Insights. Municipal. in this issue. Investment Perspectives. August The BMO tax-free income team

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1 Investment Perspectives August 2014 Municipal Insights The BMO tax-free income team Portfolio managers John D. Boritzke, CFA Joseph J. Czechowicz Craig J. Mauermann Duane A. McAllister, CFA Erik R. Schleicher Credit analysts A.G. Anglum Michael E. Janik, CFA Catherine M. Krawitz, CFA Andrew W. Tillman in this issue 2 } Market commentary We are on the road back to normal, which includes sustainable and sufficient growth and yields less influenced by extraordinary Fed policy Normal also has historically meant more market volatility and a flatter yield curve - potentially significantly flatter from current levels The Great Rotation from bonds to stocks has not occurred and the demographic demand for income will likely limit the upside for yields 4 } Credit updates The trial to review Detroit s Plan of Adjustment to exit bankruptcy begins in August The Illinois Supreme Court ruled that other post-employment benefits enjoy the same constitutional protection as pensions, which complicated their reform efforts Nearly all of Puerto Rico s debt is now rated below investment grade following the passage of the Recovery Act. Legal battle lines are now drawn with strong forces and arguments on both sides 5 } Strategy and performance Maintain a moderately short duration posture with a bias toward a flatter yield curve Maintain a credit overweight, but focus A and BBB rated issues short on the curve Seek optionality (i.e., call risk) to enhance portfolio yield 6 } Data for the journey bmofundsus.com/taxfree

2 Market commentary The road back to normal There have been many terms used to describe the macro-economic environment of the last several years. Relative to past economic cycles perhaps the most appropriate description is simply not normal. It is not normal, for example, for the economy to contract by 2.1% in the middle of an expansion, as it did in the first quarter of this year. Nor is it normal for the Federal Reserve (Fed) to lower the fed funds rate to zero and hold it there for more than five and one-half years while embarking on three separate quantitative easing (QE) programs, the most recent of which involved the purchase of essentially all of the net new supply of Treasury debt. We could go on with the many abnormal aspects of recent economic and financial conditions, but the good news is that the environment is improving, normalizing. Normal is a place where the fed funds rate is above zero and Treasury yields are set primarily by market forces, rather than by extraordinary central bank policy. Of course, normal is an illusory place that only exists in the context of current data and conditions resembling historical averages. We would define normal as a place where economic growth is sustainable and sufficient, allowing for both employment and wage growth. Normal is a place where the fed funds rate is above zero and Treasury yields are set primarily by market forces, rather than by extraordinary central bank policy. Although the road to normal has already been a long journey, we may find in coming months that we are further along than many currently believe. The most recent above-consensus 4.0% second quarter gross domestic product (GDP) print thankfully helped more than offset the first quarter contraction, and six months of 200,000+ employment gains (sixmonth average is 244,000) suggests sustainable and sufficient may already be here. What s lacking still are the wage gains, but as the labor market tightens, hopefully this too will soon follow. The Fed s gradual reduction in QE purchases, now scheduled to end in October, continues the transition away from their direct influence on Treasury yields. The debate is now increasingly focused on the timing of the first and subsequent rate hikes. A quiet month still no rotation At times last month, it felt as if the market had pulled over at a rest stop along the road to normal, as yields neither rose nor fell much at any point along the curve. Ten-year AAA yields were unchanged while both shorter and longer yields rose just two to three basis points (bps). Not surprisingly, little change in yield and curve slope was the result of a relatively quiet month in trading activity as well. New long-term supply slipped more than 30% from June s levels and year-to-date supply remains 15% below year-ago levels. The lighter new supply this year has been felt most acutely by investors in so-called specialty states, those with strong retail demand seeking to capture both in-state as well as federal tax exemption. For our national tax-free strategies, the light supply has also provided modest challenges, primarily because more money is chasing fewer market opportunities. Tax-free funds have benefited from total