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Real Return Fund —
Inflation-linked bonds decline but top investment-grade bonds
2nd Quarter, 2015
"The market's inflation expectations, as reflected in TIPS' values, are low relative to the Fed's target for inflation. That means that there is an opportunity for investors to buy real return bonds at a time when they are still relatively inexpensive. "
– Pacific Investment Management Company LLC

U.S. inflation-linked bonds lost -1.06% for the second quarter of 2015, as measured by the Barclays U.S. TIPS Index. The index tracks the performance of U.S. Treasury Inflation-Protected Securities (TIPS). By comparison, investment-grade bonds, as measured by the Barclays U.S. Aggregate Bond Index, dropped -1.68% for the quarter.
The Harbor Real Return Fund declined by -1.11% for the quarter, slightly underperforming the TIPS index. The Fund invests primarily in inflation-indexed bonds issued by the U.S. and other governments.
The Fund’s performance during the quarter was roughly in line with the index. Interest rate strategies contributed to performance during the quarter. In particular, positions designed to benefit from declines in the prices of long-term nominal Treasury bonds in the U.S., U.K., and Europe aided results. On the other hand, currency strategies, and in particular the Fund’s long position in the U.S. Dollar versus the Euro, detracted from results because the Dollar weakened due to uncertainty about the start and pace of interest rate hikes.
PIMCO’s comments were made in a July 15, 2015 interview. Highlights adapted from the interview appear below. All comments relate to the quarter ended June 30, 2015, unless otherwise indicated. All references to the year-to-date are for the period January 1 through June 30, 2015.

Interview Highlights

Economic Backdrop
The U.S. economy continued to show signs of strength over the second quarter. First quarter GDP was revised upward, nearly every labor market indicator pointed to sustainable growth, and we also saw high levels of consumer confidence. While Europe’s economy also showed signs of improvement, they were overshadowed by uncertainties surrounding Greece. Finally, China reported strong economic growth once more, especially relative to the rest of the world, but equity market volatility may prove to be a headwind for the Chinese economy. Bond markets exhibited higher volatility, and the overall backdrop was challenging for high quality bonds including inflation-protected bonds.
Negative Performance Overall
TIPS initially gained in April, primarily driven by a meaningful recovery in oil prices which pushed TIPS yields lower. However, the sector saw headwinds to returns in following months. TIPS yields generally followed nominal Treasury yields higher due to improving U.S. economic data. The prices of global inflation-linked bonds also fell alongside nominal government bonds as stronger economic releases in other developed markets led to increases in market yields. Overall, inflation-linked bonds outperformed nominal government bond counterparts as inflation expectations continued to increase.
Inflation View
In the immediate future, we expect that inflation will remain relatively muted. Over time though, we believe that global inflation will accelerate gradually from both goods and services inflation. Further, the Fed and other central banks would probably welcome a modest overshoot relative to their targets. We do not think deflation is likely in the next several years due to inflationary monetary policy actions by the major developed market’s central banks.
Low Expectations
The market’s inflation expectations as reflected in TIPS’ values are low relative to the Fed’s target for inflation. This means there is an opportunity for investors to buy real return bonds at a time when they are still relatively inexpensive. Additionally, inflation expectations for non-U.S. TIPS are lower still, making it attractive for the Fund to diversify beyond the U.S. TIPS market.
Portfolio Positioning
We continue to underweight duration versus the benchmark, with a slightly larger underweight in longer term bonds. We are holding tactical positions in Italian, Spanish, German, and New Zealand inflation-linked bonds in the developed world. This is driven by attractive yields and/or inflation expectations that appear too low to us. Additional off-benchmark positions include Mexican and Brazilian inflation-linked bonds and a long position in the U.S. Dollar relative to the Euro.

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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.