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 1.11%, 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 Barclays U.S. Universal Index,14 returned 1.34% during 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: 3.70%; five years: 4.91%; and 10 years: 5.04%.  Gross Expense ratio: 0.85%. Net Expense ratio: 0.68%. 

Performance data quoted represent past performance, which is no guarantee of 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 888-522-2388 or visit us at www.lordabbett.com.

During the quarter, Treasuries slightly outperformed credit sectors of the bond market, as the sharp drop in oil prices hurt bonds in the energy sector. The Treasury curve continued to flatten over the quarter with short-maturity Treasury yields trending higher and longer-dated Treasury yields falling. Declining interest rates acted as a tailwind in the fixed income markets throughout much of 2014, resulting in generally positive returns. While the Fund continued to have an up in quality bias throughout the quarter, we increased its overall allocation to credit-sensitive sectors to take advantage of relative-value opportunities, although concerns surrounding oil prices weighed heavily on credit-sensitive sectors over the final weeks of the year.

Security selection within the corporate sector was the primary drag on performance in the fourth quarter. The Fund’s overweight allocation to corporate bonds also detracted from relative performance as spreads (defined as the difference in yield compared to risk-free Treasuries) widened, especially over the final month of the year. We remain constructive on corporate bonds and, as spreads widened, allocations were shifted from Treasuries to take advantage of the yield differential. The Fund’s underweight allocation to agency securities further detracted from relative performance against the benchmark, the Barclays U.S. Universal Index, as U.S. agencies and other higher-quality issues saw positive performance this quarter. We maintained the Fund’s underexposure to agencies, as we continue to find greater relative value in the credit sectors.

The Fund benefitted from its exposure to the commercial mortgage-backed securities (CMBS) sector. We are generally constructive on commercial real estate, and maintain a modest overweight allocation to this sector. The Fund’s overweight allocation to asset-backed securities (ABS) also helped relative performance during the quarter. We continue to find value in the liquidity offered by high-quality ABS, primarily investing in ‘AAA’ rated securities backed by auto loans and, to a lesser extent, credit card receivables. In addition, we continue to add ‘AAA’ rated collateralized loan obligations (CLOs), which currently offer strong relative value, as we move the Fund up in quality. The Fund also benefitted from its strong security selection within fixed rate mortgage-backed securities (MBS). We continue to prefer conventional 30-year fixed-rate pass-throughs over Ginnie Maes, which underperformed during the quarter. In addition, our exposure to taxable municipal bonds was additive to performance.

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

Following five years of a zero interest rate policy from the Fed, debt-market participants now are closely monitoring the Fed for any signal as to when it may begin to normalize interest rates.  In the most recent statement following its meeting on December 17, the policy-setting arm of the Fed, the Federal Open Market Committee (FOMC), judged that it could be “patient in beginning to normalize the stance of monetary policy.”1 However, following that December meeting, futures markets implied a fed funds rate of approximately 55 basis points (bps) by the end of next year, down from 75 bps following the Fed’s meeting in September.  Such investor expectations are consistent with FOMC’s “dot-plot” projections for the fed funds rate, which came down 25 bps during that same period.  Fed chairwoman Janet Yellen repeatedly has indicated that any decision to tighten monetary policy will be data-dependent, leading investors to closely watch economic data releases, with a particular eye on labor market and inflation measures.

Labor market conditions improved gradually throughout 2014, with headline unemployment falling from 6.7% in December 2013 to just 5.8% in November 2014.15 Meanwhile, the most recent data for inflation showed only a 1.3% increase in price levels over the 12 months ended November 2014.16  Economic growth, as measured by gross domestic product (GDP), continued its impressive trend upward, with third quarter GDP increasing at an annual rate of 5.0%;17 further, Fed officials are predicting positive GDP growth of 2.6–3.0% in 2015 and 2.5–3.0% in 2016.2 The Fed will potentially have to balance an improving economy with low levels of inflation when deciding when, and to what degree, it normalizes monetary policy over the coming months and years.

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