Navigating the potholes while making America great again

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1 Asset Management Municipal Insights Navigating the potholes while making America great again Municipal investors remain cautious as President Trump s agenda comes to life through legislation and his proposed budget. Economic recovery across the country has been uneven with weak energy markets, growing healthcare and technology sectors and diminishing manufacturing employment. President Trump s agenda will continue to support this trend as those areas with a strong defense presence will benefit while states with expanded Medicaid programs and institutions receiving federal research dollars will be hurt. The replacement of the Affordable Care Act (also known as ACA or Obamacare) which is still in question would result in the loss of funding for Medicaid expenses that can represent up to one-third of a state s budget. The reduction in climate-change support and the reversal of the Clean Power Act could provide relief for coal-producing regions while slowing the growth rate of renewable resources. Education, research and development, climate change, cultural arts and foreign aid are some of the largest programs negatively impacted by the President s proposed budget. President Trump s budget focuses increased funding for the military, support of Veterans Affairs and Homeland Security. The Administration introduced the American Health Care Act (AHCA) hoping to repeal and replace the ACA. Despite the recent failure to push approval through the House, the potential is still there to negotiate passage. The introduction of the AHCA addresses the major components of the ACA that are under attack. States will bear the cost, having to address the loss of federal funding for Medicaid. The Congressional Budget Office s (CBO) review of the initial AHCA bill indicated potential federal government savings of $337 billion by Despite these savings, the largest factor in lack of support for the AHCA was the CBO s estimate that 24 million people could lose health insurance by Will the repeal of the ACA help the U.S. economy? One study dated January 2017 by George Washington University reported that the elimination of federal funding for Medicaid expansion could result in the loss of 2.6 million U.S. jobs in 2019 and $6.8 billion in state and local taxes between 2019 and Local governments are fearful of the push-down effect as states will be forced to address their budgets as Medicaid payments from the federal government represent nearly one-third of a state s budget. So, the economic benefits of repealing the ACA are highly questionable. The BMO tax-free income team Portfolio managers Thomas Byron Brian Sipich, CFA Robert Wimmel Michael Montgomery Credit analysts Michael E. Janik, CFA Catherine M. Krawitz, CFA Christopher Nowakowski, CPA Andrew W. Tillman Contact us bmofunds.com bmo-global-asset-management

2 ACA Affordable Care Act Mandatory requirement to obtain healthcare Cannot deny access to health insurance based on pre-existing conditions Medicaid expansion with federal funding for those with income that does not exceed 138% of Federal Poverty Limit AHCA American Health Care Act No mandatory requirement to obtain healthcare Cannot deny access to health insurance based on pre-existing conditions Medicaid expansion is no longer available to new parties after March 2017, but remains in place for those already in the system Top states by total defense spending (in billions) $ billions Open-ended funding of actual costs for Medicaid expansion Creation of health insurance exchanges in each state for purchase of health insurance policies Source: BMO Global Asset Management Federal funding changed to a per capita basis with ability to choose between per capita or block grant funding Federal government will provide tax credits and age-based federal aid to purchase health insurance through a company On March 16th, the President presented a spending plan that provides a more detailed look at his Make America Great Again campaign. The proposed spending increases defense spending by $541 billion or 10% over the previous budget. The President s plan will be negotiated through Congress with a final budget to be released in May. The expiration of the current spending bill is quickly approaching, on April 28th, as the last Congress was unable to reach a formal budget. It s likely that a new spending bill, through fiscal year ending September 30, will be addressed the last week of April when the legislature returns from recess. This will push tax reform until later this year under the fiscal 2018 budget. The President s plan will be negotiated through Congress with a final budget to be released in May. The President s budget proposal addresses discretionary spending. This accounts for approximately 30% of the total federal budget. The remaining 70% is mandatory spending that includes Medicare, Social Security and interest on federal debt. Under the proposed budget, more than 10 agencies will experience double-digit declines in their budget to offset the increased spending in the Department of Defense, Veterans Affairs and Homeland Security. The Environmental Protection Agency (EPA), State Department, Agricultural Department and Labor Department are expected to realize the greatest cuts in spending. 0 Virginia California Texas Maryland Florida Source: National Conference of State Legislatures, Department of Defense, Office of Economic Adjustment Among the beneficiaries of the budget proposal are those states with the largest defense presence, such as Virginia, California and Texas (see chart above). Among those with the most to lose are higher education institutions receiving funding from the National Institute of Health, which supplies funding for research and medical centers. Also losing are rural areas that benefit from federal support of educational and cultural programs, such as the Corporation for Public Broadcasting and National Endowment for Arts, and subsidy programs sponsored by the U.S. Department of Agriculture. Support for President Trump s agenda is not clear, evidenced by the delayed vote for the repeal and replacement of the ACA. Among the beneficiaries of the budget proposal are those states with the largest defense presence, such as Virginia, California and Texas. States and local governments have experienced changes in federal policies and spending levels in the past. Their sovereign powers provide the tools necessary to address changing financial resources and spending. States are able to push down greater responsibility to the local level. Monitoring regional and local economic trends along with political willingness to make appropriate changes when necessary will provide investment opportunities along the way. The municipal market continues to demonstrate a strong credit backdrop with defaults remaining at historically low rates. Municipal investors will continue to benefit from the strong framework of municipal governments as well as the attractive yields offered in the tax-exempt market. Pennsylvania Washington Georgia Massachusetts Alabama 2

