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Market View

Here is an approach that offers the potential for attractive current income and the potential opportunity for superior total return should interest rates begin climbing again.

The yield on the 10-year Treasury note has trended downward in recent months, likely reflecting continuing constraints on the supply of Treasury securities available in the market and a “flight to quality” move amid rising geopolitical tension. This pullback followed a sharp rise in interest rates that began in the summer of 2012 and accelerated in May 2013 following the Federal Reserve’s first indication that it might begin to reduce the amount of bond purchases under its quantitative easing (QE) program. The 10-year Treasury yield climbed more than 156 basis points (bps) over the 17 months through December 31, 2013. (All Treasury data are from Bloomberg.)

Many market observers expect that interest rates will resume their climb in the months to come. Why? Among other things, the Fed anticipates ending QE in October 2014. Meanwhile, the supply of Treasury securities coming to market could increase later this year, according to Zane Brown, Lord Abbett Partner and Fixed Income Strategist. Recent data suggesting stronger economic growth and a modest rise in inflation could also drive Treasury yields higher.

From this perspective, then, it appears that it is not a question of if but rather of when interest rates move higher. But how can investors who expect such an outcome position themselves in the interim? We believe there is an approach that offers investors the potential opportunity for attractive income now in the current interest-rate environment and the chance for total return outperformance later should rates resume their rise.

First, let’s focus on the “now.” Chart 1 shows the yields on various asset classes (as of July 31, 2014). Note that two credit-sensitive fixed-income categories, floating-rate loans and high-yield bonds, offered appreciably higher income for investors than higher credit-quality debt categories. Yields on equity-linked bonds and large cap stocks were comparable to those of higher-credit quality bonds, which may be somewhat surprising to many investors. [However, there is no guarantee that these securities will perform in a similar manner in the future.]

 

Chart 1. Yields on Credit-Sensitive Issues Have Outpaced Other Fixed-Income Categories in 2014
Yields on various fixed-income categories, as of 07/31/2014

Source: Barclays, Bloomberg, and BofA Merrill Lynch.
1Barclays U.S. Aggregate Bond Index.
2 Bloomberg Generic Inflation Indexed U.S. 10-Year Government Security Index.
3S&P 500 Index (Dividend Yield only).
4The Barclays U.S. Convertible Bond Index.
5Credit Suisse Leveraged Loan Index.
6BofA Merrill Lynch High Yield Master II Constrained Index.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future.
Past performance is no guarantee of future results. Please see below for information regarding the indexes referenced in these charts.

 

Next, we’ll look at what could come “later.” During episodes of rising interest rates, the fixed-income category as a whole tends to underperform, potentially causing investors to seek other asset classes. But not all underperformance is created equal: Our examination of rising interest-rate environments over the past two decades shows that the underperformance tended to be focused in more interest rate-sensitive, government-related securities. (See Table 1.) Other categories within the market, especially select types of corporate credit, historically have held up relatively well during such periods.

Over the previously cited 17-month period ended December 31, 2013, that featured a 156 basis-point rise in the 10-year Treasury yield, high-yield bonds returned 13.8%, and floating-rate loans returned 10.1%. Convertible securities posted a return of 33.9%, a fairly competitive showing versus the S&P 500® Index. (The last row of Table 1 shows the performance of various asset classes during this time period in greater detail.)

 

Table 1. Credit Historically Has Performed Well When Treasury Yields Rise
Index returns during periods of Treasury yield rising 100 basis points or more, 9/30/1993–12/31/2013

Source: Morningstar.
1 Citigroup 10-Year U.S. Treasury Index.
2 Barclays U.S. Aggregate Bond Index.
3 BofA Merrill Lynch 1-3 Year BBB-Rated Corporate Bond Index.
4 BofA Merrill Lynch High Yield Master II Constrained Index.
5 Credit Suisse Leveraged Loan Index.
6 BofA Merrill Lynch All Convertibles, All Qualities Index.
7 S&P 500 Index.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Floating-rate loans are lower-rated, higher-yielding instruments, which are subject to increased risk of default and can potentially result in loss of principal. Bond prices move inversely to interest rates: when interest rates rise, bond prices fall, and when rates fall, bond prices rise. With floating-rate loans, the opposite is true: loan prices tend to move in the same direction as interest rates; when short-term interest rates rise, loans pay higher income, and they pay less when rates fall. High-yield securities carry increased risks of price volatility, illiquidity, and the possibility of loss in the timely payment of interest and principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Convertible securities have both equity and fixed-income risk characteristics.
Past performance is no guarantee of future results. Please see below regarding index information.

 

In examining why these fixed-income categories have continued to perform strongly in rising-rate environments, our previous conclusions appear to still hold true: Periods of rising interest rates have been historically coincident with economic expansion, which tends to enable weaker companies, whose debt is often of lower quality, to remain financially sound. Also, Brown notes that, in many cases, the yield on securities with lower credit quality and shorter maturities had been higher than their duration, a scenario in which such issues could potentially provide income to more than offset a price decline that could occur with rising interest rates.

“In past rising-rate environments, fixed-income asset classes such as bank loans and high-yield securities have provided more attractive returns than their U.S. Treasury counterparts,” says Brown.

 

CONCERNED ABOUT RISING INTEREST RATES?
The Fund seeks to deliver a high level of current income by investing primarily in a variety of below investment grade loans.
LOOKING FOR CURRENT INCOME?
The Fund seeks to deliver current income and the opportunity for capital appreciation by investing primarily in high yield corporate bonds.

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