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Article iMGP APA Enhanced Municipal Bond Fund Due Diligence Report

FUND:           iMGP APA Enhanced Income Municipal Fund
SUB-ADVISOR:   Asset Preservation Advisors
PORTFOLIO MANAGERS:Kevin Woods, Kyle Gerberding, and Patricia Hodgman
FIRM/MANAGER AUM $10.7 Billion (as of September 30, 2024)
OBJECTIVES: The iMGP APA Enhanced Income Municipal Fund seeks to provide investors with a high level of income exempt from federal income tax, with a secondary investment objective of capital appreciation.

Background & Overview

Asset Preservation Advisors (APA) is an Atlanta-based municipal bond manager established in 1989. APA manages over $10 billion (as of September 30, 2024) of high-quality federal tax-exempt and taxable municipal bond portfolios for large wealth management platforms, registered investment advisors, family wealth offices, and institutional clients.

Since its founding, APA has developed a suite of municipal bond strategies, all of which fall in the short- and intermediate-term duration segments. The firm offers seven strategies, including High-Quality Intermediate, Enhanced Intermediate, Short-Term, Taxable Municipal, Positive Impact, and a hybrid strategy combining High-Quality and Enhanced Intermediate. The High-Quality Intermediate strategy was introduced in December 2003 and is their flagship strategy. Its investor base is made up primarily of state-specific, separately managed accounts that are highly customizable for individual clients. APA manages portfolios for clients in more than thirty-five states.

The firm’s Enhanced Intermediate strategy dates to June 2009 and was introduced as a more opportunistic strategy following the 2008/09 GFC environment, the result of attractive yields and client interest. The Enhanced Intermediate strategy is more opportunistic than the High-Quality Intermediate strategy, the difference being that the opportunity set is wider for the Enhanced Intermediate strategy.  It is geared to higher duration and lower-rated investment-grade municipal bonds seeking higher invested yield and long-term returns.

The focus of our work (and this report) is on the Enhanced Intermediate strategy, as it serves as the underlying strategy for the iMGP APA Enhanced Income Municipal Fund. Below we provide an overview of the investment team, the investment process, and opinion supporting our rationale for introducing the iMGP APA Enhanced Income Municipal Fund.

Sub-Advisor Investment Team

There are twenty-six members of the firm, and the investment team is made up of 18 individuals with experience spanning the buy and sell-side industry, research, portfolio management, trading, and client-servicing functions. The iMGP APA Enhanced Income Municipal Fund will be led by three individuals: Kevin Woods, Kyle Gerberding, and Patricia Hodgman.

Woods is Co-Chief Executive Officer and Chief Investment Officer of APA. He brings 22 years of experience in the investment industry, specifically in the municipal bond market, to his role. Woods currently leads the firm’s Investment Committee and shares oversight of all of APA’s investment strategies, outlook, and positioning. Throughout his time at APA, Woods has held multiple positions contributing to every aspect of the organization that he now leads. He holds a Bachelor’s degree in Finance from the University of Mississippi.

Gerberding joined APA in 2008 and has been in successive fixed-income roles since joining the firm. As lead portfolio manager, he is primarily responsible for the construction, implementation, and monitoring of client portfolios in separately managed accounts, and is actively involved in trading for each of APA’s municipal strategies. Additionally, he serves on APA’s Investment Committee and became a partner of the Firm in 2021. Kyle graduated from the University of Florida where he earned a Bachelor of Science in Business and Sport Management. He is a member of the National Federation of Municipal Analysts.

Hodgman joined APA in 2015, with 20 years of investment experience in the financial services industry and specifically in the municipal bond market. Hodgman serves on APA’s Investment Committee and became a partner of the Firm in 2021. In addition to her role on the Investment Committee, she focuses on portfolio analytics, performance attribution, and client services. Trish works closely with the Business Development team in presenting APA’s investment strategy to their current and prospective clients and directs the firm’s marketing mix. Trish earned a BA in Economics from Hollins University, is a member of the CFA Institute, the Atlanta Society of Financial and Investment Professionals and the National Federation of Municipal Analysts.

As it pertains to team structure, there is an eight-member Investment Committee (led by Woods), which meets frequently to discuss strategy duration, credit-rating exposures, sector and state developments based on macroeconomic and market analysis, as well as industry trends derived from credit analysts’ research on individual bonds and issuers.

