Limited Duration Income Fund

A Word On The Markets  as of Mar 31, 2013

The first quarter began with the U.S. economy facing a number of headwinds. After Congress weathered the “fiscal cliff” storm at the beginning of the quarter, investor fears that the U.S. economy would face the full force of significantly higher taxes subsided. As U.S. economic data strengthened, investors became more comfortable and a rally in riskier assets, such as high-yield bonds, ensued. As the U.S. economy gained steam, the dysfunction in Washington resumed on March 1st with the automatic spending cuts, known as sequestration, triggered by an impasse between Democrats and Republicans. The U.S. labor market has yet to see the full potential impact of the sequestration cuts, which have the potential to meaningfully impact the U.S. economy in the months to come.

Even with mortgage rates hovering around all-time lows during most of the quarter, changes in generic and seasoned agency mortgage-backed security (MBS) prepayments remained relatively muted. Many of the largest lenders continued to deal with capacity constraints during the quarter, which helped keep prepayment speeds depressed. Despite the Federal Reserve’s (the Fed) heavy involvement in both the Treasury and agency MBS markets, yields finished the quarter higher in both markets. Seasoned and generic agency MBS spreads ended the quarter wider to Treasurys, partially due to fears the Fed would begin lessening its mortgage purchases.

The U.S. floating-rate loan market performed solidly during the first quarter, reflecting positive investor sentiment across the capital markets. The S&P/LSTA Leveraged Loan Index⁶—a broad barometer for the loan market—advanced 2.11% for the three-month period ended March 31, 2013. With fundamentals broadly in check and the default rate low, returns during the quarter were primarily driven by technical conditions, which remained favorable. With loans priced near par, strong demand continued to drive spread compression in the market throughout the quarter, lowering coupon income in a way not dissimilar to the reduced yields found in many other income market segments, such as high-yield bonds.

High-yield bonds started 2013 not just by continuing last year’s trend of strong performance, but also with an impressive display of resilience. High-yield bonds returned 2.89% during the quarter, the highest among fixed-income sectors, based on the BofA/Merrill Lynch U.S. High Yield Index.⁷ These results were driven by generally favorable U.S. economic developments and the Fed’s continued accommodative policies.

Performance Summary 

For the three-month period ended March 31, 2013, Eaton Vance Limited Duration Income Fund (the Fund) had total returns of 2.26% at net asset value and 4.52% at market price. The Fund is a closed-end fund and trades on the NYSE Amex exchange under the symbol EVV. The Fund’s primary investment objective is to provide a high level of current income, with a secondary objective of capital appreciation.

• For the quarter, the Fund’s investments in seasoned MBS outperformed the Treasury market, as measured by the BofA Merrill Lynch 1-10 Year U.S. Treasury Index (Treasury Index).⁸ The income advantage from seasoned MBS and lower duration in a rising rate environment more than offset the spread widening that occurred in the MBS market relative to the Treasury Index.
• The Fund’s bank loan investments underperformed the loan market, as measured by the S&P/LSTA Leveraged Loan Index,⁶ during the period. The Fund’s bank loan holdings were slightly overweight BB-rated securities,⁹ which were outpaced by the lower-quality B-rated and below categories (as rated by Moody’s and S&P). Defaulted loans remained below 1% of Fund bank loan assets, lower than the market overall. Also, Fund bank loan performance was enhanced by market underweights in retailers and aerospace and defense, offset by market underweights in utilities.
• Fund high-yield bond investments outperformed the broader market, as measured by BofA Merrill Lynch U.S. High Yield Index (High Yield Index),⁷ during the three months. Credit selection was again the primary driver of returns particularly in the technology, services and telecommunications sectors. The Fund’s CCC-rated holdings showed the strongest performance during the quarter among the ratings classes, as riskier securities in general had the strongest returns for the market. Detracting from performance were the Fund’s BB-rated holdings, as well as underweight positions in the steel and food and drug retail sectors.

Investment Outlook And Fund Positioning 

We believe the MBS market continues to hold value relative to most other U.S. government securities. Supply/demand technicals remain supportive of agency MBS spreads, as the Fed will continue its purchases of over $40 billion in new bonds on a net basis per month and now owns over 20% of outstanding agency MBS. As mortgage rates continue to hover around all-time lows, prepayment rates on seasoned agency MBS—like those owned by the Fund—continue to prepay at stable rates. We believe that seasoned agency MBS offer the most value in the agency MBS market and don’t have the extension risk that generic MBS have.

We believe the environment for loans should remain benign in the near term, thanks to low credit risk and a positive technical bias. The default rate in the market ended March at 2.21% by principal amount, which translates to theoretical credit losses of 66 basis points after an assumed 70 percent recovery. Looking at technicals, demand continues from all quarters including funds, CLOs and institutional accounts. Should the positive technical condition in the market persist, lower coupon income for the loan investor is in the offing. Still, given the low-yield environment, heightened bond risk and dearth of fairly valued, low duration income alternatives, we believe loans should retain their relative attractiveness ahead.

We anticipate that the supportive environment for high yield will continue. We believe the Fed is unlikely to change its accommodative stance as long as the economy has low growth without inflationary pressures. With record-high corporate cash levels in a strengthening economy, default levels are near record lows—that is why we see credit risk as preferable to interest-rate risk, which poses significant downside. We believe B-rated bonds offer the best value, with less interest-rate sensitivity than BB-rated issues and lower default risk than CCC-rated bonds.

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.

The information contained herein is provided for informational purposes only and does not constitute a solicitation of an offer to buy or sell Fund shares. Common shares of the Fund are only available for purchase and sale at current market price on a stock exchange. There is no assurance that the Fund will achieve its investment objective. The Fund is subject to investment risks, including possible loss of principal invested. The Fund is not a complete investment program and you may lose money investing in the Fund. An investment in the Fund may not be appropriate for all investors.

The premium/discount is calculated as [(market price/NAV)-1].

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