3 Market commentary The first quarter of 2017 ended on a sour note with March municipal bond returns barely in positive territory. The Bloomberg Barclay s Municipal Bond Index returned 0.22% for the month. However, first-quarter returns remained firmly in positive territory with the index returning 1.59% over the first quarter. On the macro front, the two biggest events were the failure of Congress to repeal and replace Obamacare and the Federal Reserve Board s (Fed) interest rate hike of 25 basis points (bps) putting the Fed Fund s target range at %. The Fed hike had little impact on the markets as it was widely telegraphed by the Fed. The failure of the House Republicans to pass the American Health Care Act, which would have repealed Obamacare, was viewed as an indication that the Trump Administration may have difficulty passing its agenda. As a result, the fixed income markets backed off inflation expectations leading to declining yields, which have continued through the month of April. Further attempts will be made to repeal Obamacare, but it appears to be a high hurdle. For now, the Trump Administration is moving on to tax reform, which we will be closely following. Municipal/ETF fund flows with yield 10-yr AAA yield (%) Municipal net flows ($B) Municipal net flows 10-yr AAA yield Jan 14 Feb 14 Mar 14 Apr 14 May 14 Jun 14 Jul 14 Aug 14 Sep 14 Oct 14 Nov 14 Dec 14 Jan 15 Feb 15 Mar 15 Apr 15 May 15 Jun 15 Jul 15 Aug 15 Sep 15 Oct 15 Nov 15 Dec 15 Jan 16 Feb 16 Mar 16 Apr 16 May 16 Jun 16 Jul 16 Aug 16 Sep 16 Oct 16 Nov 16 Dec 16 Jan 17 Feb 17 Mar 17 Sources: TM3 and ICI Sector performance Sector performance was unremarkable for the past month. However, over the quarter, lower-quality bonds easily outperformed high-grade bonds. The Bloomberg Barclays Muni BBB Index returned 2.18% and the High Yield Muni Index returned 4.06% over the quarter. The best performing sub-sector was the HY Tobacco index, which returned 13.12%. We did not see any significant change in hospital spreads from the failed GOP challenge to Obamacare. Supply and demand The market saw another light month of municipal issuance: about $30 billion. This is down 30% from last year and 19% from the 10-year average. For the quarter, issuance totaled $88 billion, down 12% from last year s first quarter. Last year was a record high year of issuance for the municipal market. Low supply continues to support municipal bond prices. Flows into municipal bond funds and ETFs surprised us to the upside over the past month; March saw about $1.4 billion flow into municipal funds and ETFs. Year-to-date we are at a solid $8 billion of net inflows. Last year was a record high year of issuance for the municipal market. Yield curve The municipal curve was virtually unchanged over the past month a bit lower on the short end and higher out long. Over the first quarter, municipal yields were about 10 to 25 bps lower on the 1- to 10-year portion of the curve due to strong retail demand. The best returns over the quarter were on the 5- to 7-year spots of the curve. The Bloomberg Barclays Five and Seven Year Indices returned 1.90% and 1.95%, respectively. AAA municipal yield curve Yield (%) /30/16 12/31/16 03/31/ Years Source: Thomson Municipal Market Monitor 3

