Market Review as of 12/31/2015

Major categories of U.S. fixed-income securities posted negative returns in the fourth quarter of 2015, as high-grade fixed income declined along with other higher-yielding categories. Market expectations ultimately were confirmed in December, as the U.S. Federal Reserve (the Fed) hiked interest-rates for the first time since 2006. The hike lifted the fed funds target range from 0–0.25% to 0.25–0.50%, however, speculation remains regarding the future pace of interest rate hikes and the effectiveness of existing Fed tools given the unprecedented quantitative easing cycle of the past several years.

Following its policy meeting on December 15–16, the Fed released a statement suggesting that U.S. economic growth has been expanding at a moderate pace, as household spending and business fixed investment continue to increase at solid rates. However, the Fed noted that exports have been soft and that inflation continues to run below the Federal Open Market Committee’s (FOMC) longer-run 2% objective. During the meeting, the Fed decided to raise the targeted fed funds rate by 0.25%, to a target range of 0.25–0.50%, and reiterated that it “expects economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate.”1 Fed policymakers’ median projected estimate for the fed funds stands at 1.4% for the end of 2016, indicating a 1% increase over the course of the year.2

Both government-related securities and credit-sensitive segments of the fixed-income market posted negative returns in the fourth quarter, as the market considered the impact of a less accommodative Fed on fixed-income assets. U.S. Treasuries (as represented by the BofA Merrill Lynch U.S. Treasury Index3) posted a return of -0.93% for the three-month period ended December 31, 2015.  The high-yield bond market (as represented by the BofA Merrill Lynch U.S. High Yield Constrained Index4) posted a return of -2.16% for the quarter. The floating-rate loan market (as represented by the Credit Suisse Leveraged Loan Index5) returned -1.96%, reflecting slightly stronger relative performance against the high-yield bond market. The convertible bond market (as represented by the BofA Merrill Lynch All Convertibles, All Qualities Index6) returned 0.85%, benefiting from an underlying rally in equities, in large part due to expectations for a growing U.S. economy and a general rotation out of fixed-income assets.

Among higher credit-quality securities, investment-grade corporate debt (as represented by the Barclays U.S. Corporate Bond Index7) posted a return of -0.58%. Agency mortgage-backed securities (as represented by the Barclays MBS Index8) returned -0.10%. Commercial MBS (CMBS) (as represented by the Barclays U.S. CMBS Investment Grade Index9) returned -1.32%.

Despite pockets of distress in high-profile issuers such as Illinois, Puerto Rico, and New Jersey, the municipal bond market (as represented by the BofA Merrill Lynch U.S. Municipal Securities Index10) outperformed most notable asset classes and returned 1.72%. 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 themes remained Chinese volatility and the impact of commodity weakness. However, accommodative central bank policies helped mitigate weakness in commodities and reduced new debt issuance provided technical support for the asset class. Thus, the emerging markets corporate debt asset class (as measured by the JP Morgan Corporate Emerging Markets Bond Index Broad Diversified Index11) returned 0.44%, outperforming most U.S.-centric fixed-income asset classes

U.S. inflation increases in October were largely offset due to a decline in the energy sector during the month of November. However, the Consumer Price Index (CPI)12 for all items, excluding food and energy, increased 0.2% in November, the same increase as in September and October. The overall CPI increased 0.5% over the 12-month period ended November 2015, and remains below the Fed’s target of 2.0%. The CPI, excluding volatile food and energy prices, however, increased slightly from the previous quarter, to 2.0%.13

The U.S. labor market continued to strengthen in the fourth quarter, albeit at a slower pace. The U.S. Bureau of Labor Statistics reported that non-farm payrolls increased by 211,000 in November, slightly below the average monthly gain of 237,000 over the prior 12 months, while the unemployment rate held steady 5.0%.14

High-yield new-issue volume trended lower in the fourth quarter, totaling only $42.3 billion, nearly a 30% decline from the previous quarter, with December’s $4.7 billion marking the lowest monthly total since December 2011. In 2015, high-yield issuance totaled $293 billion, down approximately 18% year-over-year. Institutional loan issuance experienced a second consecutive annual decline, totaling $326 billion, down 30% on a year-over-year basis. J.P. Morgan Securities is forecasting the high-yield default rate to rise, to 3.0%, in 2016, although this is largely due to an expected default rate of approximately 10% in the troubled energy sector. This forecast is based on an expectation that WTI (West Texas Intermediate Oil) averages close to $45 throughout the year. If WTI remains in the mid-$30s, energy defaults would likely increase to 20%, and the overall default rate forecast would increase to 4.5% for 2016. Excluding commodities, J.P. Morgan forecasts high-yield bond and loan-default rates of 1.5% for 2016 and 2017, respectively, both of which are well below their long-term averages of 3.6% and 3.3%, respectively.

Fund Review as of 12/31/2015

The Fund returned -0.17%, reflecting performance at the net asset value (NAV) of Class A shares, with all distributions reinvested, for the quarter ended December 31, 2015. The Fund’s benchmark, the BofA Merrill Lynch All Convertibles, All Qualities Index,6 returned 0.58% 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 December 31, 2015, are: one year: -10.20%; five years: 4.11%; and 10 years: 4.45%. Expense ratio, gross: 1.11%, 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.

The Fund’s overweight allocation to Clovis Oncology, Inc., a biopharmaceutical company, detracted from relative performance during the period. Convertibles of Clovis Oncology fell after the company revised data regarding the efficacy tests of a late-stage lung cancer drug, potentially delaying FDA approval of the drug. The Fund’s underweight exposure to meat producer Tyson Foods, Inc., further weighed on relative performance. Tyson presented a better than expected outlook for the coming year, citing both expanding chicken margins and higher anticipated synergies from its Hillshire Brands acquisition.

The Fund’s underweight allocation to the energy sector contributed to relative performance during the period. Firms in the energy sector continued to face headwinds primarily due to further weakness in commodity markets in the fourth quarter. Weak commodity pricing generally led to firms struggling to secure financing as cash flows from operations continued to fall. Additionally, aggregate security selection in the information technology sector further contributed to the Fund’s relative performance. In particular, NVIDIA Corp., a developer of visual computing processors, posted better than expected third quarter results, driven primarily by expanding revenues in the automotive and video gaming markets.

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

We remain positive on the state of the U.S. consumer and therefore maintain the portfolio’s overweight to the consumer discretionary sector. We see an improving housing market as representative of a stronger U.S. economy, and we believe that low energy costs and the strengthening employment environment will remain a tailwind for domestic discretionary spending.

The Fed’s announcement to raise interest rates contributed to continued volatility and spread widening in the fourth quarter of 2015. Given broad global macroeconomic concerns we expect volatility to remain elevated in the near future. As such, we are closely monitoring near-term developments in credit with an emphasis on fundamental valuations and earnings trends. In line with this conservative outlook, we continue to maintain a bias towards large cap companies and liquid securities. In addition, the portfolio has exposure to companies which have already deployed their balance sheets to pursue mergers and acquisitions, and which, we believe, will begin to reward investors in coming periods with expanding margins and improved earnings. 

After convertible issuance began 2015 at a brisk pace, the second half of the year saw issuance slow significantly, although with a small pickup in the fourth quarter. Issuance likely slowed during the latter half of the year due to weaker equity markets and widening credit spreads. Although issuance in 2015 was down from the previous year, we continue to witness improving new issue terms with higher coupons and lower conversion premiums. We also anticipate that M&A activity financed with convertible debt will continue to be an attractive option, particularly in industries like life sciences, where valuations are favorable and the likely acquirers still have ample access to capital.

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