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High-Yield Opportunities Fund —
Fourth Quarter Manager Commentary
1st Quarter, 2019
"We maintain a constructive outlook on below investment grade corporate credit. "

Economic Overview
After a disappointing end to 2018, the market rallied in the first quarter of 2019, supported by a shift in Federal Reserve (Fed) policy to a dovish tone, improved trade talks between the U.S. and China, and strong improvement in oil and equity prices. WTI oil rose 32%, ending the quarter at $60 a barrel, while the S&P 500 gained 13.65%. The market is now pricing in a Fed interest rate cut instead of additional hikes at the end of 2019, following similar action by other central banks around the globe as they adjust policy to an accommodative mode. Fund flows reversed trend and now stand at a positive $10.5 billion, according to Lipper. U.S. Treasury yields were much lower, as the 10-year Treasury note decreased by 27 basis points from the end of 2018 to 2.41% at the end of the first quarter. The U.S. high yield market benefited from the improved tone and generated its strongest first quarter performance in over 25 years, outperforming all other fixed-income asset classes.
Portfolio Review
In the first quarter of 2019, the Harbor High-Yield Opportunities Fund (Institutional Class) returned 6.88%, underperforming its benchmark, the ICE BofAML US High Yield Index (H0A0), which returned 7.40%.
All industry sectors participated in the market rally; specifically, the best performing sectors during the quarter were Energy (8.42%), retail (8.27%), and Financial Services (8.03%). The worst performing industries were transportation (+0.03%), automotive (+0.10%), and telecommunications (+0.56%). In terms of credit quality, all credit tiers generally performed in line with the overall market, with CCC-rated bonds leading the way with a return of 7.48%, BB-rated securities returning 7.40%, and B-rated assets returning 7.33% for the quarter.
The main driver of relative Fund underperformance was weak security selection in the Energy sector. Specifically, four of the five biggest detractors from relative performance were Energy names.
Despite better than anticipated results for the fourth quarter of 2018, EP Energy (Everest Acquisition Finance Inc.) bond prices were pressured on weaker than expected forward guidance for fiscal 2019 and subsequent concerns regarding the company’s liquidity and ability to deal with near-term maturities. Despite an improved commodity price environment in the first quarter, Sanchez Energy’s decision to materially reduce capital spending in 2019 and the resultant effect on production added to existing concerns about the company’s liquidity situation and ability to service its large debt burden. We have since sold our position in the company’s notes. Jones Energy bonds underperformed as the sharp sell-off in commodity prices during the fourth quarter pressured an already-strained liquidity position and eventually forced the company to enter into restructuring proceedings. The bonds of Welltec, a small energy services provider focused primarily on offshore drilling operations, were negatively impacted by the weakness in commodity prices in late 2018 and early 2019. We have exited our position in this security.
Additionally, Windstream Services bond prices materially declined after the company defaulted following the resolution of a long-running legal dispute with hedge fund Aurelius, which was unexpectedly decided in favor of Aurelius. The ruling created an immediate payment liability of $310 million that Windstream was unable to satisfy, forcing it to file for bankruptcy. Given the anticipation of a long and complex reorganization process, the Fund exited its position.
Conversely, the Fund benefited from strong security selection in capital goods, Real Estate and basic industry. The Fund maintained an approximate 2.5% position in cash, which also detracted from performance by about 16 basis points.
Among contributors to Fund performance, Kronos Acquisition bonds moved steadily higher during the quarter and recouped most of their late 2018 losses. The company announced a debt-financed acquisition in late 2018 that was initially viewed unfavorably by the market, which caused bond prices to drop sharply. However, that move appears to have been an overreaction as the company reported earnings for the fourth quarter in line with expectations. Talen Energy bonds outperformed as quarterly earnings continued to exceed expectations and guidance for full-year 2019 showed continued steady credit improvement.
Favorable sector-level developments were also a positive factor. Bombardier bonds rallied as the company reported quarterly results that exceeded expectations. The company’s bond prices also reacted positively as the new senior management team continued to successfully implement planned growth initiatives. Rackspace Hosting bonds recovered much of their late 2018 weakness following fourth quarter earnings that generally met expectations; the company also stabilized financial results and improved free cash-flow generation. CSC Holdings bonds rallied on the back of strong earnings highlighted by a decline in leverage due to strong free cash-flow generation.
From a credit quality standpoint, the Fund benefited from strong security selection in the BB-rated credit tier. However, this benefit was offset by weak security selection in the B-rated and CCC-rated credit tiers. We have been upgrading the credit quality of the Fund and have increased our exposure to the BB–rated credit tier by approximately 3%. We subsequently reduced exposure to the CCC-rated credit tier by 3.5%. The allocation effect of the repositioning has been neutral for the BB-credit tier and positive for the CCC–rated tier. All credit tiers generally performed in line during the quarter; as a result, the allocation effect has been muted. At quarter end, the Fund was underweight in CCC- and B-rated credit tiers and overweight in BB-rated credits.
Despite adding BB-rated credits to the Fund, we still maintained a shorter duration profile versus the benchmark by approximately five months. We have been closing the duration gap as we believe the Fed will pause on interest rate hikes in the next few quarters as a result of a tightening of credit conditions and signs of slowing economic growth.
We have been reducing exposure to commodity-related sectors and rotating into consumer noncyclical sectors. As such, the Fund has adopted overweight positions in the Financial Services sector (positive impact), technology and electronics (negative impact), and media (neutral impact) and underweight positions in basic industry (positive impact), Energy (negative impact), and capital goods (positive impact).
Outlook
We maintain a constructive outlook on below investment grade corporate credit. Interest rate concerns have subsided with a dovish pivot in Fed monetary policy, a positive development for credit assets, we believe. Fundamentals in the U.S. high yield space remain stable, with minor shifts in the fourth quarter of 2018; leverage levels were unchanged with a modest decline in interest coverage ratios. Earnings before interest, tax, depreciated, and amortization (EBITDA) growth continues to be strong but slowed slightly compared to the previous quarter. Continued strength in technical factors is also supportive of U.S high yield, we believe, as fund flows have reversed trend since last year and now stand at plus $10.5 billion. Following the deep fourth quarter 2018 sell-off, we believe valuations for the asset class look more compelling. Many sell-side analysts are forecasting mid-to-high single-digit returns in 2019 for U.S. high yield, and some have revised their forecasts upward, noting the improved return profile offered by the asset class after the year-end 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 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%-3.0% per year, there is neither concern about recession nor overheating in the near-term, we believe.

Performance data shown represents past performance, which is no guarantee of future results. Current performance may be higher or lower than the past performance data shown. Investment returns and the value of an investment will fluctuate, and an investor's shares, when sold, may be worth more or less than their original cost. You can obtain performance data current to the most recent month-end (available within seven business days after the most recent month-end) by calling 800-422-1050 or visiting harborfunds.com.

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.