inflows of $10.2 billion through July with positive flows in 24 of the 30 weeks this year. Demand for tax-exempt income remained robust last month as reinvestment needs from July coupon payments and maturing debt continued to exceed supply, and we foresee similar challenges in August. Fund flows have been consistently positive for bond funds in general this year, with tax-free funds getting their share of the flow. According to EPFR Global, bond fund flows have been positive for 15 consecutive weeks and in 29 of the past 30 weeks. Tax-free funds have benefited from total inflows of $10.2 billion through July with positive flows in 24 of the 30 weeks this year. Conversely, equity fund flows have been negative for three consecutive weeks, and 2

3 domestic equity funds in particular have had outflows for 14 consecutive weeks. Our goal is not to pick on stock funds, but to recall that the Great Rotation some had predicted, out of bonds and into stocks, has simply not occurred despite strong equity market returns. Demographics are clearly playing a role in the continued demand (and need) for income. Ironically, the lower yields fall, the more assets need to be invested in fixed income (or other income-producing) assets in order to achieve a target level of income. Market volatility, rather than tranquility, is typical and should be expected to increase as we normalize the yield curve. Undoubtedly fixed income investors will likely react as they have historically when rates begin to rise. Some will want to be shorter and others to be out of bonds altogether. At least partially offsetting this tendency will be the many investors who have been waiting a long time for the opportunity to buy bonds and/or bond funds at higher yield levels. Although our outlook is for a transition to normalcy, including more volatility and higher rates, this structural demand component will likely be a limiting factor in how high yields may ultimately rise. To flatten is normal Although we willingly accept the challenge, fixed income portfolio managers are expected to understand the past, assess the current and position portfolios for the future. Not always so simple! Fortunately, we have been positioned for a flatter yield curve for some time, which has worked well this year. At the end of 2013, the spread between two- and 10-year AAA tax-exempt yields was +244 bps. Now that spread has narrowed to +195 bps, thanks to 49 bps of flattening over the last seven months. There is a high probability that Fixed income portfolio managers are expected to understand the past, assess the current and position portfolios for the future. the curve will continue to flatten on the road back to normal even as a gradual Fed tightening cycle begins to unfold next year. A look back suggests that segment of the curve remains steeper than normal as the twoto 10-year spread over the last three years is +180 bps, 15 bps narrower than current levels. But a longer term view provides even more insight into the likelihood of further curve flattening. Historical perspective illustrates how much further potential flattening could occur as monetary policy normalizes. The last Fed tightening cycle ran from June 2004 through June of 2006, as the fed funds rate rose from 1.0% to 5.25%. In hindsight, the Fed was way too aggressive in that cycle. Nonetheless, the slope of the two- to 10-year portion of the tax-exempt curve over the two-year period from June 2006 through June 2008, the beginning of the financial crisis, was just 55 bps. Although we don t expect the tax-exempt curve to flatten to that extent anytime soon, historical perspective illustrates how much further potential flattening could occur as monetary policy normalizes. We are already well positioned for this possibility through a barbelled curve posture: overweight very short-term maturities, including floating rate securities, and intermediate to longer term issues while underweight the two- to five-year maturity segment. We also expect that most of the flattening will come through a rise in short-term rates rather than a decline in intermediate and long-term yields, which has largely run its course. Instead, we anticipate a bear-flattening trend will remain our base case forecast, where all rates rise, but short rates rise more than long rates. 3

