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Real Return Fund —
Inflation-linked bonds edge lower in Q3; nine-month return remains positive
3rd Quarter, 2014
"We believe that inflation will increase modestly but will remain subdued in the short-term across the board in the global market. "
– Pacific Investment Management Company LLC

Inflation-indexed bonds retraced some of their earlier gains as the Barclays U.S. TIPS Index returned -2.04% for the third quarter of 2014. The index, which tracks the performance of U.S. Treasury Inflation-Protected Securities (TIPS), maintained an overall positive performance for the year, with a return of 3.67% for the nine months ended September 30, 2014. Rates increased across all maturities of U.S. TIPS, with the 10-year yield increasing by 26 basis points. Bond prices fall as yields rise.
With returns of -2.40% for the third quarter and 3.95% for the latest nine months, the Harbor Real Return Fund outperformed the index on a year-to-date basis, while lagging in the quarter. The Fund invests primarily in inflation-indexed bonds issued by the U.S. and other governments. It is managed by Mihir Worah of Pacific Investment Management Company (PIMCO).
Allocations to inflation-linked bonds outside the U.S., particularly Italy and the UK, helped Fund performance relative to the benchmark in the third quarter, the PIMCO team reports. Also aiding relative performance were a tactical exposure to non-agency mortgage-backed securities and currency positions that benefited as the value of the U.S. Dollar rose relative to the Euro and the Japanese Yen. Yield-curve positioning hurt relative performance as the portfolio was focused on the intermediate portion of the TIPS yield curve, where rates rose.
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

Mixed performance
TIPS underperformed like-duration Treasuries as inflation expectations in the U.S. declined. Elsewhere in the world, inflation-linked bonds in Europe and the UK fared better amid support from the European Central Bank and the Bank of England. Outside of Europe, inflation-linked securities had mixed performance; Latin American real yields increased given higher market volatility, while Australian inflation-linked bonds were relatively unchanged.
Modest inflation
There has been no significant change in our outlook for the next 12 to 18 months. We believe that inflation will increase modestly but will remain subdued in the short-term across the board in the global market. Inflation rates have been around 1% and we would expect them eventually to begin rising closer to 2% over the longer run. But in the short run our view is that we will continue to see low levels of inflation in both the United States and Europe.
Portfolio strategies
We are continuing to target a neutral duration versus the benchmark. We are positioning ourselves in the middle part of the yield curve, where the slope is steepest and therefore should provide the best opportunity for returns from roll down, the price appreciation that typically occurs as bonds approach maturity. We continue to hold inflation-linked bonds from Germany, Italy, Australia, and New Zealand, where we see potential for attractive real, or inflation-adjusted, returns. We hold some nominal, or non-inflation-protected bonds, from Spain and Slovenia, which are there to add yield to the portfolio. We also hold positions in Brazil as an out-of-index diversifier and as a source of incremental yield. We have some foreign exchange exposure in the portfolio, primarily designed to benefit from further weakening of the Euro and the Japanese Yen against the U.S. Dollar.
Continued ECB support
We expect slow growth in Europe, roughly 0.75% to 1.25%, for the next 12 months. The primary driver for this, in our view, will be the European Central Bank, which should continue to provide support through monetary policy, potentially including some form of quantitative easing. We don't expect substantial steps to be taken on the fiscal side.

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