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Bond Fund —
U.S. bond market up slightly in Q3 as investors exit riskier assets
3rd Quarter, 2014
"Risks to the U.S. economy remain predominantly external, as continued weakness in Europe or Japan could potentially derail some of the U.S. prospects. "
– Pacific Investment Management Company LLC

The third quarter of 2014 saw a divergence in market sentiment from the first half of the year as geopolitical events fostered increased uncertainty, causing most risk assets to struggle. U.S. Treasurys rallied, driven by geopolitical tensions, helping the Barclays U.S. Aggregate Bond Index to post a slightly positive return of 0.17% for the quarter. The index is a measure of the broad taxable U.S. bond market. Inflation-indexed bonds and commodities lost ground, given declining inflation expectations and a stronger U.S. Dollar.
The Harbor Bond Fund posted a return of -0.37% for the quarter, lagging the index. Longer term, the Fund outperformed the index for the 5-year and 10-year periods ended September 30, 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 proved to be a positive contributor to Fund performance in the third quarter, the PIMCO team reports, as the portfolio was positioned to benefit from the growing strength of the U.S. Dollar against the Euro and Japanese Yen. Other factors helping relative performance included an exposure to non-agency mortgage-backed securities and a smaller-than-index allocation to corporate credits. A focus on the short-to-intermediate part of the yield curve weighed on Fund performance relative to the index, as shorter-maturity yields rose while yields declined at the long end of the curve. Bond yields and prices move in opposite directions. Investments in emerging markets debt, inflation-linked securities, and municipal bonds also detracted from relative returns.
PIMCO's comments were made in an October 15, 2014, interview. Highlights adapted from the interview appear below. All comments relate to the quarter ended September 30, 2014, unless otherwise indicated. All references to year-to-date are for the period January 1 through September 30, 2014.

Interview Highlights


Monetary and fiscal support
In the U.S. we expect growth in the range of 2.5% to 3%, the highest in the developed markets. This reflects a variety of efforts to provide monetary and fiscal support, which have helped spark some of the brighter spots in the U.S. economy, such as housing, energy, and finance. Risks to the U.S. economy remain predominantly external, as continued weakness in Europe or Japan could potentially derail some of the U.S. prospects.
Duration strategy
We are going to be slightly underweight the benchmark duration, focusing on intermediate maturities, where we continue to see benefits from a steeper yield curve and therefore higher returns from roll down, the price appreciation that occurs as fixed income securities move closer to maturity. We will continue to be underweight the long end of the curve, an area that we believe does not provide enough return potential to compensate investors for a higher degree of volatility.
Mortgage-backed bonds
We are underweight mortgage-backed bonds issued by U.S. government agencies. This is based on what we regard as relatively rich valuations, especially in light of the Fed's plan to discontinue its monthly purchases of agency mortgages at the end of October. We continue to hold non-agencies, which in our view provide an attractive amount of spread and yield for the portfolio.
Adding select corporates
We are currently underweight in the corporate sector but have been adding to short-dated corporate credits, especially in sectors such as housing, finance, and energy, which in our view have good prospects and high barriers to entry, providing them with an ability to potentially raise prices in the near future. We continue to hold TIPS, or Treasury Inflation Protected Securities, as part of the portfolio, as a hedge against inflation. And we are investing in emerging markets, mainly in Mexico, to provide incremental return for the portfolio.
Growing economies
The Fund's emerging markets allocation has remained relatively stable. We increased it modestly, from about 8% at the end of June toward 10% at the end of September. From our perspective, emerging markets still provide the best opportunity for economic growth because of favorable demographics and because of the lower levels of debt to GDP that most of these countries have.

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.