Beyond the Investment Committee, there are five individuals who make up the credit research group. The credit research group is co-led by Paul Nolan and Matt Riggle, who have final say on all credits. Nolan has over 20 years of experience, and was previously responsible for taxable and municipal credit, and market research. He formerly held a role as a municipal credit analyst at Moody’s. Riggle began his investment career in 2004 and has been with APA since 2006. Research coverage is divided by sectors and geographic regions.

The credit research group is tasked with evaluating and reviewing credits for eligibility for portfolios as well as continuous monitoring. (Additional details on APA’s credit research process are described below in the Investment Process section.) Bonds in the iMGP Enhanced Income Municipal Fund must be approved by the firm’s directors of research, i.e., the team requires two opinions for higher-income credits. If a disagreement on credit rating arises, a third analyst opinion is required. Personnel turnover among investment professionals has been low over time.

Background on the Municipal Bond Market

The APA team believes that persistent pricing inefficiencies exist in the municipal bond market. At the root of the Enhanced Intermediate strategy is the fact that the municipal bond market’s breadth and diversity resist generalizations. The municipal bond market is an approximately $4.0 trillion market with nearly a million CUSIPs, 70,000 issuers, and numerous structures that often involve non-standard features. Furthermore, while municipal bonds trade actively around the time of issuance, trading subsequently drops off materially in the secondary market. There are several studies showing how infrequently municipal bonds are traded, while bond ratings from rating agencies are infrequently updated. This limited liquidity in the secondary market often makes it difficult for investors to find counterparties/sellers for the bonds they wish to buy, especially of any meaningful size. Furthermore, the average deal size for municipal bonds is small, at less than $35 million. The illiquidity and small average deal size can present challenges to large municipal bond managers, as significant asset growth leads to a growing reliance on non-fundamental, top-down calls (e.g., the changing shape of the yield curve, duration, etc.) to be successful.

Investment Process

The iMGP APA Enhanced Income Municipal strategy is a national intermediate-term, investment-grade municipal portfolio that seeks to capitalize on municipal bond market inefficiencies through bottom-up, internally generated credit research and active portfolio management. APA attempts to identify higher quality, overlooked issues that are likely to generate a return advantage over the benchmark. The competitive advantage will come from utilizing a flexible strategy, while managing an appropriately sized asset base to capitalize on opportunities in the municipal market. This strategy is less about tracking a benchmark and cutting out the worst names in a sector, or over- or underweighting a sector by a few percentage points compared to a benchmark, both of which are common among larger municipal bond strategies. Instead, the focus is on selectively taking advantage of relative value and mis-pricings, and a willingness to look different from the benchmark, whether its sector or state exposures.

Bottom-up, fundamental credit research is a critical aspect of the investment process. The team’s credit research focuses primarily on identifying durable investment-grade securities and is typically most active in the secondary market though they will buy new issue securities. Securities in the portfolio will typically be characterized as resilient issuers that have demonstrated the ability to weather downturns and avoid defaults and multi-notch credit rating downgrades. In keeping with this capital-preservation mindset, APA’s credit analysts attempt to mitigate these risks by placing a strong emphasis on forward-looking credit fundamentals.

The credit team assigns internal credit ratings to all credits held in portfolios, evaluating the short-term and long-term outlooks for an issuer’s ability to pay. To the extent that the team monitors ratings assigned by external credit rating agencies, it is to gauge the likelihood of upgrades or downgrades. (Rating agencies tend to focus more on the size of a municipality’s population and revenues, with less regard for other credit fundamentals. APA believes it is critical to understand the current stance of those agencies on credits as their change in ratings and rating outlooks impact bond prices.) The team assigns ratings for issuers currently held in the portfolio as well as numerous securities not presently in the portfolio. At this time, the team has ratings on more than 4,000 issuers, though the number of individual issues is significantly higher due to multiple issues from the same issuer. Ratings are continually reviewed as updated financials become available.

Analysis of each credit will vary based on the issuer’s geography, sector, and structure but will typically include metrics such as purpose of the project, operating revenues, margins, liquidity (days cash on hand), reliance on state/federal funding, pension funding levels, the diversity and dependence of a state’s key revenue sources, etc. The durability of a credit, or an issuer’s ability to pay, is critical, and the team will perform a stress-test to understand the impact on an issuer’s ability to pay under bearish scenarios. The extent of the bearish scenario will vary and include the probability, magnitude, and duration of the downturn. They avoid issuers that would be unable to withstand severe downturns and understanding bondholder protections are part of this analysis.

