Income Fund of Boston (A)

A Word On The Markets  as of Mar 31, 2012

The U.S. high-yield corporate bond market generated a solid gain in the first quarter of 2012, as measured by the 5.15% advance of the BofA Merrill Lynch U.S. High Yield Index². Favorable supply and demand conditions were key drivers of investment performance. Investors who were frustrated by the ultra low yields offered by U.S. government bonds, wary of equity market volatility and encouraged by improving macroeconomic developments, increasingly poured money into high-yield bonds. In the first three months of 2012, flows into high-yield mutual funds totaled nearly $19 billion, more than each of the prior two full years. This robust demand easily offset a significant increase in the supply of high-yield bonds, which totaled almost $108 billion for the quarter, the largest quarterly issuance on record.

Refinancings, rather than new bond issuance, accounted for the bulk of that supply, as issuers opportunistically replaced older, more expensive debt at lower prevailing rates and took advantage of strong demand for high-yield bonds. During the quarter, the high-yield market enjoyed its biggest gains in January (+2.90%) and February (+2.05%) when demand was at its peak, but was virtually flat in March (-0.09%) when demand subsided and supply surged.

Throughout most of the period, investors also were encouraged by favorable macroeconomic developments and strengthening issuer fundamentals. Improved global economic data led investors to shift capital to riskier investments - including high-yield bonds - which historically have performed well in periods of economic expansion. Additionally, further progress in the resolution of Europe's sovereign debt woes - particularly the long-awaited bailout of Greece - buoyed investors' appetite for riskier asset classes.

The fundamentals for many high-yield issuers continued to strengthen during the quarter, as evidenced by rising corporate earnings and ongoing delevering of balance sheets. These factors helped keep default rates low at 1.9% at the end of the quarter, and below the market's long-term averages.

Performance Summary 

Income Fund of Boston underperformed its primary benchmark, the BofA Merrill Lynch U.S. High Yield Index, during the first quarter at net asset value.

• Quarter over quarter, the average bond price in the benchmark rose to $101.36 from $97.38, while the average yield-to-worst ¹⁰ and spread declined to 7.15 and 609 from 8.36% and 743 basis points, respectively.
• The high-yield market's par-weighted default rate ended the quarter at 1.9%, according to JP Morgan, well below the market's 25-year average of 4.21%.
• The best performing sectors in the benchmark were banks & thrifts, transportation (ex air and rail), insurance, homebuilders/real estate and broadcasting.
• The worst performing sectors in the benchmark were metals/mining, utilities, railroad, energy, cable/satellite TV and environmental.
• Bonds rated CCC were the strongest performers during the quarter, followed by B-rated bonds and then by BB-rated bonds¹¹.

Contributors 

Factors contributing to the Fund's performance relative to the benchmark during the quarter:

• Relative performance was aided by strong credit selection, particularly within the gaming, energy, automotive, steel and cable/satellite TV sectors of the market, as well as within the BB-rated credit segment of the market.
• The Fund's overweight positioning in the gaming and chemical sectors of the market contributed to relative returns, as these segments outperformed the overall market.

Detractors 

Factors detracting from the Fund's relative performance compared to the benchmark during the quarter:

• The Fund's underweight positioning in banks & thrifts, homebuilders/real estate and technology sectors detracted from relative performance, as these segments outperformed the broad market.
• Credit selection within the services, diversified media and consumer products sectors detracted from relative returns.

Investment Outlook And Fund Positioning 

We believe technical factors will be the key to high-yield bond performance near term. We see a more muted supply of newly issued bonds in the second quarter. New financing for leveraged buyouts, mergers and acquisitions, and growth capital has also been slower than expected. But the Federal Reserve's money policy has redirected capital to risk-based assets, including high-yield bonds. Our view is that demand will remain somewhat sensitive to macroeconomic factors.

In the near term, we see the high-yield market earning its coupon, with potential for some small capital appreciation. Given our focus on downside management, the portfolio is currently positioned to give shareholders exposure to the market, while seeking to lower the potential volatility to macro factors and events that may unduly slow the U.S. economy.

The views expressed in this report are those of portfolio manager(s) and are current only through the date stated at the top of this page. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. This commentary may contain statements that are not historical facts, referred to as "forward looking statements". The Fund's actual future results may differ significantly from those stated in any forward-looking statement, depending on factors such as changes in securities or financial markets or general economic conditions, the volume of sales and purchases of Fund shares, the continuation of investment advisory, administrative and service contracts, and other risks discussed from time to time in the Fund's filings with the Securities and Exchange Commission.

Fund invests in an affiliated investment company (Portfolio) with the same objective(s) and policies as the Fund. References to investments are to the Portfolio's holdings. Portfolio profile subject to change due to active management. Percentages may not total 100% due to rounding.

About Risk 

An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of non–payment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer's ability to make principal and interest payments. Investments rated below investment grade (typically referred to as "junk") are generally subject to greater price volatility and illiquidity than higher rated investments. As interest rates rise, the value of certain income investments is likely to decline. Derivatives instruments can be used to take both long and short positions, be highly volatile, result in economic leverage (which can magnify losses), and involve risks in addition to the risks of the underlying instrument on which the derivative is based, such as counterparty, correlation and liquidity risk. If a counterparty is unable to honor its commitments, the value of Fund shares may decline and/or the Fund could experience delays in the return of collateral or other assets held by the counterparty. No Fund is a complete investment program and you may lose money investing in a Fund. The Fund may engage in other investment practices that may involve additional risks and you should review the Fund prospectus for a complete description.

No attribution information is available.

Fund invests in an affiliated investment company (Portfolio) with the same objective(s) and policies as the Fund. References to investments are to the Portfolio's holdings. Portfolio profile subject to change due to active management. Percentages may not total 100% due to rounding.

About Risk 

An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of non–payment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer's ability to make principal and interest payments. Investments rated below investment grade (typically referred to as "junk") are generally subject to greater price volatility and illiquidity than higher rated investments. As interest rates rise, the value of certain income investments is likely to decline. Derivatives instruments can be used to take both long and short positions, be highly volatile, result in economic leverage (which can magnify losses), and involve risks in addition to the risks of the underlying instrument on which the derivative is based, such as counterparty, correlation and liquidity risk. If a counterparty is unable to honor its commitments, the value of Fund shares may decline and/or the Fund could experience delays in the return of collateral or other assets held by the counterparty. No Fund is a complete investment program and you may lose money investing in a Fund. The Fund may engage in other investment practices that may involve additional risks and you should review the Fund prospectus for a complete description.