Market Review as of 12/31/2014

Key categories of fixed-income securities posted divergent performances in the fourth quarter of 2014. While investors had to contend with plummeting oil prices, dramatic currency devaluations, and renewed market volatility, their primary concern remained future policy moves by the U.S. Federal Reserve (the “Fed”). The central bank is widely expected to begin hiking interest rates in 2015, given signs of a strengthening U.S. economy.

In a statement following its policy meeting on December 16–17, the Fed replaced the language of “a considerable time” regarding how long it would maintain its zero-interest rate policy, saying instead that it could be “patient” before making any changes.1 Fed policymakers lowered their median estimate for the fed funds rate for the end of 2015, to 1.125%, compared with 1.375% in September 2014.2

U.S. Treasuries (as represented by the BofA Merrill Lynch U.S. Treasury Index3) posted a return of 2.28% for the three-month period ended December 31, 2014. The municipal bond market (as represented by the BofA Merrill Lynch U.S. Municipal Securities Index4) gained 1.33%, benefitting from solid investor demand for tax-free securities amid a tightening supply of available issues.

Certain credit-sensitive segments of the fixed-income market underperformed government-related securities in the fourth quarter. The high-yield bond market (as represented by the BofA Merrill Lynch U.S. High Yield Constrained Index5) posted a return of -1.06% for the quarter, as investor sentiment appeared to be dampened by weakness in energy issues, which represent a significant part of the high-yield market. The floating-rate loan market (as represented by the Credit Suisse Leveraged Loan Index6) posted a return of -0.40%, reflecting lower appetite for credit risk amid the decline in energy prices and renewed market volatility. The convertible bond market (as represented by the BofA Merrill Lynch All Convertibles, All Qualities Index7) returned 1.62%, likely reflecting the relative strength of equities.

Among higher credit-quality securities, investment-grade corporate debt (as represented by the Barclays U.S. Corporate Bond Index8) posted a return of 1.77%. Agency mortgage-backed securities (as represented by the Barclays Mortgage-Backed Securities Index9) gained 1.81%. Commercial MBS (CMBS) (as represented by the Barclays U.S. CMBS Investment Grade Index10) returned 1.45%.

U.S. inflation remained well-contained in the fourth quarter. In November, the overall Consumer Price Index (CPI)11 increased 1.3% over the prior 12 months, below the Fed’s target of 2.0%.12 The index (excluding volatile food and energy prices) rose 1.7% over the prior 12 months.

The U.S. labor market showed signs of acceleration. The U.S. Bureau of Labor Statistics reported that non-farm payrolls increased by 321,000 in November, above the average monthly gain of 224,000 over the prior 12 months, while the unemployment rate held at 5.8%.13

Corporate credit quality generally remained consistent with an improving economic environment, though the total amount of defaulted debt increased. In 2014, 28 companies defaulted, affecting a total of $70.2 billion in bonds and institutional loans, a five-year high, and the second highest total on record, according to J.P. Morgan. However, the defaults of Energy Futures (totaling $36 billion) in April and Caesars Entertainment ($18.1 billion) in December accounted for 77% of the year’s total volume. Excluding these two defaults, high-yield default activity of $16.0 billion represented the lowest total volume since 2007. J.P. Morgan expects the default rate in the high-yield bond market to be 2.5% in both 2015 and 2016. These estimates are well below the high-yield market’s average long-term default rate of 3.8%. 

Fund Review as of 12/31/2014

The Fund returned 1.22%, reflecting performance at the net asset value (NAV) of Class A shares, with all distributions reinvested, for the quarter ended December 31, 2014. The Fund’s benchmark, the BofA Merrill Lynch All Convertibles, All Qualities Index,7 returned 1.62% 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, 2014, are: one year: 3.55%; five years: 8.84%; and 10 years: 5.73%. 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.

Broad weakness in the energy sector was a detractor to relative performance during the quarter. A marked decline in oil prices negatively affected the sector, and although the Fund maintained an underweight position in energy, the Fund’s exposure to high-cost exploration and production companies specifically detracted from the Fund’s performance relative to the benchmark index. The weak commodity pricing environment also led to worries about the competitive positioning of alternative energy companies. In particular, weakness in SunPower Corporation, a solar panel manufacturer, presented a drag on the Fund during the quarter. 

During the fourth quarter, the Fund’s relative performance benefited from strong security selection in the healthcare sector. In particular, an overweight position in Cubist Pharmaceuticals positively contributed to performance, as the company announced that it would be acquired by Merck. In addition, our continued overweight to the airline industry helped performance of the Fund. As fuel prices fell and travel trends remained strong, airlines exhibited improved pricing power and performed well.

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

Our outlook for the convertibles market is influenced particularly by the effect of falling oil prices, potentially rising interest rates, and strengthening U.S. economic fundamentals.  We are seeking to increase the Fund’s exposure to the materials and consumer discretionary sectors of the economy, as we believe that falling commodity prices may be favorable for certain firms in those sectors.  In addition, we are looking to selectively increase the Fund’s exposure to the energy sector by focusing on firms that maintain attractive fundamental valuations and can generate positive cash flow in the current pricing environment. 

We remain very mindful of the Fund’s interest rate sensitivity, as the Fed may look to raise short-term interest rates sometime in the coming year.  In addition, in light of strong recent domestic economic indicators and a strengthening dollar, we are looking to avoid firms that depend on revenues from foreign countries and have primarily domestic cost structures. 

We continue to monitor the credit markets very closely. In the past year, the markets have seen convertible security issuance grow as fewer securities were redeemed and the market witnessed approximately $50 billion in new issuance. As the high-yield market becomes less attractive as a source of financing and companies receive higher equity valuations than last year, we believe the coming year will be favorable for continued growth in convertible security issuance.

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