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Bond Fund —
Harbor Bond outpaces index in Q2
2nd Quarter, 2014
"Central banks historically have raised their policy rates to a level that can be called the neutral monetary rate, reflecting a condition that is neither recessionary nor overheated. In the past we've seen a rate of about 4% but we believe that the new neutral will be closer to 2%. "
– Pacific Investment Management Company LLC

The Harbor Bond Fund posted a return of 2.26% for the second quarter of 2014, outperforming its benchmark, the Barclays U.S. Aggregate Bond Index, by 22 basis points, or 0.22 percentage points. The Fund also outpaced the index, a measure of the broad taxable U.S. bond market, for the 5-year and 10-year periods ended June 30, 2014, and since the Fund's inception in 1987. Bill Gross, managing director, chief investment officer, and founding partner of Pacific Investment Management Company (PIMCO), has managed the Harbor Bond Fund since its inception.
Factors contributing to the Fund's outperformance in the latest quarter included interest rate strategies in Spain, Italy, and elsewhere outside the U.S., exposure to non-agency mortgage-backed securities, investments in emerging markets debt, and an allocation to municipal bonds, PIMCO reports. A focus on the front end of the U.S. Treasury yield curve hurt performance relative to the index, as longer-dated bonds outperformed those with shorter maturities, PIMCO notes. Below-index exposures to mortgage-backed securities issued by U.S. agencies and to corporate credits also weighed on relative performance.
Although central banks will eventually begin to raise short-term interest rates as the global economy continues to recover, policy rates are likely to remain below historical levels over the next three to five years, in PIMCO's view. In terms of strategy, the investment team has moved portfolio duration close to that of the benchmark and has increased the Fund's exposure to corporate credits.
PIMCO’s comments were made in a July 14, 2014, interview. Highlights adapted from the interview appear below. All comments relate to the quarter ended June 30, 2014, unless otherwise indicated. All references to year-to-date are for the period January 1 through June 30, 2014.

Interview Highlights

Lower policy rates
Central banks historically have raised their policy rates to a level that can be called the neutral monetary rate, reflecting a condition that is neither recessionary nor overheated. In the past we’ve seen a rate of about 4% but we believe that the new neutral will be closer to 2%. Given the debt overhang and other slack in the system we believe that most central banks, including the Fed, will not be able to return to the old neutral rate of about 4%.
Flatter yield curve
We saw indications in the second quarter of investors beginning to embrace the view that policy rates could remain lower than historical norms. The Treasury yield curve flattened. Spreads between 2-year and 30-year U.S. Treasurys narrowed by 24 basis points over the quarter and this was driven mostly by 30-year Treasury yields declining 20 basis points.
Adding exposure to corporates
We have been underweight in corporate credits but we are paring that gap back over time. We have used shorter-dated credits in areas such as housing, finance, and energy in order to bring the credit exposure in the portfolio closer to that of the benchmark.
Mortgage-backed securities
We are going to be underweight in agency mortgages based on valuation concerns; they have rallied quite a bit and we have taken down some of our exposure to that sector. We have maintained an allocation to the non-agency sector, which we believe continues to provide incremental yield as well as relatively attractive valuations.
Mixed data
Economic data in the U.S. was mixed. First quarter GDP was revised downward to -2.9%, suggesting a heavier than expected impact from an unusually cold winter. On the other hand, the employment outlook improved as job gains stabilized to about 200,000 per month and U.S. employment returned to its pre-recession peak in May. Business investment showed positive signs of improvement and consumer confidence increased to its highest level in over six years.

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