During the second quarter of 2019, market tone oscillated month-to-month, as headlines surrounding trade tensions, global growth, and the Federal Reserve (Fed) drove investor sentiment. An appetite for risk initially spilled over from the first quarter, as early economic indicators suggested a fairly healthy economy, with first quarter Gross Domestic Product ("GDP") coming in above expectations, at an annualized rate of 3.1%. However, escalating trade tensions amid threats of tariffs on Chinese and Mexican goods caused Treasury yields to fall sharply, by more than 0.30%, across the curve. The rate move coincided with the yield of the 10-year Treasury note falling back below the yield of the 3-month Treasury bill for the second time this year, potentially indicating that investors believe monetary policy is too restrictive. The Fed, acknowledging the escalating risks, commented that they would “act as appropriate to sustain the expansion.” These dovish comments led investors to price in at least one rate cut in 2019, and the market-implied probability of three cuts by year end rose to 60%. The yield curve ended the quarter inverted, with a 3-month Treasury yield of 2.09% and a 10-year Treasury yield of 2.01%.

In the second quarter of 2019, the Harbor Core Bond Fund (Institutional Class) returned 3.08%, matching the performance of its benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index, which also returned 3.08%.

Positive drivers of performance included the Harbor Core Bond Fund’s ("Fund") underweight to Treasuries and its overweight to corporates, namely within Financials and Industrials. Security selection within Small Business Administration bonds (SBAs), the Industrials sector, and agency residential mortgage-backed securities (RMBS) also aided relative performance. Detractors to performance included the Fund’s security selection within collateralized mortgage-backed securities (CMBS) and municipals, as well as the Fund’s overweights to SBAs and asset-backed securities.

From a credit quality perspective, the Fund’s underweight to AAA-rated securities and its overweight to BBB-rated securities contributed to relative performance.

Among non-index positions, the Fund’s out-of-benchmark allocation to SBAs detracted from performance. However, the security selection within SBAs contributed.

The largest contributors to Fund performance were Berkshire Hathaway Energy, KKR Group, and Anheuser-Busch InBev.

The largest detractors from Fund performance included Abbvie, New York State Urban Development Corporation, and JP Morgan Mortgage Master.

We added a seasoned credit risk transfer (SCRT) position to the Fund, which is a security made up of re-performing loans (RPLs). SCRT securities are backed by seasoned, 12-plus months of clean-pay RPLs and the timely payment of interest and principal is guaranteed by Freddie Mac.

We sold out of Juniper Networks during the quarter. Although gross leverage has remained resilient, Juniper continues to experience prolonged weakness.

In the second quarter, the most significant shifts in the Fund were a decrease to Treasuries with a corresponding increase in exposure to credit and to securitized bonds, mostly within RMBS. We added five RMBS securities during the quarter, a sector where our convexity advantage and security selection aided our relative performance. We expect this positioning will persist through the next quarter. However, if market weakness and volatility arises, as it did in April, we have ample liquidity and dry powder to take advantage of dislocations across the investment grade universe.

Entering the third quarter, investors will be paying close attention to the Fed for any signals surrounding the future path of yields and the number of potential rate cuts in 2019. Despite entering the 121st month of economic expansion – a new record – inflationary pressures remain muted and growth abroad appears to be slowing, which could bring about recessionary fears. Yet, even with global risks and a dovish Fed, expectations of lighter investment grade corporate supply in the summer months could provide a supportive technical backdrop for domestic bonds, potentially offsetting any broad market weakness. At Income Research + Management ("IR+M"), we remain steadfast in our approach as bottom-up security selectors.