4 Strategy overview Duration Favoring slightly shorter duration and defensive positioning primarily due to potential turmoil surrounding President Trump s tax reform efforts. Also, fiscal policy stimulus and trade restrictions could increase inflation expectations. There may be better opportunities to buy munis over next several months than currently exists. We are expecting a vacillating market. A definitively more hawkish tone from the Fed of late. The Fed tightened for the third time in March since they began the cycle in December The latest hike puts the Fed Fund s target rate at %. The market is expecting two more hikes this year at a measured pace. This pace is much slower than historical moves. A typical tightening cycle in the past would be about 300 bps of tightening over a 12-month period. Municipal fund and ETF flows continue to surprise us on the upside. If there was not so much uncertainty on the policy side, we would be longer duration to take advantage of the solid demand. Curve Retaining barbell structure with municipal floating rate notes on the short-end of the curve and fixed coupon bonds on the longer end of the fund s investment horizon. We earn more incremental credit spread on the longer end but remain duration neutral. Since the Fed began tightening, the curve is flatter with short rates higher and long rates lower. We will continue to monitor inflation expectations for a reduction to our long-end exposure. Daily and weekly tax free floating rate notes remain at elevated yields, providing attractive yields to interest rate sensitive investors. The weekly municipal floating rate index (SIFMA rate) is at 0.89% versus 0.04% in April Tax-exempt money market and ultra short funds are at very attractive yield levels for risk-averse investors. Credit and structure Lower-quality bonds posted the best performance over the quarter. We continue to look for undervalued A and BBB rated bonds, which could outperform this year if we see sustained positive flows into municipal high yield funds. The higher yield (wider spread) of the lower quality bonds also helps performance. We continue to focus on bonds with 4 and 5 percent coupons due to their defensiveness. Sector We are less concerned about general underperformance of the hospital sector with the failure of the GOP to repeal and replace the Affordable Care Act. We will continue to look for undervalued securities in the healthcare sector. We are being more selective in the higher education sector. National demographic trends are working against this sector, with fewer high school graduates, particularly in the Northeast and Midwest. Also, strained state budgets are squeezing the funding to public higher education schools. Look for institutions with good demand due to name recognition or a niche, like a good engineering school. 4

5 Performance Fund performance as of March 31, 2017 Fund/Index Share class 1 Returns as of March 31, 2017 (%) Expense ratios (%) 2 Inception date Ticker 1-month YTD Q1 1-year 3-year 5-year 10-year Since inception Gross Net BMO Ultra Short Tax-Free Fund A NAV 05/27/14 BAUSX BMO Ultra Short Tax-Free Fund A OFFER BMO Ultra Short Tax-Free Fund Y 09/30/09 MUYSX BMO Ultra Short Tax-Free Fund I 09/30/09 MUISX Blended Benchmark BMO Short Tax-Free Fund A NAV 05/27/14 BASFX BMO Short Tax-Free Fund A OFFER BMO Short Tax-Free Fund Y 11/29/12 MTFYX BMO Short Tax-Free Fund I 11/29/12 MTFIX Barclays Short (1-5 Year) Municipal Index BMO Intermediate Tax-Free Fund A NAV 05/27/14 BITAX BMO Intermediate Tax-Free Fund A OFFER BMO Intermediate Tax-Free Fund 5 Y 02/01/94 MITFX BMO Intermediate Tax-Free Fund I 12/27/10 MIITX Barclays U.S Year Blend Municipal Bond Index Returns as of March 31, 2017 (%) Other benchmarks as of March 31, month YTD Q1 1-year 3-year 5-year 10-year Bloomberg Barclays U.S Year Blend Municipal Bond Index Bloomberg Barclays U.S. Municipal Bond Index Source: Bloomberg Barclays and BMO Global Asset Management Performance data quoted represents past performance and past performance is not a guarantee of future results. Investment returns and principal value will fluctuate so that an investor s shares, when redeemed, may be worth more or less than their original cost. Mutual fund performance changes over time and current performance may be lower or higher than what is stated. To receive the most recent month-end performance, call Returns quoted are pre-tax. Investor should consider his or her current and anticipated investment horizon and income tax bracket when making an investment decision as the illustration above does not reflect these factors. For more information about performance, please contact your investment professional. Total returns for periods of less than one year are cumulative. 1 Performance data quoted prior to the inception of the Class A Shares for the fund listed below is the performance of the Fund s Investor Class (Class Y), not adjusted for any difference in their expenses of the classes. 2 Expenses for Class A shares are based on estimated amounts for the current fiscal year. Net expense ratios reflect contractual fee waivers and/or expense reimbursements if applicable, made by BMO Asset Management Corp., the investment adviser (Adviser). The Adviser may not terminate these fee waivers and/or expense reimbursements prior to December 31, 2017 without the consent of the Board of Directors, unless the investment advisory agreement is terminated. Without these contractual waivers, the Fund s returns would have been lower. 3 Offering Price (MOP) returns for the BMO Ultra Short Tax-Free Fund and the BMO Short Tax-Free Fund include the maximum sales charge of 2.00%. Offering Price (MOP) returns for the BMO Intermediate Tax-Free Fund include the maximum sales charge of 3.75%. Net Asset Value (NAV) returns exclude this charge, which would have reduced returns. 4 The Blended Benchmark: 50% Bloomberg Barclays 1-Year Municipal Bond Index and 50% imoneynet Money Fund Tax Free National Retail Index. 5 Performance data quoted prior to Inception of Class I of the Fund is the performance of the Fund s Investor Class (Class Y), not adjusted for any differences in the expenses of the classes. 5

