Fund and asset class will fluctuate in price. Often this has little to do with the composition or fundamentals of the portfolio itself, but rather with the external factors that influence markets – politics, Federal Reserve policy, fiscal policy, and US and global growth prospects, to name only a few. We encourage our investors to focus on the consistency and high level of income that has been generated by the Fund – its primary objective – and to be calm if the Fund has moderate swings in valuation – either up or down. These moderate swings are normal, even in a fixed income product and can be influenced by far-reaching factors.

Looking Forward

With an attractive macroeconomic environment as our backdrop, we remain positive in our outlook for the Fund and the asset class. In our opinion, the strength and value in our market, both relative and absolute, is helping to attract new investment dollars that, in turn, has bolstered prices and total return.

Overall, we continue to be pleased with the Fund’s performance and positioning within the market. Many of the indicators that we monitor suggest a positive outlook for the bond market, and in our opinion for high yield, in particular:

  • On a relative basis the high yield tax-exempt market has some of the best value / yields available in the fixed income universe, without much of the volatility that the corporate market, for instance, is experiencing;
  • As of the quarter end, Treasury rates are hovering at about 2.50% for the 30-year bond and at 2.00% for the 10-year (a remarkable rally), mitigating the idea of much higher rates in the near future;
  • All eyes seem to be focused on the specter of a global economic slowdown, mitigating the idea of inflationary pressures and a making fixed income products more desirable;
  • The Federal Reserve seems to have adopted a dovish stance towards interest rate increases that should, in fact, lead to rate decreases this year. In our opinion, this stance should favor the Fund and fixed income products;
  • The muni / treasury ratio is about 92%, suggesting that muni bonds remain cheap relative to other asset classes;
  • The supply / demand imbalance remains in place, suggesting that our market may experience lower yields rather than higher, which could generate positive performance.

Philosophy

Our philosophy remains a constant, even in periods of disruption. Our goal is to provide a quality product for our investors and to provide quality service, as well. As we continue to grow, we look forward to more conversations about your investment in the high yield municipal bond asset class, our investment process and goals, our efforts to find yield and generate income in a difficult environment, and to add diversification to your portfolios. This dialogue is an integral part of our philosophy, and consistent with the theme of transparency and accessibility that governs the way we manage the Fund. As always, we adhere to the four cornerstones of our strategy and investment philosophy at all times:

  • Credit – applying a rigorous top down / bottom up credit-driven investment process that seeks to mitigate risk, preserve capital, enhance income and increase the potential for capital gains;
  • Value – finding and unlocking value in a selective asset class;
  • Transparency – providing transparency in our investment process and outlook; and
  • Accessibility – working directly with you, our clients, to answer a variety of questions, offer advice where we are able and help enhance your portfolio.

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The performance data quoted represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than their original cost and current performance may be lower or higher than the performance quoted. For the most recent month-end performance, please visit principalstreetfunds.com.

You should consider the Fund’s investment objectives, risks, and charges and expenses carefully before you invest. This and other important information is contained in the Fund’s summary prospectus and prospectus, which can be obtained by calling 1.877.914.7343 or visiting our website at principalstreetfunds.com. Read carefully before you invest.

Opinions expressed are subject to change at any time, are not guaranteed and should not be considered investment advice.

Fund holdings and sector allocations are subject to change and are not recommendations to buy or sell any security. Current and future portfolio holdings are subject to risk.

The Principal Street High Income Municipal Fund’s primary investment objective is to provide current income exempt from regular federal income tax. Income may be subject to state or local tax.

Mutual Fund investing involves risk. Principal loss is possible. The Fund’s value investments are subject to the risk that their intrinsic values may not be recognized by the broad market or that their prices may decline. Fixed‐income securities are or may be subject to interest rate, credit, liquidity, prepayment and extension risks. Interest rates may go up resulting in a decrease in the value of the fixed‐income securities held by the Fund. High‐yield fixed income securities or “junk bonds” are fixed‐income securities held by the Fund that are rated below investment grade are subject to additional risk factors such as increased possibility of default, illiquidity of the security, and changes in value based on public perception of the issuer. The municipal market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. The Fund is new with no operating history ax, legislative or political changes and there can be no assurance that the Fund will grow to or maintain an economically viable size.

Tax Equivalent Yield is the interest rate which must be received on a taxable security to provide the bondholder the same after-tax return as that earned on a tax-exempt security. The tax rate used to calculate the Taxable Equivalent Yield is the 37% marginal federal income tax bracket.

SEC 30-Day Yield is based on a 30-day period ending on the last day of the previous month. It is computed by dividing the net investment income per share earned during the period by the maximum offering price per share on the last day of the period. The yield figure reflects the dividends and interest earned during the period, after the deduction of the Fund’s expenses. A subsidized yield takes into consideration the expenses paid by the advisers.

Bloomberg Barclays High Yield Municipal Bond Index: The US Municipal Index covers the high yield portion of the USD-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds.

High Yield Bonds: A high paying bond with a lower credit rating than investment grade bonds or Treasury bonds. Because of the higher risk of default, these bonds pay a higher yield than investment grade bonds.

Correlation: A statistical measure that determines how assets move in relation to each other. It is measured on a scale of -1 to +1. A perfect positive correlation between two assets has a reading of +1. A perfect negative correlation has a reading of -1.

A basis point is one one-hundredth of one percent.

Distributions are not guaranteed and a company’s future ability to make such payments may be limited.

Diversification does not guarantee a profit, nor does it protect against a loss in a declining market. High yield bonds, investment grade municipal bonds, tax-exempt bonds, and other asset classes have different risk profiles, which should be considered when investing. All investments contain risk and may lose value.

Principal Street Partners is the Investment Adviser to the Principal Street High Income Municipal Fund, which is distributed by Quasar Distributors, LLC.