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Convertible Securities Fund —
Market volatility remained muted for most of the second quarter
2nd Quarter, 2016
"A bright spot from a portfolio activity point of view was the resurgence of the new issue calendar enabling us to opportunistically reposition industry weightings. "
– Shenkman Capital Management, Inc.

With improvement in energy prices and a somewhat routine first quarter earnings season, the market seemed content to consolidate first quarter gains. Market volatility remained muted until late in the second quarter of 2016, when the market focused on the upcoming Federal Reserve meeting and the uncertainty surrounding the improbable Brexit outcome. The Fund’s benchmark, the BofA Merrill Lynch All US Convertibles Ex Mandatory Index, returned 4.03% for the quarter. The broad stock market, as measured by the S&P 500 Index, returned 2.46%. Investment grade bonds, as represented by the Barclays U.S. Aggregate Bond Index, posted a return of 2.21%.
The Harbor Convertible Securities Fund generated a return of 2.27%, underperforming its benchmark. The Fund invests primarily in convertible bonds, which can be converted into common stock at a predetermined price. There has been a significant shift in performance drivers in the convertibles market. From 2012 to 2014, convertible securities with the most equity-like sensitivity—those with investment premiums of 80% or higher—drove returns. As a matter of style, the Manager tends to avoid convertible securities of this type as they have little to no bond-like characteristics and are closely correlated with underlying equity risk and volatility. Beginning in 2015, and certainly during the first half of 2016, the market shifted to reward more credit-oriented securities with a defined bond floor.
Three of the largest detractors from the Fund’s relative performance during the quarter were Molina Healthcare, Illumina and Palo Alto Networks. Molina, a managed care organization, reported disappointing quarterly earnings due to higher than expected costs and fewer realized synergies from recent acquisitions. The Manager will continue to closely monitor the company. Illumina, a leader in the manufacture of systems used in DNA sequencing technology, lowered its revenue growth forecast; however, the Manager believes their long-term investment thesis for the company remains in place. Network security solutions provider Palo Alto Networks posted disappointing earnings results. Three top contributors to relative results were Integra Lifesciences, Proofpoint and Dycom Industries. Integra Lifesciences, a provider of medical technology focused on surgical instruments, continued to demonstrate steady top-line and earnings margin growth. Proofpoint, a leading security solutions provider, has benefited from the growth of and emphasis on cybersecurity. Dycom, a specialty contractor for the telecommunications industry, has benefited from wireless infrastructure demand.
Shenkman Capital Management’s comments were made in a July, 2016 report. Highlights adapted from the report appear below. All comments relate to the quarter ended June 30, 2016, unless otherwise indicated. All references to the year-to-date are for the period January 1 through June 30, 2016.

Interview Highlights

Portfolio Activity During the Quarter
A bright spot from a portfolio activity point of view was the resurgence of the new issue calendar, enabling us to opportunistically reposition industry weightings. On the buy-side, we took advantage of benign market conditions, with an eye toward enhancing optionality, to swap into somewhat longer-dated tranches of several core positions. These included BioMarin Pharmaceutical, CalAtlantic Group,, Illumina, Siemens, Twitter, WebMD and Wright Medical Group. In addition, we added new positions in Empire State Realty Trust, diversifying our REIT holdings, and STMicroelectroncs and Integrated Device Technology, which increased and broadened our semiconductor exposure. We also purchased a new issue from Tutor Perini.
Market Outlook
We believe two of three upside accelerators that were present for most of 2009-2015 continue to be in place, with theoretical convertible valuations and equity improvement potentially acting as catalysts. With overall credit fundamentals firming due to improved corporate balance sheets and historically low default rates, we see potential for further overall spread compression, especially if fears related to macro-global concerns and energy sector fundamentals continue to stabilize. We expect convertible new issue activity to continue to pick up at any sign of a prolonged backup in the corporate and high yield calendars, as issuers look to take advantage of the opportunity to sell into the apparent supply and demand imbalance. We believe additional catalysts for convertible new issue activity could come from continued improvement in underlying equity prices, as well as potentially higher interest rates.

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