Federated Manager Joseph Balestrino thinks corporates are a good bet.
As a financial advisor in the early 1980s, Joseph Balestrino learned that it often makes sense to rebalance the fixed-income side of a portfolio as economic conditions change. Like stocks, he says, bonds have different sectors that move in and out of favor.
Today, the 48-year-old manager of Federated Total Return Bond Fund thinks that the likelihood of a modest economic recovery later in the year makes this a good time to shift gears from ultra-safe Treasury securities into more adventurous fixed-income vehicles.
"Quality was king in 2002, but we don't think that will be the case going forward," says Balestrino. "What worked last year is not going to be what works this year. If I were a financial advisor, I'd be wary of Treasury bonds and looking at overweighting the bond side of a portfolio toward medium- and lower-quality corporate issues."
That viewpoint represents a departure from the safety-centric tone of last year's bond market, which rewarded the best-rated credits with the most attractive total returns among fixed-income sectors. Corporate accounting scandals, the threat of terrorist attacks, and a possible war with Iraq shattered confidence among investors, despite signs of an economic recovery, and sent them scurrying to the safety of Treasury bonds, mortgage-backed securities and government agency issues.
While rising bond prices and falling interest rates put most fixed-income sectors in solidly positive territory, with the Lehman Brothers Aggregate Bond Index up 10.26% for the year, the safest corners of the bond market fared best. Treasury bonds in the index rose 11.79%, compared with a drop of 1.41% for the high-yield bond component.
The turn of events proved a mixed blessing for the fund. On the one hand, the plunge in interest rates and its mandate to keep overall portfolio quality in investment-grade territory helped it end 2002 with a solid 9.1% total return for the year, some 1.2% higher than the average intermediate-term bond fund, according to Morningstar. The performance attracted investors, with assets rising from $560 million in January 2002 to $891 million a year later.
The longer-term picture has been strong as well. The fund's average annual return of 7.18% for the five years ending January 27 placed it in the top 13% of its category. A relatively benign annual expense ratio of 35 basis points for institutional-class shares, compared with 99 basis points for the category average, has kept the bite out of total return to a minimum over the years.
Yet the fund failed to beat its benchmark, the Lehman Brothers Aggregate Bond Index, in 2002. Balestrino attributes the underperformance to his decision to overweight corporate bonds relative to the index-in anticipation of an economic recovery-and underweight Treasury securities. "The corporate accounting scandals created price deterioration through the entire sector," says Balestrino, who started working at Federated in 1986 and has managed the fund since its inception in 1996. "The index was a very tough bogey to beat last year."
This year, improving earnings and credit quality, a moderating supply of new bonds, and a desire by investors for higher yields presents a different picture that Balestrino believes will lead to a switch in leadership between corporate bonds and Treasury securities. Although he doesn't expect a rollicking recovery, he believes that the U.S. economy will gradually pick up steam as the year progresses.
The war cloud hanging over Iraq could prolong the dominance of higher-quality issues, he cautions. "Until the picture of what will happen in Iraq comes into clearer focus, the demand for higher-quality securities could remain in place. If the conflict is resolved in a relatively short time, the market will begin reacting more directly to basic economic fundamentals."