4 Credit updates From the Midwest to Puerto Rico It s getting hot out there! In contrast to the relative calm in yields last month, credit news in the municipal market was robust. Detroit continued to move toward the beginning of its confirmation hearings, scheduled to start in August, in which it will seek approval of its Plan of Adjustment (POA) to exit bankruptcy, perhaps as early as this fall. Although the Detroit bankruptcy continues to be on a very aggressive time schedule, the City has reached tentative agreement with most creditors, but significant challenges remain. In particular, those holding the outstanding pension debt (and the insurers of that debt) as well as water and sewer bondholders (from which the City is seeking the ability to adjust coupon rates and call features on some of the debt) have yet to reach agreement with the City. In other news, the Illinois Supreme Court ruled last month that retiree healthcare benefits enjoy the same constitutional protection as pensions, striking a blow to the recent efforts toward pension reform. Conventional thinking among many market participants, as well as the rating agencies, has been that adjustments in other postemployment benefits (OPEB) would be allowable. Some states, such as New York, have ruled that OPEB benefits are not protected by state law, while Hawaii and Alabama courts have sided with the Illinois court. In response to the Illinois court ruling, S&P revised the state s credit outlook, from stable to negative, and credit spreads on the State of Illinois debt widened relative to AAA rated debt. The Illinois Supreme Court ruled last month that retiree healthcare benefits enjoy the same constitutional protection as pensions. But the lead credit story in recent weeks has been Puerto Rico. After the passage of the Puerto Rico Corporations Debt Enforcement and Recovery Act (Recovery Act) on June 28, allowing certain public corporations on the island that are in financial distress to restructure their debt, the rating agencies and investors reacted quickly. Moody s moved first, followed by Fitch, by taking the debt of all Puerto Rican entities, including those specifically excluded from restructuring by the Recovery Act, to below investment grade. The general obligation (GO) debt was lowered to B2 and BB- by Moody s and Fitch, respectively, both maintaining a negative ratings outlook. Each agency also lowered the sales tax debt (COFINA) below investment grade as well: Moody s to Ba3 and B1 for the senior and subordinate, respectively, and Fitch to BB- for both the senior and sub debt. Only S&P maintains an investment grade rating on any of the public debt of the Commonwealth now. Although they dropped the GO debt to BB, they kept the senior COFINAs at BBB and the subordinate lien at BBB-. Concurrently, yields on all of the Puerto Rico debt spiked as many investors elected to sell, and trading activity was very high through much of July. Despite Puerto Rican officials argument that the law s passage does not signal a near-term expectation to restructure any outstanding debt, the consensus market opinion is that the Puerto Rico Electric Power Authority (PREPA) would be the most likely first candidate. Some of the PREPA uninsured debt traded down to the high-$30s price range, while other agency, GO and even COFINA debt traded down into the $60s price range. Investors are now skeptical of the island s ability to service its debt, as well as their willingness. By the end of the month, however, prices had recovered up to one-half of the losses from pre-recovery-act pricing, but still very much at distressed levels. Increasingly, the holders of Puerto Rico debt are now hedge funds rather than traditional mutual funds and retail investors, both of which had been the primary investor base for the island debt for decades. The legal battle lines are becoming clearer as groups align to argue both for and against the constitutionality of the Recovery Act. A consortium of 18 hedge fund firms has formed, which combined have in excess of $240 billion in assets under management, approximately $4.2 billion of which is Puerto Rico debt. They are aligned with Puerto Rico officials and will argue that the Recovery Debt is legal. Clearly, they hold mostly GO and COFINA debt, which would benefit by allowing the public corporations to be restructured in an orderly manner. Importantly, having this group in Puerto Rico s corner may offer secondary benefits if they also choose to provide the Commonwealth with additional capital, which they will surely need in the future. On the other side of the legal battle are mutual fund firms with relatively large exposure to PR debt, who will argue that the Recovery Act is unconstitutional and must be revoked. One group that is certain to benefit over the next several months, if not years, are the lawyers, who will get paid regardless of whether bondholders do or not. Good work if you can get it. 4