6 Market data for the journey Valuation data as of March 31, 2017 AAA yields (%) Change Year Current 1-month 3-month 1-year Source: InvestorTools Perform Cross-market values (%) 1 Current (1-year averages) Year Muni/treasury Muni/corporate 2 81 (90) 70 (71) 5 81 (83) 74 (73) (94) 83 (79) (98) 86 (81) Sources: InvestorTools Perform and Bloomberg Yield curve data as of March 31, 2017 Slope changes (%) Change Current 1-month 3-month 1-year Wkly - 2s s s s Source: InvestorTools Perform Performance by maturity (%) Year 1-month 3-month 1-year Source: Barclays Point Credit data as of March 31, 2017 Current rating spreads (%) 2 Current (1-year averages) Year AAA A AAA BBB (0.18) 0.46 (0.45) (0.37) 0.70 (0.68) (0.54) 0.90 (0.86) (0.56) 0.88 (0.85) Source: InvestorTools Perform Performance by quality (%) Rating 1-month 3-month 1-year AAA AA A BBB Source: Barclays Point BMO Funds Tax-Free Suite Ticker Fund name Class A Class Y Class I Premier Class BMO Tax-Free Money Market Fund MTFXX MFIXX BMO Ultra Short Tax-Free Fund BAUSX MUYSX MUISX BMO Short Tax-Free Fund BASFX MTFYX MTFIX BMO Intermediate Tax-Free Fund BITAX MITFX MIITX 1 Cross-market values represent the ratio of tax-free municipal yields to taxable Treasury yields. The percentage in the parentheses represents that average of this ratio over the prior twelve months. 2 The current rating spread is the difference between the benchmark AAA municipal yield curve and the associated rating benchmark (either A or BBB) for the appropriate maturity time frame. The percentage in the parentheses represents the spread over the prior twelve months. 6

7 All investments involve risk, including the possible loss of principal. You should consider the Fund s investment objectives, risks, charges, and expenses carefully before investing. For a prospectus and/or summary prospectus, which contain this and other information about the BMO Funds, call Please read it carefully before investing. BMO Asset Management Corp. is the investment adviser to the BMO Funds. BMO Investment Distributors, LLC is the distributor of the BMO Funds. Member FINRA/SIPC Keep in mind that as interest rates rise, prices for bonds with fixed interest rates may fall. This may have an adverse effect on a Fund s portfolio. Interest income from Tax-Free Fund investments may be subject to the federal alternative minimum tax (AMT) for individuals and corporations, and state and local taxes. Credit risk is the possibility that an issuer will default on a security by failing to pay interest or principal when due. Lower credit ratings correspond to higher credit risk. Municipal bonds are subject to risks including economic and regulatory developments in the federal and state tax structure, deregulation, court rulings, and other factors. An investment in money market funds is neither insured nor guaranteed by the Federal Deposit Insurance Corporation. You could lose money by investing in the Fund. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. The Fund does not intend to impose a fee upon sale of your shares or temporarily suspend your ability to sell shares if the Fund s liquidity falls below required minimums because of market conditions or other factors, but reserves the right to change this policy, subject to providing advance notice of any such change. An investment in the Fund is not a deposit of BMO Harris Bank N.A., or any of its affiliates, and is not insured or guaranteed by the FDIC or any other government agency. The Adviser has no legal obligation to provide financial support to the Fund, and you should not expect that the Adviser will provide financial support to the Fund at any time. Bloomberg Barclays 1-10 Year Blend Municipal Bond Index is an unmanaged index of municipal bonds rated BBB or better with 1 to 12 years to maturity. Bloomberg Barclays U.S. Municipal Bond Index is an unmanaged index of a broad range of investment-grade municipal bonds that measures the performance of the general municipal bond market. Blended Benchmark consists of 50% Bloomberg Barclays 1 Year Municipal Bond Index and 50% imoneynet Money Fund Tax Free National Retail Index. Money Fund Report Averages is an arithmetic average of performance for all money market mutual funds tracked within this category. Money Fund Report Averages is a service of imoneynet, Inc. (formerly IBC Financial Data). The Bloomberg Barclays 1-Yr Municipal Bond Index is the 1-year component of the Bloomberg Barclays Municipal Bond Index, which is an unmanaged index composed of long-term tax-exempt bonds with a minimum credit rating of Baa. Bloomberg Barclays Short (1-5 Year) Municipal Index includes investment-grade tax-exempt bonds that are issued by state and local governments and have maturities of 1 to 5 years. Bloomberg Barclays U.S Year Blend Municipal Bond Index is the 1-15 year Blend component of the Bloomberg Barclays Municipal Bond Index, which is an unmanaged index composed of long-term tax-exempt bonds with a minimum credit rating of Baa and a range of maturities between 1 and 17 years. Investments cannot be made in an index. This is not intended to serve as a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. Information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. This publication is prepared for general information only. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investment involves risk. Market conditions and trends will fluctuate. The value of an investment as well as income associated with investments may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. 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