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The fourth quarter of 2013 was the best performing quarter of the year, as represented by the Barclays Municipal Bond Index1. The ratio of Treasury bond yields relative to municipal bond yields remained elevated on a historical basis across most maturities, even as municipal bonds outperformed Treasuries. 'AAA' rated municipal bonds continued to yield more than corresponding Treasury yields among longer maturities.
Individual investor demand, as reflected in mutual fund flows, was tepid. However, institutional demand remained strong; as crossover buyers and banks viewed municipal bond market indicators attractive relative to other taxable fixed-income markets. Due to increased interest rates, supply lagged last year's pace as issuers no longer had the same economic incentive to refund bonds. In addition, issuers faced decisions whether to delay new issuances until interest rates stabilize and the pace of fund outflows recedes.
Generally, there was no differentiation of returns in bonds with credit ratings 'A' or higher during the quarter. The underperformance of the high-yield market can primarily be attributed to a handful of larger, lower-rated issuers and sectors. Bonds with shorter maturities performed the best, as investors remained risk averse and supply was limited. Bonds within the 10-year maturity range performed the worst as interest rates increased due to the Federal Reserve's plan to begin "tapering" its asset purchase program.
The final version of the so-called Volcker rule, which is a federal rule on proprietary trading mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, was presented. Municipal bonds, both general obligation and revenue bonds, were exempted from the proprietary trading restrictions, which quelled concerns the rule could result in higher borrowing costs for municipalities.
The largest detractor from performance was the Fund's allocation to bonds rated 'BBB,' while bonds rated 'AA' performed the best, as investors remained risk averse. Regarding sectors, tobacco and sales tax bonds underperformed, while transportation and state general obligation bonds outperformed. On a state level, bonds from the Commonwealth of Puerto Rico underperformed, as significant market pressures persisted. The Fund did have strong performance from Illinois bonds, as state lawmakers agreed on a pension reform bill. Although Illinois bonds rallied, the outcome is far from certain as legal challenges will ensue. California bonds also performed well as the state's economy continued to improve.
The strongest driver of performance during the quarter was the Fund's underweight to bonds with maturities of eight years and shorter, as rising interest rates negatively affected intermediate-maturity bonds. The main cause of the yield curve steepening was the Fed's announcement that it will begin to slow its pace of asset purchases of Treasury and government-sponsored enterprise securities. The clarity of the Fed's tapering plans concentrated the increased pressure of interest rates in the 10-year range. As a result, the Fund's exposure to bonds with 10-year maturities performed the worst on an absolute basis.
Please refer to www.lordabbett.com under the "Portfolio" tab for a complete list of holdings of the Fund, including the securities discussed above.
The divergence in demand of individual and institutional investors will be a focus of the markets as we enter 2014. It remains to be seen whether mutual fund outflows in the waning months of 2013 were a result of tax-loss selling or whether individual investors are more permanently leaving the market. In addition, institutional demand was strong in the latter half of 2013, and relative value indicators should determine whether the strong demand will continue.
We anticipate that supply, both new money issuance and refunding activity, will continue at a slow pace. In addition, we believe net supply of outstanding municipal bonds will continue to decrease as more bonds are called out of the market than new bonds being issued.
Ratios of municipal bond yields to Treasury yields remain above historical averages for bonds with maturities of 10 years and longer, with the 30-year ratio still above 100%. Going forward, movement in these ratios will be heavily dependent upon demand from individual investors.
Higher-rated bonds outperformed lower-rated bonds during 2013, primarily due to the concentration of fund outflows in lower-rated securities. As a result, credit spreads, the difference in yields of various municipal bond credit qualities relative to Treasuries of the same maturity, are wider than where they were a year ago. Credit spreads have the potential to tighten if individual investor demand increases for lower-rated bonds.
Longer maturities significantly underperformed shorter maturities during 2013. As a result, the yield curve is very steep moving into the new year. As the economy improves and the Fed continues to decrease the size of its asset-purchasing program, we expect the yield curve might flatten, with most of the movement on the shorter end of the yield curve. However, the direction and timing of this move is uncertain as it is dependent upon developments in the overall economy.
State revenues have increased every quarter for the past four years. Local government revenues have stabilized in many areas of the country where the real estate market has improved. The fiscal health of the states, with the notable exceptions of Illinois and the Commonwealth of Puerto Rico, has benefited from increasing revenues and balanced budget agreements.
A portion of the income derived from the fund's portfolio may be subject to the alternative minimum tax. Any capital gains realized may be subject to taxation. Shareholders should consult with their tax advisers for more specific information on taxation.
Performance data quoted is historical. Past performance is not indicative of future results. Current performance may be higher or lower than the performance 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 quarter-end, go to quarter ending performance on our Website or call Lord Abbett at (888) 522-2388.
1 The Fund’s dividend yield is shown without sales charges (at NAV) and with maximum sales charges (at MOP). The Fund’s dividend yield takes into account any fee waiver or expense limitation arrangements, if any. Without such fee waivers or expense limitation arrangements, the Fund’s dividend yield would have been lower. Information regarding any fee waivers or expense limitation arrangements applicable to the Fund is provided with the Fund’s expense ratio information.
2 The Fund’s unsubsidized dividend yield is shown without sales charges (at NAV) and with maximum sales charges (at MOP). The Fund’s unsubsidized dividend yield reflects what the yield would have been without the effect of fee waivers or expense limitation arrangements.