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Real Return Fund —
Declining inflation expectations send inflation-linked bonds lower in Q3
3rd Quarter, 2015
"Falling commodity prices alongside weakness in China weighed heavily on global inflation expectations over the quarter. "
– Pacific Investment Management Company LLC

Investors saw a diminished chance of inflation during the third quarter of 2015 and sent inflation-linked bond prices lower. The inflation outlook was depressed by falling crude oil prices and signs of slowing growth in China. The Barclays U.S. TIPS Index fell -1.14% for the quarter, significantly underperforming the Barclays U.S. Aggregate Bond Index, a diversified benchmark of investment-grade bonds, which gained 1.23%.
The Harbor Real Return Fund fell -2.29% in the third quarter, underperforming the Treasury Inflation-Protected Securities (TIPS) index. The Fund invests primarily in inflation-linked bonds issued by the U.S. and other governments.
The Fund held an overweight position in longer-term TIPS, which proved detrimental to performance as real interest rates rose over the period. Smaller positions, including exposure to Mexican inflation-linked bonds and a short position in U.K. inflation-linked securities, also hurt relative returns in the quarter. On the plus side, the Fund benefited from exposure to Italian inflation-linked bonds.
PIMCO’s comments were made in an October 14, 2015 interview. Highlights adapted from the interview appear below. All comments relate to the quarter ended September 30, 2015 unless otherwise indicated. All references to the year-to-date are for the period January 1, 2015 through September 30, 2015.

Interview Highlights

Taking a Long-Term View
We don't believe that inflation expectations will turn vastly higher than they are today over the short-term. Obviously, the oil price decline this year has been a pretty big headwind. If the oil price continues to rise slowly from here, that could filter back into the inflation figures, but we don't expect that to dramatically change the inflation picture over the near-term. On a more secular horizon, we would expect inflation to start rising closer to the Federal Reserve’s 2% target, and we believe they have all the tools they need to get inflation closer to that mark. All that being said, what's important is what the markets are pricing into inflation-linked securities. If the market's view of future inflation increases, we expect our positioning to benefit from market value gains. We don't have to wait for the actual inflation data to arrive in order to gain from these positions. It can be achieved through price appreciation that results from a change in the market's view of future inflation.
Catalysts for Increased Inflation Expectations
We believe that current inflation expectations are colored by two things: global growth expectations, which took a confidence hit in the third quarter that we don’t think is warranted, and the decline in oil prices, which we also think is somewhat overdone. We don't expect oil prices to linger at the $45 or $47 mark where we have been in the past few weeks. Instead, we expect some production to come off-line, especially in shale here in the U.S. We expect the oil price to start to reflect that and eventually creep up closer to $60 per barrel in about a year or so, and we believe that will factor into inflation expectations.
Portfolio Positioning
The Fund’s positioning has not changed dramatically from the previous quarter. We continue to be underweight duration versus the benchmark. The Fund’s TIPS exposure is focused on maturities between five and seven years and to a lesser extent between 10 to 15 years. We find real yields and inflation expectations more attractive in these areas of the TIPS curve. We continue to hold a small off-benchmark position in long dated Mexican inflation-linked bonds. The Fund also has a slightly larger position in Italian inflation-linked bonds, reflecting the fact that the market is pricing in an inflation rate of about 0.9%, which we believe is too low.
Lastly, I would mention a change in currency positioning. We've maintained the long Dollar bias, but we trimmed the short positions in the Japanese Yen and Euro and added short positions on a basket of Asian currencies – the Singapore Dollar, Korean Won and Taiwanese Dollar – expecting the Dollar to continue to strengthen.

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