5 Strategy and performance Strategy The summer seasonal period typically benefits from a demand/ supply imbalance as reinvestment needs exceed new supply. This favorable technical position should moderate in the fall when supply improves and upward pressure on rates may resume. A moderately short duration posture is prudent, as is a barbell curve structure. Both portfolio decisions should benefit as the market begins to anticipate the first hike in the fed funds rate. We prefer to accept structural risk over credit risk, given the relatively narrow credit spreads presently in place, but want to maintain a credit overweight to help offset price declines when rates rise. Lower quality issues should be kept short on the yield curve, while AA should be the focus out longer. Revenue-backed bonds will likely continue to outperform GOs, and we particularly like sectors such as hospitals, transportation and housing. Strategy overview Duration: Moderately Short Curve: Position for further curve flattening with short rates rising more than long-term rates. The benefit of rolling along the curve, while still meaningful, will diminish over time Credit: A credit overweight will outperform when rates rise, but keep A and BBB exposure short, with longer exposure focus on AA credits Sector: Remain overweight in revenue-backed issues, particularly hospitals, transportation and housing Structure: Accept more optionality (i.e. call risk) to enhance yield Fund performance as of July 31, 2014 As of July 31, 2014 (%) Returns as of July 31, 2014 (%) Expense ratios (%) 1 Fund / Index Share class Inception date Ticker 1-month YTD 1-year 3-year 5-year 10-year Since inc. 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 3 A NAV 05/27/14 BASFX BMO Short Tax-Free Fund 3 A OFFER BMO Short Tax-Free Fund 3 Y 11/29/12 MTFYX BMO Short Tax-Free Fund 3 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 4 Y 02/02/94 MITFX BMO Intermediate Tax-Free Fund I 12/27/10 MIITX Barclays U.S Year Blend Municipal Bond Index Other benchmarks as of July 31, 2014 As of July 31, 2014 (%) Returns as of July 31, 2014 (%) 1-month YTD 1-year 3-year 5-year 10-year Barclays U.S Year Blend Municipal Bond Index Barclays U.S. Municipal Bond Index Source: 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 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, 2015 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. 2 The Blended Benchmark: 50% Barclays 1-Year Municipal Bond Index and 50% imoneynet Money Fund Tax Free National Retail Index 3 The Gross Expense Ratios for this Fund are based on estimated expenses for the current fiscal year because it is a new Fund. 4 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 Data for the journey Valuation data as of July 31, 2014 AAA yields (%) Change Year Current 1-month 3-month 1-year Cross-market values (%) Current (1-year averages) Year Muni/Treasury Muni/Corporate 2 58 (94) 54 (70) 5 70 (79) 73 (75) (93) 84 (85) (106) 90 (97) Yield curve data as of July 31, 2014 Source: InvestorTools Perform Source: InvestorTools Perform and Bloomberg Slope changes (%) Change Current 1-month 3-month 1-year Wkly - 2's 's 's 's Performance by duration (%) Year 1-month 3-month 1-year Credit data as of July 31, 2014 Source: InvestorTools Perform Source: Barclays Point Current rating spreads (%) Current (1-year averages) Year AAA A AAA BBB (0.17) 0.55 (0.67) (0.46) 0.96 (1.11) (0.72) 1.19 (1.39) (0.72) 1.11 (1.23) 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 Fund name Ticker (Class Y/Class I) BMO Tax-Free Money Market Fund MTFXX / MFIXX BMO Ultra Short Tax-Free Fund MUYSX / MUISX BMO Short Tax-Free Fund MTFYX / MTFIX BMO Intermediate Tax-Free Fund MITFX / MIITX 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. M&I Distributors LLC is the distributor. BMO Funds are not marketed or sold outside of the United States. 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. 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. 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% 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 Barclays Capital 1-Yr Municipal Bond Index is the 1-year component of the Barclays Capital Municipal Bond Index, which is an unmanaged index composed of long-term tax-exempt bonds with a minimum credit rating of Baa. 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. Barclays U.S Year Blend Municipal Bond Index is the 1-15 year Blend component of the Barclays Capital 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. BMO Global Asset Management is the brand name for various affiliated entities of BMO Financial Group that provide investment management, retirement and trust and custody services. Certain of the products and services offered under the brand name BMO Global Asset Management are designed specifically for various categories of investors in a number of different countries and regions and may not be available to all investors. Products and services are only offered to such investors in those countries and regions in accordance with applicable laws and regulations. BMO Financial Group is a service mark of Bank of Montreal (BMO). 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. For more information visit us at bmofunds.com. Investment products are: NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE BMO Financial Corp. 7/14