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Convertible Securities Fund —
The convertible market remained volatile during the first quarter of 2016
1st Quarter, 2016
"After an unprecedented six week near sell-off, the convertible market finished March on a positive note, thanks to a rally in energy and a strong earnings season. "
– Shenkman Capital Management, Inc.

After barely breaking even in the fourth quarter of 2015, the convertible market first dropped and then rebounded during the first quarter of 2016. In a sharp reversal starting in mid-February, after an unprecedented six-week near sell-off, the convertible market finished March on a positive note. However, the BofA Merrill Lynch All US Convertibles Ex Mandatory Index benchmark returned -2.56% during the quarter. The market turnaround was spurred by a rally in Energy and a relatively strong earnings season. The broad stock market, as represented by the S&P 500 Index, returned 1.35%. Investment grade bonds, as represented by the Barclays U.S. Aggregate Bond Index, gained ground, posting a positive return of 3.03%.
The Harbor Convertible Securities Fund generated a return of -1.04% for the quarter, faring better than its benchmark, the BofA Merrill Lynch All US Convertibles Ex Mandatory Index. The Fund invests primarily in convertible bonds, which can be converted into common stock at a predetermined price. Portfolio Manager Ray Condon reports that there was a decided shift in the makeup of the performance drivers in the convertibles universe. From 2012 to 2014, convertibles with the most equity-like sensitivity — that is, investment premiums of 80% or higher — drove the majority of returns. As a matter of style, the Manager tends to avoid convertibles of this type, believing that they are too closely correlated with underlying equity risk and volatility.
According to Condon, the Fund’s best performing industries during the quarter were semiconductors, biotechnology and pharmaceuticals. The primary driver of relative outperformance was the Fund’s underweight to the semiconductors group. Deft stock selection in this industry was also a key contributor, as its zero exposure to Micron and Sun Edison, both down for the period, proved beneficial. An out-of-benchmark allocation to NXP Semiconductors also boosted relative returns. In biotechnology, the Fund’s security selection was particularly helpful, as the lack of exposure to the poorly performing Incyte Corporation was additive. Similarly, the Fund benefited from positive stock selection and an underweight allocation to the poorly performing pharmaceuticals group. The health equipment and supply, food, and software applications industries were key detractors during the period.
Ray Condon’s comments were made in an April 14, 2016 interview. Highlights adapted from the interview appear below. All comments relate to the quarter ended March 31, 2016, unless otherwise indicated. All references to the year-to-date are for the period January 1 through March 31, 2016.

Interview Highlights

Shifting Profile of Convertible Valuations
The profile of the underlying convertible valuations that has resembled the very equity-like condition over the last several years has continued to shift. In addition to recent market volatility, influencing factors for this shift could be the influx over the past year of multiple new issues — which tend to be balanced, meaning they have a medium sensitivity to changes in the underlying equity — and the retirement of very equity-like issues. However, despite the recent trend, we believe the more equity-like conditions will likely continue to persist. As the market continues to assimilate overall economic and political concerns, we expect to see the convertible market continuing to focus on the growth attributes of underlying equities, given the overall fundamental stability and credit in the marketplace. We also anticipate that the continuance of the recent pickup in volatility will provide market participants with multiple entry and rebalancing opportunities. We took full advantage of that phenomenon during the first quarter.
Market Outlook
From an outlook point of view, what we see as positive drivers for convertibles continue to be in place. Key drivers would be improving the underlying equities for the convertible index, which has dramatically underperformed this year, and returning to fair market value. With overall credit fundamentals and corporate balance sheets continuing to improve, and with continued low default rates outside of energy, we see the potential for spread compression — meaning demand could drive yields lower and prices higher — as fundamentals begin to stabilize.

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