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High-Yield Bond Fund —
High yield market posts gain for 2014 despite Q4 decline
4th Quarter, 2014
"The fundamental performance of our companies has been good. Earnings have been coming in on target. Our companies are predominantly U.S.-based, which has been very helpful. "
– Shenkman Capital Management, Inc.

Bonds issued by lower-rated U.S. companies declined in the fourth quarter of 2014 but registered a positive return for the full year. Speculative-grade bonds, as measured by the BofA Merrill Lynch US High Yield Index, posted a return of -1.06% for the quarter, as yields did not generate enough income to offset declines in security prices. For the 12 months ended December 31, 2014, the index returned 2.50%.
The Harbor High-Yield Bond Fund returned -0.79% for the fourth quarter, slightly outperforming the BofA Merrill Lynch US High Yield benchmark. For the full year, the Fund returned 2.11%, lagging the index. Portfolio Manager Eric Dobbin reports that a larger-than-index exposure to the cable industry and an underweight to metals and mining companies helped to boost Fund returns relative to the index for both the fourth quarter and the year. Below-benchmark positions in longer-duration securities and in BB-rated bonds hurt relative performance for both periods.
Looking ahead, Dobbin sees a favorable environment for the high yield market. Low interest rates, a growing U.S. economy, favorable supply/demand dynamics, and attractive yield spreads could provide a positive backdrop for high yield securities in 2015, he believes.
Eric Dobbin'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

Volatile market
It was a very strong year for Treasurys and a volatile one for the high yield market. Part of the volatility was driven by a collapse in commodity prices, and in energy prices in particular. It was an unusual environment in that the U.S. economy was doing very well, yet the commodities would tell you that economies globally are slowing. The interest rate environment remains one that would lead you to believe that growth is slowing, yet the U.S. is sailing right along.
Flight from risk
A real stratification took place in the high yield market, where higher-quality, long-duration paper did well, in line with the gains by U.S. Treasurys and in line with the solid U.S. economy, while riskier paper did poorly. There was a flight from the riskiest securities. BB-rated bonds, which have a longer duration, were up 5.3%, while single-Bs were up 1.3% and triple-Cs, at the low end of the high yield market, returned -2.57%. We tend to concentrate on the single-B space. We try to limit our exposure to volatility in the double-B sector of the market, associated with moves in Treasurys, and avoid the fundamental issues that triple-Cs can often have.
Domestic focus
The fundamental performance of our companies has been good. Earnings have been coming in on target. Our companies are predominantly U.S.-based, which has been very helpful. We’ve tried to avoid international or more global, cyclical-type companies because we see a continuation of stagnation in Europe. That’s a big-picture concern for us. We are also seeing a slowing in Asia as both Japan and China appear to be wrestling with difficult situations.
Oil and gas outlook
We think there will be a slight uptick in oil and gas bankruptcies but not as many as people think because a lot of these issuers are very well hedged. A lot of these companies have done an excellent job in hedging out 2015 and parts of 2016 and 2017, so their cash flows are much stronger than you would think. Many of them are taking steps that you would expect: cutting capital spending, cutting expenses, and devoting cash to increasing liquidity.
Attractive yields
Yield spreads between the high yield market and U.S. Treasurys ended the year at about 564 basis points, compared with 25-year averages of 580 to 585. Those averages include periods of severe distress in the marketplace and severe recessions in the U.S., so we see today's spread levels as very attractive from a historical perspective. We think they are attractive also when you compare them to the yields currently available from Treasury bonds, corporate bonds, and mortgage-backed securities.
Portfolio positioning
We think a higher quality, shorter-duration portfolio should do well 2015. I think consensus is calling for a mid-2015 rate hike by the Federal Reserve. Our view is that there is a high likelihood that there will be no rate hikes this year, and our portfolio is positioned for that with duration a bit lower than that of the index. We would look to increase some of our double-B exposure and move a little higher in the quality spectrum. We also are looking to reduce our exposure to cyclicals.

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