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High-Yield Opportunities Fund —
Fourth Quarter Manager Commentary
2nd Quarter, 2019
"We maintain a cautious but constructive outlook on below investment grade corporate credit. "

Market in Review
The U.S. high yield asset class fared well during the second quarter of 2019, delivering a 2.57% return as measured by the ICE BofAML US High Yield Index. The asset class was supported by a dovish Federal Reserve, continued labor market stability, low inflation, and better than expected first quarter earnings. At the same time, the market contended with persistent trade-related concerns about the U.S. and its trading partners and slower growth data, which led to lower Treasury yields, stock prices, and oil prices in May. Specifically, West Texas Intermediate (WTI) oil prices fell 2.8% during the quarter, ending at $58.50 a barrel. U.S. Treasury yields were much lower compared to the end of the previous quarter: the 10-year yield decreased by 40 basis points and the five-year decreased by 47 basis points to end the quarter at 2.01% and 1.77%, respectively. Harbor High-Yield Opportunities Fund ("Fund") flows were slightly negative for the quarter at $300 million, after recovering from a weak May, when the market saw outflows of $4.7 billion. New issuance was strong in the second quarter, totaling $75.2 billion. For the year-to-date period, gross new issuance now stands at $140.5 billion, which is up 11% year-over-year.
We maintain a cautious but constructive outlook on below investment grade corporate credit. Rate concerns subsided with a dovish pivot in monetary policy from the Fed, a positive development for credit assets. The market is now expecting two to three rate cuts by the Fed in the second half of 2019.
Portfolio Performance
In the second quarter of 2019, the Harbor High-Yield Opportunities Fund (Institutional Class) returned 2.96%, outperforming its benchmark, the ICE BofAML US High Yield index, which returned 2.57%.
The main driver of outperformance was the Fund’s significant underweight position in the Energy sector. Energy was the worst performing sector during the second quarter, with a -0.84% return, while all other sectors delivered positive returns. Additionally, the Fund benefited by avoiding defaulted issues of Weatherford International and Sable Permian Resources as well as issuers whose bonds sold off materially during the quarter, such as Halcon Resources, Sesi LLC and Covey Park Energy.
The Fund also benefited from strong security selection in several other sectors and industries, such as Financial Services, capital goods, Utilities, consumer goods, Information Technology, electronics, and basic industry. Conversely, the Fund’s performance was adversely impacted by weak security selection in the Real Estate and Health Care sectors. From a credit quality standpoint, the Fund benefited from strong security selection in the CCC-and-below credit tier by avoiding the defaulted issues of Weatherford International. The Fund also exhibited strong security selection in the BB-rated credit tier.
Portfolio Positioning
The Fund’s duration position was previously longer than the benchmark by approximately two months. We have been closing the duration gap between the Fund and the benchmark for the past few quarters and now maintain a market-neutral duration position. We believe the Fed may cut interest rates in the next few quarters as a result of a tightening of credit conditions and signs of slowing economic growth.
Regarding sector and industry positioning, the Fund is overweight media, which had a positive impact on Fund performance, Financial Services (positive impact) and consumer goods (positive). We believe these areas exhibit favorable fundamentals and good relative value. The Fund is underweight basic industry, which had a negative impact on performance, Energy (positive) and banking (negative). We believe these market segments exhibit fundamental challenges and poor relative value.
From a credit quality perspective, the Fund is overweight the BB-rated credit tier (positive impact on performance) and underweight B-rated securities (neutral impact) and CCC and below (positive). Credit quality exposures are a result of our bottom-up research process, our view on the relative value offered by different credit rating tiers, and our duration positioning.
The Fund’s exposure to the investment grade tier had a positive impact of about 1.3%.
Contributors and Detractors
Among contributors, Sprint bonds rallied as optimism increased around the likelihood that its planned merger with T-Mobile will receive regulatory approval if certain negotiated concessions are agreed upon. However, trading in the name has generally been volatile on a year-to-date basis as the market reacts to various news headlines regarding the status of the deal.
Springleaf Finance bonds outperformed, driven by strong first quarter 2019 earnings results, coupled with a continued positive macroeconomic backdrop for the consumer and an increasingly accommodative rate environment, which bodes well for the company’s net interest margin and consumer finance business.
Sunoco bonds rallied as earnings exceeded expectations on the back of strong volumes and increasing profit margins driven by lower crude prices. Management expects to see continued favorable gasoline margins throughout 2019.
Realogy bonds have been weak after the company posted first quarter results that were below already subdued expectations and management alluded to lower than expected volumes and increased competitive pressures.
Polaris Intermediate (dba MultiPlan) bonds sold off largely on concerns that the Lower Health Care Costs Act of 2019 and President Trump’s executive order on pricing transparency could cause downward revenue and margin pressure on the Health Care sector.
Mallinckrodt bond prices came under pressure due to general weakness within the overall pharmaceutical subsector as well as idiosyncratic concerns relating to reimbursement risk associated with one of the company’s primary drugs.
Buys and Sells
With bond spreads more than two standard deviations wider than historical ranges, we opted to increase exposure to Reynolds Packaging Group (Pactiv LLC), as we believe the weakness in earnings witnessed in late 2018 was transitory and would ease as the company successfully implemented planned cost-cutting measures to improve margins. We added to the position over several trades during the quarter at prices in the $103 range. Bond prices subsequently rallied to close the quarter in the $109 range as spreads tightened back towards historical averages on improved earnings and sentiment. The security was the fifth best contributor to the Fund’s quarterly returns, at 4.8 basis points.
Although Energy was one of the top performing sectors during the first quarter, we continue to hold a bearish longer term view on the space and used the rally to opportunistically reduce exposure in several names. For example, we opted to exit our exposure to Weatherford in April, selling the bonds over two trades priced at $67.50 and $66.50, respectively. The company’s 2022 bonds had been one of the top performing bonds on a year-to-date basis, but after we sold our position the company announced it would be preemptively filing for Chapter 11 bankruptcy protection to restructure its over-levered balance sheet. The company’s entire capital structure subsequently traded down to the estimated recovery value of $50.00.
We maintain a constructive outlook on below investment grade corporate credit. Rate concerns have subsided with a dovish pivot in Fed monetary policy, a positive development for credit assets. The market is now expecting two to three rate cuts by the Fed in the second half of 2019. Fundamentals in the U.S. high yield space remain stable with only minor signs of weakness. Specifically, in the first quarter, leverage ratios increased for the first time in 10 quarters to 4.08 times, but still remain below historical averages while improving in 10 out of the last 11 quarters. Revenue and earnings before interest, tax, depreciation and amortization (EBITDA) growth was positive year-over-year but began showing signs of deceleration. Continued strength in technical factors is supportive of U.S high yield as fund flows have reversed trend since last year and now stand at a positive $10.2 billion year to date. Following the deep fourth quarter 2018 sell-off, valuation for the asset class looks more compelling, we believe. Many sell-side analysts are forecasting high single-digit returns in 2019 for U.S. high yield while some have revised their forecasts upward, noting the improved return profile offered by U.S. high yield following the year end 2018 spread widening. Major rating agencies project defaults to come in below 3.0% in 2019, well below the historical average of 4.6%.
We do not foresee any major fundamental concerns for the asset class. Risks to our view include unexpected Fed rate actions, a potential peak in corporate earnings growth, oil price volatility, and rising risks of a global trade war. At present, a continuation of the status quo for the U.S. economy seems most likely, in our view. With Gross Domestic Product (GDP) growth of 2.0 to 3.0% per year, there is neither concern for recession nor overheating in the near-term, we believe.

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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.