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The municipal bond market experienced heightened volatility throughout the third quarter, driven by substantial outflows from mutual fund investors. Fund outflows were concentrated mostly on the longer end of the yield curve; however, municipal bond yields increased across all maturities.
Municipal bond yields rose to attractive levels relative to other fixed-income alternatives, and, as a result, crossover buyers, such as hedge funds, increased demand. Individual investors also took advantage of elevated yields and focused their bond purchases predominately in the short- and intermediate-term ranges. Due to increased interest rates, supply continues to lag last year's pace as issuers no longer have the same economic incentive to refund bonds. In addition, issuers are now faced with decisions to delay new issuances until interest rates stabilize and the pace of fund outflows recedes.
Higher-rated bonds outperformed lower-rated bonds due to the concentration of fund outflows in lower-rated securities. Furthermore, uncertainty surrounding the U.S. Federal Reserve's (the "Fed") plan to begin "tapering" its asset-purchase program, along with negative headlines relating to a few high-profile credits, led to increased risk aversion. Investors' concerns of rising interest rates and Fed tapering caused shorter-maturity bonds to outperform longer-maturity bonds.
The Fund returned -0.16%, reflecting performance at the net asset value (NAV) of Class A shares, with all distributions reinvested, for the three-month period ended September 30, 2013. The Barclays 1-15 Year Municipal Bond Index,1 returned 0.57% in the same period. The Fund's average annual total returns, which reflect performance at the maximum 2.25% sales charge applicable to Class A share investments and include the reinvestment of all distributions, as of September 30, 2013, are: one year: -4.17 %; five years: 5.25%; and 10 years:3.76%. Expense ratio, gross: 0.70%, and net: 0.69%.
Performance data quoted represent past performance, which does not guarantee future results. Current performance may be higher or lower than the performance data quoted. The investment return and principal value of an investment in the fund will fluctuate so that shares, on any given day or when redeemed, may be worth more or less than their original cost. To obtain performance data current to the most recent month-end, call Lord Abbett at 1-888-522-2388 or visit us at www.lordabbett.com.
Within the Fund, bonds with maturities longer than nine years performed the worst, as rising interest rates negatively affected longer-maturity bonds. The Fund's exposure to bonds with maturities shorter than nine years performed the best, as investors sought to avoid risk. The municipal yield curve steepened as investors became concerned that the Fed will eventually slow its pace of asset purchases of Treasury and mortgage-backed securities even though it refrained from doing so for now at the September Federal Open Market Committee Meeting.
Detracting the most from relative Fund performance was an overweight to bonds rated 'BBB' and lower, as demand remained strong for higher-quality securities relative to lower-quality securities.
At the sector level, water and sewer and tobacco bonds underperformed within the Fund. Water and sewer bonds were negatively affected by heavy selling of some larger credits within the sector. Tobacco bonds underperformed not due to any credit concerns but rather due to heavy selling, as the sector contains many large and liquid issues.
On the state level within the Fund, Puerto Rico bonds underperformed as the Commonwealth faced significant headline risk regarding its fiscal and debt-market challenges. California and Florida bonds performed well; however, performance was primarily driven by underlying sector composition within the states rather than by any idiosyncratic issues with the states themselves.
Please refer to www.lordabbett.com under the "Portfolio" tab for a complete list of holdings of the Fund, including the securities discussed above.
Municipal bond fund outflows decreased during the final weeks of the third quarter, but remain at elevated levels. The receding pace of fund outflows was an encouraging sign; however, demand remains muted. Supply continues to come to the market at a slower pace than last year due to higher interest rates. We anticipate that supply, both new money issuance and refunding activity, will continue at a slower pace over the final quarter of the year than occurred in 2012.
The municipal bond yield curve steepened during the quarter as municipal bonds underperformed Treasuries in longer maturities, while outperforming in shorter maturities. As interest rates stabilize and fund outflows recede, we anticipate that ratios of municipal bond yields to Treasury yields will converge. However, the continued headline risks of a few high-profile credits will most likely restrain these ratios from moving back to pre-2008 levels.
Higher-rated bonds outperformed lower-rated bonds during the third quarter due to the concentration of fund outflows in lower-rated securities. Demand started to return during the final weeks of the quarter, and, consequently, lower-rated bonds began to outperform. Furthermore, shorter maturities outperformed longer maturities primarily driven by concerns of Fed tapering. The direction of interest rates appears to depend on consensus projections of the Fed's activities as market participants try to project future Fed actions. Because tapering was delayed during the third quarter, interest rates are not expected to rise until economic numbers strengthen. We anticipate that investor demand, headline risk, and relative value will be the key determining factors moving into the fourth quarter.
A concern many municipal bond investors share is the proposal limiting the tax exemption of municipal bonds to 28% for high-income earners. We believe there is an even chance the proposal will be approved. The insistence of the Obama administration on including the cap in its 2014 fiscal year budget will prompt continued debate among legislators and market participants over this issue.
The fiscal health of the states, with the notable exceptions of Illinois and the Commonwealth of Puerto Rico, which are under pressure due to headline risk and their apparent inability to improve their financial situations, has benefited from increasing revenues and balanced budget agreements. This has led to improved credit quality accompanying the continuing, albeit modest, expansion of the overall economy. The underfunding of pensions has garnered increased attention even as most states have taken steps to improve their financial standing. We anticipate this issue will continue to create more headline risk than actual credit risk.
Performance data quoted is historical. Past performance is not indicative of future results. Current performance may be higher or lower than the performance quoted. The investment return and principal value of an investment in the Fund will fluctuate so that shares, on any given day or when redeemed, may be worth more or less than their original cost. To obtain performance data current to the most recent quarter-end, go to quarter ending performance on our Website or call Lord Abbett at (888) 522-2388.
1 The Fund’s dividend yield is shown without sales charges (at NAV) and with maximum sales charges (at MOP). The Fund’s dividend yield takes into account any fee waiver or expense limitation arrangements, if any. Without such fee waivers or expense limitation arrangements, the Fund’s dividend yield would have been lower. Information regarding any fee waivers or expense limitation arrangements applicable to the Fund is provided with the Fund’s expense ratio information.
2 The Fund’s unsubsidized dividend yield is shown without sales charges (at NAV) and with maximum sales charges (at MOP). The Fund’s unsubsidized dividend yield reflects what the yield would have been without the effect of fee waivers or expense limitation arrangements.