4th Quarter 2016

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The fourth quarter of 2016 continued a year-long trend of surprises for investors. Markets certainly reminded us that the probability of non-consensus outcomes can be severely discounted when heading into controversial decision points. The result of November's U.S. presidential election, for instance, was a surprise for most markets. The day Americans went to the polls, the yield on the 10-year U.S. Treasury was 1.85%. Merely one week later, it rose to 2.22%, and by mid-December it moved to a near-term high of 2.60%.

Despite yields having bottomed in July 2016, many investors' portfolios were caught off guard as yields rose faster than most expected. While not immune to the rise in rates during the quarter, Thornburg Strategic Income Fund ultimately outperformed its benchmarks, delivering positive returns in a tumultuous period for fixed income investors. While yields moved up dramatically during the quarter, both investment-grade and high-yield corporate spreads tightened, with the Bloomberg Barclays U.S. Aggregate Bond Index option adjusted spread (OAS) moving 0.15% tighter, and the Bloomberg Barclays U.S. Corporate High-Yield Index OAS moving 0.71% tighter.

Over the last few years, we decreased duration in Thornburg Strategic Income Fund as the risk-reward dynamic for longer-dated maturities pointed in the wrong direction. We also decreased the credit risk held in the portfolio by moving toward higher-quality corporates and asset-backed securities amidst declining compensation for undue risk.

Philosophically, we've remained defensive around duration and credit risk positions over the past few years, given their scant compensation potential. Our mindset led us to build a portfolio that was relatively shorter in duration and higher in quality compared to its history. As a result, the portfolio was less exposed to the recent backup in yields, and thus partially insulated from some of the negative duration-related effects.

As can be expected, we remain consistent in our philosophy of taking on incremental risk only when we believe that risk offers proper compensation. Due to the dual forces of higher risk-free rates and lower credit spreads, we ended the fourth quarter with a cash position of 13.2%, which is on the historically high side for the fund. We remain well positioned, however, to convert our cash rapidly and be opportunistic given any potential weakness in spread markets, which we could see as investors continue to assess economic developments.

While spreads remain stubbornly tight, corporate leverage continues to flirt with all-time highs. Regardless of one's opinion on global growth prospects, we believe that current spread compensation per unit of risk has yet to become attractive en masse, hence our relatively high allocations to cash. Market participants appear to be pricing in a positive reaction to the new U.S. president's plans for fiscal, tax, and regulatory stimulus. Consumers and small business owners both appear optimistic. The University of Michigan Consumer Sentiment Index clocked in at 98.2 in December, the highest reading since January of 2004. Similarly, NFIB Small Business Optimism Index ended the year at 105.8, the highest reading since December of 2004. While markets may experience what some would call a happy medium of "not too hot, not too cold" growth and decent returns going forward, the current environment has yet to provide an incredibly robust opportunity set.

Along with December's 0.25% rate hike came the latest economic projections from the Federal Reserve Board (the Fed). Among those forecasts was the median expectation for the Fed Funds rate to be 1.4% by year-end 2017. This implies three hikes of 0.25% apiece between now and then, up from September of 2016's previous estimate of two rate hikes and a 1.1% median rate for 2017. Market participant consensus, as of this writing, calls for two rate hikes during 2017. Inflation by all measures is picking up. Add to this President Trump's plans for increased fiscal stimulus, and upside inflation could be surprising in the near term. If this forces the Fed's hand, we may see more rate hikes into a late-cycle economy, which may not bode well for fixed income markets. Furthermore, unpredictable election outcomes in France, Germany, as well as other geopolitical risks, such as "Brexit," will likely hold sway over the market going forward. Choppy waters may lie ahead. We believe the current environment of tight spreads, the potential for notably higher inflation, and increasingly hawkish Fed rhetoric place the risk-reward balance in favor of remaining where we are: shorter in duration and higher in quality.

However, economies have historically been known to overcome worries and continue on an upward trend for longer than what the consensus may expect. In fact, other developed economies have experienced extended economic expansions based on gross domestic product (GDP) growth. Australia, for example, has expanded for 297 months since 1991, while Canada experienced GDP upticks for 235 straight months from 1961 to 1981. In context, our current expansion since 2009 clocks in at 87 months without a recession. Despite recent experiences, markets do not tend to move in one direction or in a straight line forever. We structure our investment process around this fact and attempt to build portfolios that can persevere through many macroeconomic outcomes. We have the flexibility to make relative value decisions across our opportunity set and allocate only where and when we locate value within our mandates. While no investment process can completely immunize a portfolio, we pay attention to "the ride," and invest to smooth the potential volatility that can whipsaw investors. The latest market zig-zags and the resulting outcomes give us further confidence in our time-tested process.

Thank you for investing with us in Thornburg Strategic Income Fund.

Performance data shown represents past performance and is no guarantee of future results. Investment return and principal value will fluctuate so shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than quoted. For performance current to the most recent month end, see the mutual funds performance page or call 877-215-1330. The maximum sales charge for the Fund’s A shares is 4.50%.

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