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Convertible Securities Fund —
Convertible market concludes 2013 with solid gain
4th Quarter, 2013
"The accelerators we've seen in the convertibles market over the last four years are still in place, in our view, with credit fundamentals continuing to firm as a function of improved corporate balance sheets and historically low default rates. "
– Raymond Condon

Convertible bonds posted a solid return for the fourth quarter, continuing their strong performance in 2013. The BofA Merrill Lynch All U.S. Convertibles Index, a measure of the convertible securities market, returned 6.06% for the three months ended December 31, 2013. For the calendar year the index returned 25.00%.
The Harbor Convertible Securities Fund returned 3.71% for the fourth quarter, lagging the index. The Fund invests primarily in convertible bonds, which can be converted into common stocks at a predetermined price. For the full year the Fund returned 12.22%.
Portfolio Manager Ray Condon reports that, relative to the index, the best performing industries in the portfolio in the fourth quarter were biotechnology, led by Illumina, and aerospace, led by Alliant Techsystems. The Fund also benefited from its lack of exposure to the automotive industry, which was subject to profit-taking and posted a negative return for the quarter. The worst-performing industries relative to the index were pharmaceuticals, semiconductors, and software applications.
The Fund typically has little exposure to convertible securities having a close correlation to the price of their underlying equity shares or to convertibles trading well above their conversion rate, Condon says. While this approach historically has helped limit downside risk, he notes, it hurt relative performance in both the latest quarter and the calendar year.
Ray Condon's comments were made in a January 15, 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

Favorable fundamentals
The accelerators we've seen in the convertibles market over the last four years are still in place, in our view, with credit fundamentals continuing to firm as a function of improved corporate balance sheets and historically low default rates. We see the potential for further spread compression as the yield curve could steepen further.
Rebalancing opportunities
We are constructive on equities although it is hard to envision a total replay of the straight-up equity market we saw in 2013. Any intermittent corrections would be welcome and would benefit our strategy, which depends upon the ebb and flow of the convertibles market to rebalance our portfolio appropriately.
Resurgence of growth
Historically, the convertibles market has been dominated by growth companies that tend to be debt averse. Most are in the small and mid cap range, and many are in the Information Technology and Health Care sectors. With the resurgence of economic growth in the U.S., many of those names have taken off.
Pickup in new issuance
The year 2013 saw a continuation of the pickup in new issuance activity, with 137 deals priced for a total of just under $44 billion. Despite $40.5 billion of redemptions for the year, new issues now have exceeded redemptions over the last 24 months by $6.4 billion. We believe this could be the beginning of a reversal of the trend of redemptions exceeding new issues that was in place between 2009 and 2011.
Portfolio strategies
We think of the convertibles market as having three broad zones. On the left is the yield alternative, or the defensive portion of the market. On the right is the equity alternative, consisting of securities that are “deep in the money,” or trading well above their conversion price. In the middle is the total return zone. As securities move across the zones and become more equity-like, we lighten those positions. We are constantly looking to pick up yield and defensive characteristics while at the same time creating an element of total return. The bulk of our portfolio, about 66% at year-end versus about 36% for the index, is in the total return zone. In the equity zone we had less than 3% compared with over 36% for the index.

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.