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Convertible Securities Fund —
Market volatility tempered convertible returns in the fourth quarter
4th Quarter, 2015
"If the market continues to assimilate overall economic and political concerns, we expect the convertibles market will continue to focus on the growth attributes of the underlying equities. "
– Shenkman Capital Management, Inc.

For the year 2015, the convertible market return of -2.75%, as measured by the BofA Merrill Lynch All US Convertibles Ex Mandatory Index, has been resilient, with underlying equities returning -7.14%, underperforming both the S&P 500 and the Russell 2000® indexes. After the convertible market posted a return of 3.72% during the first half of the year as a result of continued earnings momentum and an increase in merger and acquisition activity, the second half of the year saw a reversal, which was likely due to a decided pickup in market volatility resulting from fears associated with a slowdown in the Chinese economy, weakness in commodity prices, global unrest, a changing Federal Reserve interest rate policy, and weakening of consumer sentiment resulting in a -6.23% return in the closing six months.
The Harbor Convertible Securities Fund generated a return of 0.17% for the fourth quarter, lagging its benchmark, the BofA Merrill Lynch All US Convertibles 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 index results were helped by strong performance of the most equity sensitive convertibles. This hurt the portfolio relative to the benchmark, because it had a 0% weighting in this sector. The Manager tends to avoid convertibles of this type as they have little or no bond characteristics and are closely correlated with underlying equity volatility.
From an industry perspective, areas that proved problematic for performance relative to the benchmark included lack of exposure to a security that performed strongly in internet software, an underweight to pharmaceuticals, and a holding in oil services that had a difficult quarter. The best performing industries for the Fund from an attribution standpoint were integrated oil, e-commerce, and diversified financials. An underweight to the poorly performing integrated oil group proved beneficial. In e-commerce, an overweight allocation and positions in two securities that performed well—vacation rental marketplace HomeAway, which was acquired by Expedia during the quarter, and China-focused travel site—added relative value. Having no exposure to the diversified financials group aided relative results as well.
Ray Condon’s comments were made in a January 15, 2016 interview. Highlights adapted from the interview appear below. All comments relate to the quarter ended December 31, 2015, unless otherwise indicated. All references to the year-to-date are for the period January 1, 2015, through December 31, 2015.

Interview Highlights

Positioned Properly for Market Volatility
Periodically, the thesis of why you invest in convertibles is tested. The broader thesis is that you're protected on the downside in a volatile equity environment. That proved to be the case last year and has also proven to be the case thus far this year. Year-to-date in 2016, convertibles have declined to a much lesser degree than the equity market as a whole. Currently, the convertible market is acting the way it's supposed to act, which is a good sign. In contrast to 2013 and most of 2014, when it seemed that anything you owned just went up, we're in a marketplace now where credit matters. As a priority, we look at credit first, with a focus on cash flow. In addition, in this volatile environment, portfolio positioning and security selection also matters. Stylistically we believe the Fund is well positioned to take advantage of the current market uncertainty.
Hoping for a Resurgence in New Issues of Convertibles
From a new issue point of view, generally speaking, last year was a tale of two cities. A strong new issue trend seen for most of 2013 through the first half of 2015 slowed dramatically during the second half of the year. Market volatility and uncertainty brought capital markets in the equity and convertible side to a virtual halt. If the trend of new convertible issuance resumes, we anticipate that new issuance could well exceed redemptions in 2016 for the first time in a calendar year since 2007. We typically expect convertible new issue activity to pick up at any sign of a prolonged backup in the calendar of high yield bond issues, which we're already beginning to see. In addition, if interest rates continue to rise as a result of Fed policy changes, we believe that could be an additional catalyst to increased issuance of convertibles.

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