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Bond Fund —
Investment-grade bonds up 5.97% for 2014 after Q4 advance
4th Quarter, 2014
"We have added to our position in corporates over the past couple of quarters but we are still underweight, in particular in the Energy sector, which has been hit by the decline in oil prices. "
– Pacific Investment Management Company LLC

Investment-grade bonds gained ground in the fourth quarter of 2014, as the Barclays U.S. Aggregate Bond Index posted a return of 1.79%, reflecting price changes and interest payments. The index is a measure of the broad taxable U.S. bond market. By comparison, inflation-indexed bonds returned -0.03%, as measured by the Barclays U.S. TIPS Index, while speculative-grade bonds returned -1.06%, as measured by the BofA Merrill Lynch US High Yield Index. Investment-grade bonds also outperformed for the full year, as the Barclays U.S. Aggregate Bond Index returned 5.97% for the 12 months ended December 31, 2014, while the TIPS Index returned 3.64% and the high yield index returned 2.50%.
The Harbor Bond Fund posted returns of 1.63% for the fourth quarter and 4.78% for the year, lagging the index. Longer term, the Fund outperformed the index for the 5-year and 10-year periods ended December 31, 2014, and since the Fund's inception in 1987. The Fund is managed by Scott Mather, Mark Kiesel, and Mihir Worah of Pacific Investment Management Company (PIMCO).
Currency strategies helped Fund performance in the fourth quarter, as the portfolio was positioned to benefit from a strengthening U.S. Dollar against the Euro and Japanese Yen, the PIMCO team reports. Other positive contributors to performance relative to the benchmark included positions in U.S. agency mortgage-backed securities, an underweighted position in investment-grade corporate bonds, and security selection in high yield corporate bonds. In terms of international exposure, investments in Italy, Spain, and Mexico helped relative returns while positions in the United Kingdom and Brazil detracted. Yield curve positioning hurt relative performance as the Fund had an underweighted exposure to longer-dated bonds, which rallied in response to falling oil prices. Investments in U.S. Treasury Inflation-Protected Securities, or TIPS, also weighed on performance as inflation expectations declined during the quarter.
PIMCO’s comments were made in a January 14, 2015, interview. Highlights adapted from the interview appear below. All comments relate to the quarter ended December 31, 2014, unless otherwise indicated. All references to year-to-date are for the period January 1 through December 31, 2014.

Interview Highlights


Diverging policies
The fourth quarter saw an increase in volatility as oil prices plunged and economic growth prospects and monetary policy expectations continued to diverge in regions across the globe. While the United States enjoyed positive growth momentum and a central bank preparing to hike rates, other central banks expanded easing programs as global economies continued to see a divergence in their recovery. This divergence in policy also prompted a rally in the U.S. Dollar as the greenback was stronger against virtually all currencies in the fourth quarter, especially those of developed markets pursuing easing policies, like the eurozone and Japan.
Rising rates in U.S.
In terms of positioning the portfolio, we continue to maintain an underweight in duration relative to the benchmark. If you roll the clock forward about 12 to 18 months, we would expect the rate for the 10-year U.S. Treasury note to be about 50 to 75 basis points higher than it is today. Compared with the benchmark, the duration posture of the portfolio is about 0.4 to 0.5 years shorter. It is not a high-conviction position but a modest underweight in duration to reflect our views on interest rates.
Security selection
We have added to our position in corporates over the past couple of quarters but we are still underweight, in particular in the Energy sector, which has been hit by the decline in oil prices. We think the market is going to be driven largely by security selection, meaning that selecting the right securities is going to be more important in terms of adding value than being underweight or overweight in the corporate sector as a whole.
Currency strategies
Looking at differences in central bank policy, the Federal Reserve is tightening whereas the Bank of Japan and the European Central Bank are both expanding their balance sheets. In that environment, we would expect the Euro and the Yen to weaken in relation to the Dollar, which is what has happened over the past several months. We continue to maintain that trade; we are short the Japanese Yen and the Euro. That is a position that we think has potential to add significant value to the portfolio, as it did in the past quarter.
Overseas investments
In emerging markets, Mexico and Brazil continue to be areas where we perceive value. The portfolio has about a 4% position in Mexico and 5% in Brazil. In the European peripheral markets, we have exposure to Italy and Spain.

Performance data shown represents past performance, which is no guarantee of future results. Current performance may be higher or lower than the past performance data shown. Investment returns and the value of an investment will fluctuate, and an investor's shares, when sold, may be worth more or less than their original cost. You can obtain performance data current to the most recent month-end (available within seven business days after the most recent month-end) by calling 800-422-1050 or visiting www.harborfunds.com.

Performance figures discussed reflect that of the institutional class shares.

The views expressed herein are those of the portfolio manager at the time of the interview and may not be reflective of their current opinions or future actions.  These views are not necessarily those of the fund company and should not be construed as such.

This information should not be considered as a recommendation to purchase or sell a particular security and the holdings or sectors mentioned may change at any time and may not represent current or future investments.