Continued economic recovery in the U.S. and strong investor demand for incremental yield could create a favorable climate for the high yield market in 2012, in the view of Mark Flanagan, Portfolio Manager of the Harbor High-Yield Bond Fund. Flanagan expects demand to outpace supply in the high yield market in the months ahead due in part to inflows from investors outside the U.S.

Yield spreads between the high yield market and U.S. Treasurys widened considerably during 2012 although the high yield default rate remained low by historical standards, Flanagan notes. He sees this as a disparity that could prove advantageous to high yield investors.

The Harbor High-Yield Bond Fund outperformed its benchmark, the BofA Merrill Lynch High Yield Index, for 2011 with a return of 4.83% versus 4.38% for the index. The Fund returned 6.05% for the fourth quarter while the index gained 6.18%. The Fund benefited from a strong performance by its high yield bond holdings, which generated aggregate returns of more than 7% for the quarter. Leading contributors included holdings in the utility, cable, health care, energy, technology, and gaming sectors. Investments in bank loans and convertibles detracted from Fund performance, as these holdings lagged the high yield bonds in the portfolio, Flanagan reports.

Mark Flanagan's comments were made in a January 12, 2012, interview. Highlights adapted from the interview appear below. All comments relate to the quarter ended December 31, 2011, unless otherwise indicated. All references to year-to-date are for the period January 1 through December 31, 2011.

High yield default rates remained static at approximately 1.8% during the quarter, which is well below historical levels. While the default rate increased only marginally in 2011, high yield spreads, or the risk premiums for investing in the high yield sector, widened out significantly. We believe this spread-widening was excessive and clearly represents an opportunity for high yield investors.

Our outlook for the U.S. is GDP growth in the subpar range of 2% to 2.5% in 2012. One benefit of a modest rate of economic growth is that it would allow for the possibility of a retreat in global commodity prices. Clearly if inflation stays subdued it could benefit consumers. It also could allow central bankers to be accommodative for perhaps a more extended period, as they would not have to worry about inflationary fears.

The combination of a modest U.S. recovery and subdued investor expectations could allow for 2012 to develop into a year of pleasant surprises. We think more accommodative bank lending standards and continued doses of Fed liquidity should allow for a gradual strengthening of U.S. GDP, perhaps faster than the consensus growth rate of 2.2%. If the U.S. economy stays on track, we believe the high yield market appears poised for a year of solid performance in 2012.

Fund flows into the high yield asset sector should accelerate, we believe, given record-low interest rates worldwide and demand for incremental yield. We expect a strong year of supply in the high yield market but we don't think it will meet demand. Furthermore, we expect M&A transactions, which oftentimes can be a positive driver for high yield, to accelerate this year as more companies deploy their cash to pursue growth strategies. Finally, we would expect significant inflows from foreign capital coming into the U.S. market, to meet both diversification and safety objectives.

We're not that far beyond 2008 and 2009, when about 15% of the high yield market defaulted, so we feel that a lot of the weakest high yield issuers have been purged from the market. Moreover, we haven't had a significant increase in aggressive issuance or leveraging of balance sheets over the last three or four years; in fact, we've had quite the opposite. We've seen many companies improve their operations, build in flexibility, raise subordinated capital, and put cash on their balance sheets.