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Real Return Fund —
Q4 decline caps negative year for inflation-linked bonds
4th Quarter, 2013
"We're anticipating a very modest level of inflation in the United States, somewhere between 1.5% and 2%. "
– PIMCO Investment Strategy Group

Inflation-linked bonds lost ground in the fourth quarter of 2013 and posted a substantial decline for the calendar year. U.S. Treasury Inflation-Protected Securities returned -2.00% for the three months ended December 31, 2013, and -8.60% for the full year, as measured by the Barclays U.S. TIPS Index.
The Harbor Real Return Fund lagged slightly behind the index in the fourth quarter with a return of -2.11%. The Fund's full-year return of -9.20% also trailed the benchmark index. The Fund invests primarily in inflation-indexed bonds issued by the U.S. and other governments. It is managed by Mihir Worah, a managing director and portfolio manager of Pacific Investment Management Company (PIMCO).
The Fund had focus on the intermediate portion of the U.S. TIPS yield curve, which hurt performance relative to the benchmark in the fourth quarter as rates rose, the PIMCO team reports. Investments in inflation-linked bonds in Australia and Brazil also weighed on relative performance as yields rose in those countries. On the positive side, a small position in mortgage-backed securities added to relative performance, as did a below-benchmark exposure to longer-dated Treasurys.
PIMCO's comments were made in a January 16, 2014, interview. Highlights adapted from the interview appear below. All comments relate to the quarter ended December 31, 2013, unless otherwise indicated. All references to year-to-date are for the period January 1 through December 31, 2013.

Interview Highlights

Yield curve positioning
In the short and probably intermediate run, we don't anticipate massive changes in the level of TIPS rates or in the inflation expectations built into inflation-protected bonds. As a result, we see the short to middle part of the yield curve as the most attractive. That is where the curve is steepest, which means you are getting the best compensation for the interest-rate risk that's being assumed.
Price volatility
When you look at the positioning of the portfolio, we are trying to be underweight at the long end of the TIPS curve. We believe you are getting a lot of price volatility at the longest end of the curve without being compensated adequately for it.
Modest inflation
We're anticipating a very modest level of inflation in the United States, somewhere between 1.5% and 2%. Given a high level of unemployment and excess capacity in industry, we would not anticipate a huge amount of inflation pressure in the U.S. in the foreseeable future. In fact, if anything, the inflation measures that the Federal Reserve follows have been coming in at lower levels than anticipated.
International exposure
We continue to maintain out-of-index exposures to inflation-linked bonds in Australia, Brazil, and New Zealand. We think Brazil provides a very attractive level of real yields at this point in time. New Zealand securities could be added to the Barclays indices fairly soon, and we believe that could provide additional lift for the prices of those inflation-linked bonds.
Augmenting yield
We have very little in investment-grade credits, about 1.7% percent, and a small allocation to mortgage-backed securities, about 1.4% percent. They are there to provide additional yield to the portfolio and a little more diversification, as the vast majority of bonds in this strategy are in the inflation-protected segment.

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.