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FIXED-INCOMEINSIGHTS Bonds:FedWatching—andOpportunityHunting—in2015 December22,2014 ZaneE.Brown Partner,FixedIncomeStrategist WiththeU.S.FederalReservepoisedtodominatethefinancialheadlinesin2015, whichsegmentsofthefixed-incomemarketmightbemostattractive? InBrief What can U.S. fixed-income investors expect as 2015 unfolds? Let’s look at two key areas of concern: 1)U.S.economy—Jobsgrowth,andimprovementsincommercialandconsumerlending,signalthat U.S.economicgrowthisimprovingandpotentiallyself-sustaining. 2)Fedpolicy—WhilethemedianprojectionfromU.S.FederalReservepolicymakerscallsforthefed fundsratetoincreaseto1.13%bytheendof2015,acumulativerateriseof0.50%to0.75%seems moreappropriate,andmorelikely. The key takeaway—Within fixed income, convertible securities, high yield, and the lower tiers of investment-grade debt seem positioned to perform better than lower-coupon, interest ratesensitive,high-qualitysecurities. In looking toward the prospects for markets and the economy in 2015, one cannot help but focus squarelyontheU.S.FederalReserveanditseffortstobringinterestratestoward“normal”levels. Persistentjobsgrowth,increasedbanklending,andtheconsumption-friendlybenefitsofastronger dollarandloweroilpricescreateanenvironmentidealfortheFedtobeginadjustingmonetarypolicy towardnormalinterestrates. TheFed’smovestowardthisgoalseemlikelytoberestrainedbylowinflation,afearofhandicapping U.S.expansion,andslowglobalgrowth.Ariseinlonger-terminterestratesalsocouldberestrained bylowinflationandlowratesoncomparablematuritiesofgovernmentbondsinEuropeandJapan. Even if interest rates were to rise only a portion of what the Fed expects, yields on high-quality, interestrate-sensitivedebtwillbeaffectedmorethanthoseoflower-quality,economicallysensitive securities. In a world starved for economic growth, yield, and currency security, U.S. investments seempositionedtobenefit.Withinfixedincome,convertiblebonds,highyield,andthelowertiersof investment-gradedebtshouldperformbetterthanlowercoupon,interestrate-sensitivehigh-quality securities. Let’stakeacloserlookatwhatinvestorsmayexpectas2015unfolds. 1 EconomicBackground Jobs growth, and the level of commercial and consumer lending, have been Fed focal points for indicationsthatU.S.economicgrowthisimprovingandpotentiallyself-sustaining.The2014nonfarm payrolls numbers from the Bureau of Labor Statistics suggest the Fed’s patience has been rewarded. Jobs growth has averaged more than 240,000 per month for the first 11 months of the year, compared with monthly averages of 194,000 and 186,000 for 2013 and 2012, respectively. Although many jobs are temporary or low paying, improvement has been made in the number of higher-payingjobs,includingmanufacturingandbusinessandprofessionalpositions.Towardtheend oftheyear,slightincreasesincompensationalsohavesurfaced. In terms of lending, increases are evident among all key categories. According to the Fed, commercial and industrial loans through November grew at a 12% pace in 2014, compared with about 7% in 2013. Consumer loans were up at a 5% rate versus 3.5% in 2013. And real estate lendingfinallyturnedpositiveafterseveralyearsofcontraction. Inadditiontothelabormarketandloan-growthindicators,loweroilpricesanddollarstrengthshould support U.S. growth. Cheaper oil frees consumer funds previously spent on gasoline and home heatingfuel.Similarbenefitsaccruetocompaniesthatnowcanenjoyreducedtransportationcosts (shipping),fuelcosts(especiallymanufacturers),andreducedpackagingcosts(plastics).Astronger dollar reduces the cost of imports, expanding consumer purchasing power and reducing cost of goodstobusinessandmanufacturers.Loweroilandastrongercurrency,whilenotbeneficialtoall sectorsoftheeconomy,effectivelyactformostconsumersandbusinessesasthekindoftaxbreaks thatCongresswouldfinddifficulttoachieve. FedPolicy Where does this all leave the U.S. central bank? The economic conditions we’ve discussed here seem to empower the Fed to start raising interest rates by mid- 