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."

He also believes that corporate defaults will subside. Defaults impacted high-yield bonds most dramatically last year, but cast a pall over the entire corporate bond market.

The default rate for all corporate bonds reached a record 14% in 2002. "But since defaults are a lagging indicator, it is not necessarily unusual for default rates to stay stubbornly high even after a recovery begins," Mark Durbiano, Federated's high-yield bond specialist and fund co-manager, noted in a recent report. "On the plus side, most of the weak issuers of the late 1990s have been flushed out of the market. And with so many distressed bonds already gone, we think defaults could fall below Moody's forecast for 2003, which currently is about 8% on a par value basis."

Despite that outlook, high-yield bonds represent a small portion of the fund because of strict investment parameters that, while designed to limit investment risk, also limit allocation leeway. Federated Total Return Bond Fund's 200 or so holdings include a diversified mix of mostly investment-grade securities, including mortgage-backed bonds, investment grade and high-yield corporate bonds, U.S. Treasury securities, U.S. agency issues and a sprinkling of foreign bonds. Fund policy allows for deviation of no more than 50% from the benchmark's sector weighting.

Mortgage-backed securities account for 37.6% of assets, about even with the benchmark. Corporate bonds account for 35% of assets, compared with a 26% allocation for the Lehman index. Most of the fund's corporate bonds carry single-A and triple-B ratings from Standard & Poor's, which represent the lowest rungs of the investment grade spectrum. Balestrino says the positioning allows him to keep the fund true to its charter of keeping the portfolio in investment-grade territory, while reaping the higher yields these bonds offer compared with issues with top-tier credit ratings. Overall, the portfolio's weighted-average credit quality rates an A+ from Standard & Poor's and Aa3 from Moody's.

About 8% of the fund's corporate bond holdings are in lower-rated, high-yield bonds, close to its historic 10% maximum allocation. Because of slow investor demand and default jitters, junk bond prices are low and their yields unusually high, relative to investment-grade securities.

Historically, high-yield bonds tend to put on their strongest showing as the economy emerges from recession, and those returns can be powerful. Coming out of the last downturn, the Lehman Brothers High Yield Index gained about 75% on a total return basis over the three years ending in 1993.

Such performance may be difficult to repeat, since the powerful tailwind of falling interest rates during that period isn't likely to provide the same push in today's low interest rate environment. This time around, an improving economy could send interest rates higher, and put pressure on bond prices.

Under such a scenario, Treasury issues, which tend to be more sensitive to interest rate fluctuations than most other types of bonds, would feel the pinch of rising rates than most other sectors of the bond market. That potential threat, plus a belief in the potentially superior returns of corporate bonds over Treasuries this year, is one reason Balestrino has just 11.5% of fund assets invested in the latter sector, compared with the benchmark's 21% allocation.

He believes that certificates of deposit, commercial paper and other securities at the shortest end of the yield curve will likely see the biggest yield boost as the Federal Reserve raises the cost of borrowing slightly later in the year. Right now, the yield curve is unusually steep, with short-term rates at record low levels. Historically, a steep yield curve signals the bottom of a recession and indicates that economic improvement is on the horizon, he says.

"Generally, you can earn about 1.2% more moving from cash to five-year Treasuries," he says. "Now, the difference is 1.8%." Extending Treasury bond maturities from five to 30 years usually adds 40 basis points to yield, compared to a 195 basis point pickup today.

Investors can expect the yield curve to flatten in the coming months as short-term rates gradually lead the way up. Two-year Treasuries now yielding 1.65% will probably yield 3% by the end of the year, while 30-year bonds yielding 4.88% will only creep up another one-quarter to one-half of a percentage point, he predicts. Longer-term rates should remain relatively stable, with yields on 30-year Treasuries inching up one-quarter to one-half percent by year-end.