When initiating and reviewing credit ratings, APA’s credit analysts pay attention to the frequency, quality, and comprehensiveness of financial data from issuers. These elements result in a structural preference for investment-grade and revenue bonds as these issuers tend to provide more frequent and more detailed disclosures than high-yield and general obligation bonds. For instance, revenue bond issuers offer better transparency as they often release quarterly financial updates while general obligation bonds provide annual updates. In addition to providing protection from defaults and downgrades at the credit level, the credit analysts also provide direction to portfolio managers, communicating trends in the marketplace.

The credit team utilizes a few tools to aid in their ongoing coverage. These tools include CreditScope, a credit analysis software designed by Investortools, with data updated continuously by Merritt Research Services. In addition, APA uses financial industry news sources, industry and corporate research, corporate rating services, as well as company data in the form of annual reports and company press releases. Bitvore is used to monitor headline risk amongst municipal issuers, which is a platform that provides growth, risk and sentiment scoring through identification of material business events.

Overall, the strategy tends to be concentrated in revenue bonds of varying maturities (the strategy has the flexibility to invest across the full 1- to 30-year maturity range). The remainder of the portfolio will be in general obligation bonds and opportunistic areas (such as taxable municipal bonds). In terms of credit ratings, the portfolio will tend to focus on the three lower rungs of investment-grade, though the exposure to the various rating buckets will vary based on risk and reward opportunities in the marketplace. Historically, the majority of the assets have been in the two lowest rungs of investment-grade (A- and BBB-rated credits). The team has the flexibility to own up to 20% in below-investment-grade or non-rated securities, but exposure will generally be less than 10% of assets. Portfolio holdings are commonly diversified across sectors and states though the opportunity set will dictate exposures. It is expected that exposures to high-tax states will likely be underweight the benchmark, as they typically have lower relative yields due to investor demand.

The APA team’s bottom-up approach is complemented with a top-down overlay. At the top-down level, the team bases its market views on a number of factors including the yield curve, credit risk, and price. The team’s view takes into consideration national and state-specific economies, monetary and fiscal developments, interest-rate levels, among other indicators such as market supply and demand conditions and relative valuations. In terms of yield curve positioning, the team is constantly analyzing the yield curve to target and identify attractive relative value. Many times, the term structure of the yield curve will produce an abnormal relationship between maturities. Typically, investors are compensated with higher yields for taking on the additional risk of longer maturities. However, depending on monetary policy and economic shifts, the yield curve could flatten, for example. Seeking to take advantage of these opportunities is one way that APA attempts to add value.

The strategy will maintain a duration close to the benchmark’s intermediate-term duration, which typically has been in the 5- to 7-year range. (This compares to the targeted average duration range of 3.5-5.5 for the High-Quality Intermediate strategy.) Portfolio duration may be adjusted to take a more defensive or opportunistic position as market and yield curve conditions change. For example, the structure of the portfolio may at times be more “barbelled” (high exposure to short-term and long-term maturities) or a modified laddered across maturities depending on the outlook and opportunity set.

The team tends to focus on the traditional higher-coupon securities (5% coupons) for their defensive (less interest-rate risk) and liquid nature. However, the team will invest in slightly lower-coupon securities though these securities will typically comprise a lower percentage of the Fund. The team may also increase the portfolio’s average credit quality should they feel they are not being appropriately compensated for risks in the marketplace. Portfolio turnover will fluctuate based on the opportunity set. Turnover will be lower at times when conditions are tighter, and higher during market selloffs. Furthermore, portfolio turnover will depend on the amount of short-term trading opportunities. Woods Gerberding, and Hodgman will take advantage of short-term trading opportunities if they identify attractive relative values. The portfolio is generally managed to be fully invested.

As for the sell discipline, the team will sell in the event of deteriorating credit fundamentals, if the municipal market exhibits rich valuations, or if they find better relative value.

Opinion

We believe the iMGP APA Enhanced Income Municipal Fund will be a compelling option in the national intermediate tax-free bond category. There are several positives supporting this opinion.