2015. However, policymakers’ median“dot-plot”expectationofa1.13%fedfundsratebyyear-end2015seemsaggressivefor severalreasons.First,ahistoricallymindedcentralbank’sprimaryconcernwithratehikesistoavoid a repeat of the 1937 crisis in which higher rates pushed the economy back into recession. This primary risk, combined with a more dovish Federal Open Market Committee after the departure of two policy hawks—Richard Fisher, president of the Dallas Federal Reserve Bank, and Philadelphia Fed president Charles Plosser—should produce a more cautious approach than Fed projections imply.Second,theinflationdampeningeffectsofloweroilandastrongerdollar(namely,lower-priced imports) should allow a dovish Fed more leeway in its rate agenda if economic growth slows in responsetoearlyratehikes. Third, there are other influences that could compromise U.S. growth. Recession in Japan and slow growthintheeurozonecouldaffectU.S.exportsaswellasprofitabilityofcompanieswithnon-U.S. exposure.ThecompetitivenessofU.S.exportersalsoishurtbythedevaluationsofothercurrencies versusthedollar.TotheextentU.S.exportersrespondbyreducingproductionormovingitoverseas, U.S. growth will be affected. Similarly, while lower oil helps many companies, for the U.S. energy industry it will compromise profitability, capital investment, and potentially production. Taken together, these issues could be sufficient enough to dull the edge of U.S. expansion to the point whereaslowerraterisebecomesappropriatepolicy. Thethreatofslowglobalgrowth,theimpactofastrongerdollaronU.S.exporters,andtheeffectof lower-priced oil on the domestic energy industry suggest that U.S. growth may be unable to withstand a quick rate rise to 1.13% by year-end 2015.A cumulative rate rise of 0.50% to 0.75% seems more appropriate, and more likely, owing to the increasing dovishness on the part of policymakers. 2 InvestmentConsequences Howcouldthesedevelopmentsinfluencetheperformanceoffixed-incomeportfoliosin2015?Evenif theFedwereabletoraiseratesonlyto0.50%or0.75%,high-quality,interestrate-sensitivedebtwill beaffectedmorethanlower-qualityeconomicallysensitivesecurities.OncetheFedbeginsitsrateadjustment process, investors are likely to anticipate future moves, pushing yields higher ahead of theFed’saction.Ratesonlonger-maturity,high-qualitydebtwillnotbeimmune,butwithJapanand theeurozoneteeteringonthebrinkofrecession,ayieldabove3%onthe10-yearU.S.Treasurynote seemsdifficulttoachieve. Currency devaluation, pursued aggressively in Japan, seems likely to spread to the eurozone and Chinatoavoideconomicdisasterinthoseexport-sensitiveeconomies.Theresultingstrengthinthe U.S. dollar will continue to attract foreign investment. Fed rate moves will make short-term fixedincomeinvestmentsevenmoreattractive. Collectively,inaworldstarvedforreliablegrowth,relativelyattractiveyieldandstabilityofcurrency, theUnitedStates,in2015,appearstoofferanarrayofattractiveinvestmentoptions.Withinfixed income, convertible securities, high yield, and the lower tiers of investment-grade debt seem positioned to perform better than lower-coupon, interest rate-sensitive, high-quality securities. The widening of yield spreads on lower-quality debt toward the end of 2014 should allow a more attractive income stream than higher-quality issues, as well as an opportunity for an eventual narrowingofthespreadthathashistoricallycharacterizedU.S.risinginterest-rateenvironment. Non-U.S. debt will offer selective opportunity, but total returns will be compromised if securities involvedepreciatingcurrencies.Generally,U.S.dollar-denominatedforeigndebtseemstobeabetter alternative, subject to the ability for companies and governments to repay their obligations should thedollarcontinuetoappreciate.Professionalsecurityselectionwillbeanimportantcontributorto totalreturnofnon-U.S.debtportfolios.Thisisespeciallytrueofemergingmarkets,wheredeclining commodity prices affect economic fortunes unevenly. Importers of oil, for instance, offer better prospectsthancountriesreliantonoilastheirmainexport. How,then,shouldinvestorspositiontheirfixed-incomeportfoliosinthenewyear?Theymaywishto