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Real Return Fund —
Inflation-linked bonds post positive return for 2014
4th Quarter, 2014
"We believe that inflation will be relatively subdued throughout 2015, but we also expect that it will continue to rise thereafter, getting closer to the 2% target that the Federal Reserve has indicated over time. "
– Pacific Investment Management Company LLC

Inflation-indexed bonds produced virtually flat results for the final three months of 2014. The Barclays U.S. TIPS Index returned -0.03% for the fourth quarter and 3.64% for the full year. The index, which tracks the performance of U.S. Treasury Inflation-Protected Securities, returned 5.83% for the first six months of 2014 but lost ground in the second half of the year against a backdrop of falling energy prices and mild inflation.
The Harbor Real Return Fund returned -1.28% for the fourth quarter and 2.61% for the 12 months ended December 31, 2014, trailing the index. The Fund invests primarily in inflation-indexed bonds issued by the U.S. and other governments. It is managed by Mihir Worah and Jeremie Banet of Pacific Investment Management Company (PIMCO).
In the fourth quarter, portfolio positioning in U.S. and Eurozone inflation-linked securities detracted from Fund performance relative to the benchmark, the PIMCO team reports, as falling crude oil prices caused inflation expectations to contract substantially. A focus on the intermediate part of the TIPS yield curve aided relative performance, as did investments in inflation-indexed bonds in Australia, New Zealand, and Mexico. Currency strategies also helped, as the Fund benefited as the U.S. Dollar strengthened against the Euro and the Japanese Yen.
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


International exposure
European inflation-linked bonds sold off at shorter maturities as we saw softer inflation data and weakness in the energy sector. Italy, where we have some exposure, was less affected than other European countries as a change in index structure permitted inclusion of Italian and Spanish inflation-indexed bonds, prompting some increased demand there. U.K. inflation-linked securities diverged from the performance of those in Europe as assumptions of a delayed rate hike and a risk-off sentiment helped rates to rally. New Zealand and Australia also saw yields move lower across the majority of the curve.
Subdued inflation
With a backdrop of falling oil prices, inflation expectations have been declining across the board. That is driving some of the opportunities we see in the markets, especially in the real return segment right now. We believe that inflation will be relatively subdued throughout 2015, but we also expect that it will continue to rise thereafter, getting closer to the 2% target that the Federal Reserve has indicated over time.
Yield-curve positioning
We are moving the Real Return portfolio to an underweight duration of about a half year under the benchmark duration. We prefer the middle part of the curve, which tends to be the steepest and in our view offers the best compensation for the interest rate risk you're taking in the portfolio overall. We also believe that there are attractive opportunities at the longer end of the curve. The 30-year U.S. Treasury bond is currently pricing in a breakeven inflation level of roughly 1.7%. If you compare that against future inflation expectations, we believe there is some room there in terms of opportunity.
Rally in longer maturities
Inflation expectations in the U.S. fell as energy prices declined. This helped the rally on the long end of the U.S. nominal yield curve, while short-end rates moved slightly higher in anticipation of a rate hike by the Federal Reserve later in 2015. As a result, the yield curve should continue to flatten, as it did through most of 2014. The Fed has acknowledged gains across labor markets and does not appear to be much swayed by disinflationary forces or by weakness in international markets. This past quarter brought the end of its quantitative easing program and markets were pricing in the likelihood of a rate hike sometime in the middle of this year.

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.