Market Review as of 03/31/2016

Although major sectors of U.S. fixed income securities posted positive returns in the first quarter of 2016, the period saw a sharp increase in volatility. Securities markets in January continued their sell-off from the end of 2015, as investors continued to grapple with a strengthening U.S. dollar, a slowdown in Chinese economic growth, and a renewed slump in commodity prices. However, early February marked a reversal in U.S. dollar strength and commodity prices began a sharp rebound. A dovish tone coming from the U.S. Federal Reserve (Fed), combined with the European Central Bank’s unexpected interest rate cut in March, further eased investor concerns, sparking a significant rally for risk assets through the second half of the quarter. Speculation still remains, however, regarding the future pace of interest rate hikes and the quality and persistence of the recent rally. 

Following its policy meeting on March 15–16, the Fed released a statement suggesting that U.S. economic growth has continued to expand at a moderate pace, noting that the labor market continues to improve, though business investment and net exports have been soft. The Fed again noted that inflation continues to run below policymakers’ longer-run objective of 2%. During the March meeting, the Fed decided to maintain the targeted fed funds rate in the range of 0.25–0.50%, and declared: “The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2% inflation.”1 Fed policymakers’ median projected estimate for the fed funds remains at 1.4% for the end of 2016.2

U.S. Treasuries (as represented by the BofA Merrill Lynch U.S. Treasury Index3) posted a return of 3.35% for the three-month period ended March 31, 2016.  The high yield bond market (as represented by the BofA Merrill Lynch U.S. High Yield Constrained Index4) posted a positive return of 3.25% for the quarter after beginning 2016 down over 5% through early February. The floating rate loan market (as represented by the Credit Suisse Leveraged Loan Index5) returned 1.33%, which trailed the returns of the high yield bond market, although with less volatility for the period.  The convertible bond market (as represented by the BofA Merrill Lynch All Convertibles, All Qualities Index6) returned ‑1.56%, lagging other fixed income assets due to the underperformance of the underlying equities.

Among higher credit quality securities, investment grade corporate debt (as represented by the Barclays U.S. Corporate Bond Index7) posted a return of 3.97%. Agency mortgage-backed securities (as represented by the Barclays MBS Index8) returned 1.98%. Commercial MBS (CMBS) (as represented by the Barclays U.S. CMBS Investment Grade Index9) returned 3.56%.

The municipal bond market (as represented by the BofA Merrill Lynch U.S. Municipal Securities Index10), posted a 1.64% return. Given the favorable tax treatment of many municipal bonds, the after-tax returns were comparable with other fixed income asset classes during the period, although municipals exhibited much less volatility. Overall creditworthiness in the municipal bond market continues to improve, as most states’ finances experienced rising revenues, while maintaining balanced budgets.

Within emerging markets, the major drivers of strong performance included a dovish Fed, weaker U.S. dollar, and a strong rally in commodity prices. Thus, U.S. dollar-denominated emerging markets corporate debt (as measured by the JP Morgan Corporate Emerging Markets Bond Index Broad Diversified Index11) returned 3.89%, outperforming most U.S.-centric, fixed-income asset classes.                                                        

U.S. inflation continued to struggle to reach the Fed’s 2% inflation target, as overall Consumer Price Index (CPI)12 increased just 1.0% over the 12-month period ended February 2016. The CPI (excluding food and energy prices), however, increased 2.3% over the same 12-month period.13 Increases in prices in February were offset due to a decline in the energy index. The CPI for all items (excluding food and energy) increased 0.3 % in February, the same increase as in January.

The U.S. labor market continued to strengthen in the fourth quarter of 2015, albeit at a slower pace. The U.S. Bureau of Labor Statistics reported that non-farm payrolls increased by 215,000 in March, above the trailing three-month average monthly gain of 209,000, while the unemployment rate held steady 5.0%.14

According to J.P. Morgan Securities, high yield new issue volume reached a 10-month high in March, totaling $28.2 billion in March alone. High yield issuance totaled $51.2 billion for first quarter 2016, which was a 46% decrease from the year-ago quarter, but a 21% improvement from fourth quarter 2015. Institutional loan issuance, however, decreased 41% in first quarter 2016 from fourth quarter 2015, posting a modest $35.2 billion in new issuance. Default activity notably increased over the period, with the majority of defaults expectedly coming from the energy and metals and mining sectors. During the first quarter of 2016, $24.1 billion par value of high yield bonds and $7.2 billion of par value loans defaulted for a total of $31.4 billion of defaults.  This compares to a trailing five-year quarterly average of $8.5 billion of par value defaults, according to J.P. Morgan Securities.

Fund Review as of 03/31/2016

The Fund returned -1.46%, reflecting performance at the net asset value (NAV) of Class A shares, with all distributions reinvested, for the quarter ended March 31, 2016. The Fund’s benchmark, the BofA Merrill Lynch All Convertibles, All Qualities Index,6 returned -1.56% in the same period. 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 March 31, 2016, are: one year: -13.58%; five years: 2.87%; and 10 years: 3.69%. Expense ratio, gross: 1.12%, and net: 1.06%.   

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.

Following a difficult start to the quarter for equity and fixed income asset performance, markets rebounded sharply through the second half of the quarter. Asset prices rallied as investors saw signs of economic stability in China, the Fed continued their dovish tone, and the European Central Bank surprised investors by further cutting interest rates. Against this background, we were able to tactically take advantage of the volatility to outperform the benchmark.

Security selection within the energy sector was a tailwind to relative performance. In particular, the portfolio’s allocation to Hess Corp., a global integrated oil company, contributed to performance during the period.  In addition to appreciating with the commodity rally in the second half of the quarter, Hess Corp. convertible and debt securities further benefitted from balance sheet improvements which signaled management’s commitment to maintaining Hess’s investment grade rating.

Security selection within the information technology sector was a drag on performance. Specifically, the portfolio’s overweight allocation to Proofpoint Inc., a global cybersecurity firm, detracted from relative performance. Although the company reported earnings for the fourth quarter of 2015 that exceeded investor expectations, the sell-off in January was led by growth companies with relatively high valuations as investors preferred less aggressive, value-oriented securities.  

Please refer to www.lordabbett.com under the “Portfolio” tab for a complete list of holdings of the Fund, including the securities discussed above.

Outlook

Investors will continue to closely monitor key economic data, with a particular focus on inflation, for an indication that the Fed might have sufficient justification to accelerate its interest rate-tightening cycle. Similarly, investors will be looking for reassurance that if U.S. growth stagnates, the Fed will slow its progression in order to support the economy. Finally, although fears have abated about China’s economic slowdown, and a consequent “hard landing,” the economic situation there remains an area of concern, as the country has the ability to disrupt global markets, including U.S.-centric fixed-income and equity markets.

As equities slumped in the first half of the quarter, the portfolio’s delta was materially lower than the benchmark’s delta, reflective of the defensive positioning of the portfolio. Beginning in late February, we started increasing the portfolio’s delta to take advantage of rallying equity prices and we currently maintain a delta above the benchmark’s delta as we believe that the strengthening employment environment and dovish Fed will remain a tailwind for asset prices. 

Domestic convertible issuance was particularly weak to begin 2016, likely due to the increased volatility in the equity markets. We believe that the combination of a dovish Fed and recovering equity valuations could spark a resurgence in convertible issuance with favorable terms for investors. M&A financed with convertible debt has abated from its elevated pace in 2015, although we continue to believe that M&A could be a viable option for acquirers with access to capital and looking to expand their market share. 

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