Given the characteristics of the municipal bond market, we firmly believe that an entrepreneurial, smaller-sized strategy with a flexible mandate can provide an advantage as it allows an investment team to take advantage of the inefficiencies that exist in the asset class. For example, many large municipal strategies are often forced to invest in new issue bonds regardless of the (un)attractiveness of a security. Furthermore, our experience suggests that many larger municipal bond funds maintain state and sector exposures that hue closely to benchmark exposures, only making small relative value adjustments. Large teams also become more dependent upon making top-down calls such as duration or changes to the yield curve as a means of generating alpha. We are less confident in a firm’s ability to repeatedly get these top-down calls correct. Our strong preference is for relatively smaller strategies, and based on our conversations with APA, they fully appreciate the need to responsibly manage asset growth to maintain flexibility. Gerberding stated, “Being nimble [in the municipal bond market] is a great way to add value.”

Specific to APA, we think the strategy’s edge lies in its selectivity, flexibility, and willingness to look different from the benchmark, whether it is sectors or geographies/states. The selectivity stems from the credit research group which looks to avoid issuers that may default or be downgraded, as well as observations at the credit or sector levels, highlighting potential opportunities and risks. Our conversations with the credit team left us confident in their knowledge and analysis of sectors and portfolio holdings. This, in combination with the portfolio managers’ discussion of relative value and appropriately structuring the portfolio in various environments contributes to our confidence.

We (along with our European research counterparts) have spent a considerable amount of time with the APA team, and it is clear to us that the APA team is passionate about the municipal market. Furthermore, we think the team’s depth and collective experience is a plus.

Ultimately, we think the iMGP APA Enhanced Income Municipal Fund represents the team’s best thinking and we believe the Fund will outperform its benchmark and peers over a multi-year period.

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DISCLOSURE

The fund’s investment objectives, risks, charges, and expenses must be considered carefully before investing. The statutory and summary prospectuses contain this and other important information about the investment company, and it may be obtained by calling 1-800-960-0188, or visiting imgpfunds.com. Read it carefully before investing.
Municipal Market Risk. Factors unique to the municipal bond market may negatively affect the value of the Fund’s investment in municipal bonds. These factors include political or legislative changes, and uncertainties related to the tax status of the securities and the rights of investors in the securities. The Fund may invest in a group of municipal obligations that are related in such a way that an economic, business, or political development affecting one would also affect the others. Some municipal obligations carry additional risk, such as those that are tied only to a specific stream of revenues. In addition, the municipal bond market, or portions thereof, may experience substantial volatility or become distressed, particularly during recessions or similar periods of economic stress, and individual bonds may go into default, which would lead to heightened risks of investing in municipal bonds generally. Actual or perceived changes in the financial health of the municipal market as a whole or in part may affect the valuation of debt securities held by the Fund.
Fixed Income Securities Risk. Interest rates may go up resulting in a decrease in value of the securities held by the Fund. Fixed income securities held by the Fund are also subject to interest rate risk, credit risk, call risk and liquidity risk, which are more fully described below.
Credit Risk. Credit risk is the risk that an issuer will not make timely payments of principal and interest. A credit rating assigned to a particular debt security is essentially an opinion as to the credit quality of an issuer and may prove to be inaccurate. There is also the risk that a bond issuer may “call,” or repay, its high yielding bonds before their maturity dates.
Interest Rate Risk. Interest rates may go up resulting in a decrease in the value of the securities held by the Fund. Interest rates have been historically low, so the Fund faces a heightened risk that interest rates may rise. Debt securities subject to prepayment can offer less potential for gains during a
declining interest rate environment and similar or greater potential for loss in a rising interest rate environment. A fund with a longer average portfolio duration will be more sensitive to changes in interest rates than a fund with a shorter average portfolio duration.
Call Risk. During periods of declining interest rates, a bond issuer may “call” or repay its high yielding bonds before their maturity dates.
Liquidity Risk. Certain securities may be difficult or impossible to sell at the time and the price that the Fund would like. Trading opportunities are more limited for fixed income securities that have not received any credit ratings, have received ratings below investment grade or are not widely
held. The values of these securities may fluctuate more sharply than those of other securities, and the Fund may experience some difficulty in closing out positions in these securities at prevailing market prices.
New Fund Risk. The Fund is newly formed and has no operating history for investors to evaluate. Its performance may not represent how the Fund is expected to or may perform in the long term. In addition, new funds may not attract sufficient assets to achieve investment and trading efficiencies.
High-Yield Fixed Income Securities Risk. The 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. Such
securities are generally considered speculative because they present a greater risk of loss, including default, than higher quality debt securities.
iM Global Fund Management is ultimately responsible for the performance of the fund due to its responsibility to oversee the fund’s investment manager and recommend its hiring, termination and replacement.
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