consider securities that offer higher income, and are sensitive to economic conditions rather than interest-rate moves. Conservative investors may want to focus their exposure within the United Statesandtowardhigher-incomealternativeswithless-volatile,shortermaturities. Fixed-incomeopportunitiesoutsidetheUnitedStatesseempoisedtodivergebasedonthecountryby-countryeffectsoflowcommodityprices,relativecurrencymovements,andtheeffectsofrising U.S. interest rates. Security selection based on analysis of these variables seems a more appropriatestrategyfor2015thanadjustingblanketexposurebasedongeographicregionordegree ofeconomicdevelopment. The Fed will play an important role in the future of different fixed-income asset classes, but we believetheU.S.centralbankwillnotbeasaggressiveasitsforecastsimply.TheFed’sactions,and theperformanceofmanyfixed-incomeinvestments,willbedrivenbytheconsequencesofloweroil, dollarappreciation,andpersistentbutunexcitingeconomicgrowth. 3 ANoteaboutRisk:Thevalueofinvestmentsinfixed-incomesecuritieswillchangeasinterestratesfluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. High-yield securities, sometimes called junk bonds,carryincreasedrisksofpricevolatility,illiquidity,andthepossibilityofdefaultinthetimelypaymentof interestandprincipal.Moreover,thespecificcollateralusedtosecurealoanmaydeclineinvalueorbecome illiquid,whichwouldadverselyaffecttheloan’svalue.Longer-termdebtsecuritiesareusuallymoresensitive tointerest-ratechanges;thelongerthematurityofasecurity,thegreatertheeffectachangeininterestrates islikelytohaveonitsprice.Lower-ratedbondsmaybesubjecttogreaterriskthanhigher-ratedbonds.Foreign investments generally pose greater risks than domestic investments, including greater price fluctuations and higher transaction costs. Special risks are inherent in international investing, including those related to currencyfluctuationsandforeign,political,andeconomicevents.Further,investinginthesecuritiesofissuers located in certain emerging countries may present a greater risk of loss resulting from problems in security registrationandcustodyorsubstantialeconomicorpoliticaldisruptions.Noinvestingstrategycanovercome allmarketvolatilityorguaranteefutureresults. Forecasts and projections are based on current market conditions and are subject to change without notice. Projectionsshouldnotbeconsideredaguarantee. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Thereisnoguaranteethatmarketswillperforminasimilarmannerundersimilarconditionsinthefuture. The fed funds rate is the interest rate at which a depository institution lends immediately available funds (balancesattheFederalReserve)toanotherdepositoryinstitutionovernight. Grossdomesticproduct(GDP)isthemonetaryvalueofallthefinishedgoodsandservicesproducedwithin acountry'sbordersinaspecifictimeperiod,thoughGDPisusuallycalculatedonanannualbasis.Itincludes all of private and public consumption, government outlays, investments and exports less imports that occur withinadefinedterritory. Yield is the annual interest received from a bond and is typically expressed as a percentage of the bond's marketprice. The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). Highyielding,non-investment-gradebonds(junkbonds)involvehigherrisksthaninvestment-gradebonds.Adverse conditionsmayaffecttheissuer’sabilitytopayinterestandprincipalonthesesecurities. The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequentdevelopmentsandmaynotreflecttheviewsofthefirmasawhole.Thismaterialisnotintendedtobe legalortaxadviceandisnottoberelieduponasaforecast,orresearchorinvestmentadviceregardingaparticular investmentorthemarketsingeneral,norisitintendedtopredictordepictperformanceofanyinvestment.Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This documentispreparedbasedoninformationLordAbbettdeemsreliable;however,LordAbbettdoesnotwarrantthe accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investmentdecision. 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