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High-Yield Bond Fund —
High yield market records solid gains for Q1, aided by falling rates
1st Quarter, 2014
"One theme our group has always maintained is: if you're taking a little extra risk, make sure you're getting paid for it. "
– Shenkman Capital Management, Inc.

High yield bonds generated competitive results for the first quarter of 2014, with the BofA Merrill Lynch US High Yield Index posting a return of 3.00%. By comparison, investment-grade bonds, as measured by the Barclays U.S. Aggregate Bond Index, returned 1.84%, while U.S. equities, as measured by the Russell 3000® Index, returned 1.97%.
The Harbor High-Yield Bond Fund closely tracked the index with a return of 2.91% for the three months ended March 31, 2014. Portfolio Manager Eric Dobbin reports that bonds carrying a single-B rating were the best performing area of the portfolio. Holdings in the media and cable industry provided the biggest contribution to relative performance, Dobbin notes, while portfolio returns in the oil and gas industry lagged behind those in the index.
At the end of the first quarter the duration of the portfolio was below that of the broad high yield market, a strategy designed to limit the Fund's exposure to rising interest rates, Dobbin reports. Although declining rates provided a favorable environment for the high yield market in the first quarter, he notes, a gradually improving U.S. economy along with the winding down of monetary stimulus could exert upward pressure on rates as the year progresses.
Eric Dobbin's comments were made in an April 14, 2014, interview. Highlights adapted from the interview appear below. All comments relate to the quarter ended March 31, 2014, unless otherwise indicated. All references to year-to-date are for the period January 1 through March 31, 2014.

Interview Highlights

Gradual improvement
Economic growth in the U.S. has picked up a little bit, as we anticipated. The first quarter may be mixed but it was affected by unusually severe winter weather. We expect to see GDP continuing to hum along in the 2% to 2.5% range. That should be a positive level for fixed income markets, in our view. It's not so fast as to foster out-of-control growth but fast enough that the companies we invest in can maintain solid cash flows.
Avoiding added risk
One caveat about the high yield market is that we believe it is not differentiating right now for risk. There's been a compression across double-B rated bonds, single-Bs, and triple-Cs in terms of the returns you can get. We think a lot of the lower-rated and more aggressive capital structures are not providing enough incremental return for the level of risk you are accepting. One theme our group has always maintained is: if you're taking a little extra risk, make sure you're getting paid for it.
Managing duration
As stimulus is withdrawn, that could put upward pressure on interest rates. In addition, we're calling for a stronger economy this year, which also could contribute to an upward bias in rates. One of the ways we're managing that risk is to keep the portfolio's duration inside that of the overall market. Right now, our duration is approximately 3.0 years, while the high yield market's duration is 3.6.
Historical valuations
Our view is that relative value for high yield is still acceptable. Yield spreads right now are about 400 basis points over Treasurys. That is below the historical average, which is closer to the high 500s. However, the historical averages typically occur alongside an average default rate of 3% to 4%, while current default rates are below 1%. We think there is room for spreads to tighten further, but at the same time we believe that high yield can deliver attractive returns without any additional spread tightening.
Recovery in Europe
One of the concerns we had six months to a year ago was that downside momentum in Europe would pick up and increase the default scenario. That hasn't occurred, and we now see Europe starting to turn a corner to positive GDP. It is still very depressed economically, but positive GDP is generally favorable for global trade flows and thus a positive for U.S. companies.

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.