Strategic Income Fund (A)

A Word On The Markets  as of Mar 31, 2012

Stronger-than-forecast economic data in the United States fueled a rally in U.S. equity and high-yield debt markets. Domestic GDP growth, including improving employment reports, exceeded market expectations and pushed longer-dated U.S. Treasury bond yields higher. In addition, the Federal Reserve indicated that further quantitative easing (QE) may not be necessary to stimulate the economy.

The European Central Bank (ECB) continued its program to inject much-needed liquidity into the eurozone's banking sector. With the second of the long-term refinancing operations (LTRO) completed at the end of February, over a trillion euros have been added, calming the debt crisis. Greece was able to engineer the largest sovereign debt swap ever by retroactively enforcing an inserted collective action clause (CAC) into its Greek law bonds.

Fears of a hard landing in China continued to dissipate, as real GDP growth moderated to a more sustainable level. The slowdown appears well managed, however, the continuing correction in top-tier urban real estate still bears watching. Factory output in non-China Asia was impressive, boosted by output normalization after the Thai flood. The Bank of Japan continued its asset purchase program and announced an explicit consumer price inflation target of one percent, leading to a depreciation of the yen versus the U.S. dollar.

Most Latin American and Asian currencies appreciated against the U.S. dollar during the quarter, as the liquidity provided by developed world central banks (ECB, U.S., Japan and the U.K.) helped assuage fears of another sharp decline in global economic growth.

Performance Summary 

For the quarter ended March 31, 2012, Strategic Income Fund outperformed its benchmark, the Barclays Capital U.S. Aggregate Index² at net asset value.

• Each of the component portfolios in the Fund posted positive returns, as the beginning months of 2012 were characterized by risk-on investor behavior. In order of magnitude, the highest returns were produced by emerging-market local debt, high-yield bonds, floating-rate loans, currencies, global macro and the global opportunities portfolios.
• Emerging-market local sovereign debt produced impressive returns for the quarter, as Hungary, Russia, Poland, Mexico, Columbia and Turkey all experienced double-digit gains within the J.P. Morgan GBI-EM Global Diversified Index.
• Leveraged credit contributed to the Fund's performance, as strong high-yield debt fundamentals continued to support the junk bond market with low default rates, deleveraging balance sheets, solid revenues, earnings growth and a healthier cohort of refinancing issuers. In a similar fashion, the floating-rate loan market also benefited from improving macroeconomic factors, as income streams were augmented by rising prices in leveraged credit instruments.
• Because of its weight in the Fund, Global Macro porftfolios provided core returns, as most of the long positions in emerging-market currencies appreciated versus the U.S. dollar.

Contributors 

Contributors to performance during the first quarter:

• Fundamentals remained on solid footing, as default rates for both high-yield and floating-rate issuers remained well below average as companies continued to deleverage their balance sheets.
• Most of the Fund's long Latin American and Asian currency positions appreciated against the U.S. dollar during the quarter, as the liquidity provided by developed world central banks (ECB, U.S., Japan and the U.K.) assuaged fears of an imminent financial meltdown.
• The Fund's long external credit positions in Latin America and Central and Eastern Europe appreciated during the quarter, as markets seemed to favor sovereigns with strong fundamentals and favorable political developments.

Detractors 

Detractors to performance during the first quarter:

• In the "risk on" environment that characterized the year's first quarter, lower-quality leveraged credit outperformed the higher-rated credits. This led to relative underperformance in high yield and bank loans versus their benchmarks.
• In the Fund's international exposures, short external credit positions in Brazil as well as the short position in French debt versus a long position in German Bunds detracted from the Fund's performance, as credit spreads tightened there.
• The Fund's short Taiwan dollar position detracted from performance, as it and most other Asian currencies appreciated versus the U.S. dollar.

Investment Outlook And Fund Positioning 

We believe markets will continue to focus on developments in Europe, especially as it relates to Spain's ability to fight economic contraction, fiscal budget deterioration and sovereign debt cost escalation. Activity in the Middle East is also being watched, as Syrian violence may expand across borders, and events in Iran could influence oil prices.

In the U.S., the public sector will likely continue to see fiscal deterioration, while in the private sector, corporations should continue to benefit from the ongoing financial deleveraging process.

Many emerging-market countries will likely continue to benefit from strong economic and political fundamentals that should help them weather potential market turbulence stemming from imbalances in the developed world.

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 primarily invests in one or more affiliated investment companies (Portfolios) and may also invest directly. Unless otherwise noted, references to investments are to the aggregate holdings of the Fund and the Portfolios. Portfolio profile subject to change due to active management. Percentages may not total 100% due to rounding.

About Risk 

Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. In emerging countries, these risks may be more significant. 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. 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. As interest rates rise, the value of certain income investments is likely to decline. The value of commodities investments will generally be affected by overall market movements and factors specific to a particular industry or commodity, including weather, embargoes, tariffs, or health, political, international and regulatory developments. Investments rated below investment grade (typically referred to as "junk") are generally subject to greater price volatility and illiquidity than higher rated investments. A non-diversified fund may be subject to greater risk by investing in a smaller number of investments than a diversified fund. 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.

Attribution available in Fund Literature tab.

Fund primarily invests in one or more affiliated investment companies (Portfolios) and may also invest directly. Unless otherwise noted, references to investments are to the aggregate holdings of the Fund and the Portfolios. Portfolio profile subject to change due to active management. Percentages may not total 100% due to rounding.

About Risk 

Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. In emerging countries, these risks may be more significant. 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. 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. As interest rates rise, the value of certain income investments is likely to decline. The value of commodities investments will generally be affected by overall market movements and factors specific to a particular industry or commodity, including weather, embargoes, tariffs, or health, political, international and regulatory developments. Investments rated below investment grade (typically referred to as "junk") are generally subject to greater price volatility and illiquidity than higher rated investments. A non-diversified fund may be subject to greater risk by investing in a smaller number of investments than a diversified fund. 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.