The Daily Interview: What's Happening in the Bond Market

Bonds are one of the few investment categories that have done well over the past year, so today's Daily Interview turned to Joe Balestrino, a senior vice president and senior portfolio manager with Federated Investors(FII Quote), a fund company known for its fixed-income expertise. Balestrino currently manages three bond funds for Federated: the (FEDBX Quote)Federated Bond fund, the (STIAX Quote)Federated Strategic Income fund and the (FTRBX Quote)Federated Total Return Bond fund.

Joe Balestrino Senior Vice President and Senior Portfolio Manager Federated Investors

Recent Daily Interviews

Lehman Brothers Steve Slifer

Venture Economics Jesse Reyes

Jeremy Lopez Morningstar

PricewaterhouseCoopers' Peter Petrusky

Dreyfus Peter I. Higgins

The Patricia Seybold Group's Patricia Seybold

Legg Mason Focus Capital's Robert Hagstrom

Balestrino says investment-grade corporate and Treasuries have continued to outperform, and that even though mortgage- and other asset-backed bonds have done well, the Fed rate cuts have now made him less confident about these investments.

TSC: Which fixed-income asset classes are performing well now and why? And how much of an effect have the Federal interest rate cuts had on the fixed-income securities in which you invest?

Balestrino: For sure, I would say the best is investment-grade corporate, and especially in the past two weeks the mortgage market has been doing very, very well. So, you have those two.

The laggards are probably your pure Treasuries and your high-yield market, sort of sitting there flat.

The outperformers are definitely a result of the surprise 50 basis-point cut, in that the marketplace is reading into that action that the Fed is going to be as aggressive as it has to be to get the economy back on its feet, which probably should imply two things. One, very directly, if the economy improves, corporate earnings should improve. This means that the corporate bond asset class just gets that much better.

The second is, if the economy is going to get back on its feet, it probably means that the bulk of the interest rate decline has already occurred. And usually, the mortgage market will do best in a more stable interest rate environment and not as good in a seriously falling interest rate environment. So refinancing should go down in that environment.

TSC: Prior to the recent rate cuts, were there any fixed-income asset classes that you were favoring in particular?

Balestrino: High-grade corporate, Treasuries and mortgages. The higher-quality spread products are where we are placing our bets at this point. We're sitting a little overweight on the U.S. agency market and the investment-grade corporate market.

In March we were underweight as a firm in the mortgage market. In the beginning of April, we moved that underweight to a pure neutral. What are left are basically asset-backed products, a fairly small market. We're neutral there, as well an in the emerging markets. Where we're underweighted is in the corporate high-yield, or junk bond, market.

TSC: What are the risks in fixed-income investing at this time? Perhaps corporate defaults in a weakened economy?

Balestrino: There's always the risk of default, and the headlines will continue to come out saying that default rates are rising. Especially in the high-yield market, the default rates are going up at a pretty alarming rate. There are projections that these defaults could reach as high as 10%. Last year, the default rate was at 4% to 5%.

So, even in an economy that may be bottoming, you are still going to have those companies that are having trouble and not able to pay their debt service from past years. But we think we are being compensated for it in the yields that are available.

TSC: Now that investors have faced the first bear market in 10 years, are you finding they have a renewed respect for more conservative investments like bond funds, and are you seeing your customer base expand beyond institutional and high-net-worth investors?

Balestrino: Federated has a diversified customer base. A lot of our customers come to us via bank trust departments. A lot of retail customers come to us through brokers.

In terms of their appetite for bonds, we've definitely seen that. In fact, Federated Investors as a company reported its first-quarter earnings on Thursday. Our money market group had explosive growth in the first quarter. Our bond group had decent growth, and our equity group was flat. I was surprised to see we didn't have much in shareholder redemption. Some big glamour names, like Janus, Putnam, AIM,and T. Rowe Price, are having big redemptions in their stock funds.

We haven't seen that because stocks as a percentage of assets at Federated are small. We've been a fixed-income shop historically.

But in recent weeks as the stock market has improved, we have seen the risk appetite come back a little bit. Our equity funds are getting a little bit of money for the first time in six months, and our bond funds are getting a little less money than we were accustomed to in the first quarter.

TSC: Not knowing what to do in the declining market, a lot of investors have been putting money into money market funds. Now that interest rates have come down, is that spurring interest in bond funds?

Balestrino: Definitely, because money funds experience an immediate impact on their yields when the Fed cuts rates. A typical money fund has 30 to 50 days maturity, and its yield will come down in a hurry, whereas bond funds will hold on to that yield quite a bit longer.

TSC: Do you believe the Fed has been acting as aggressively as it should?

Balestrino: I do. I've been a Fed proponent all along. I think they've done an outstanding job over the various business cycles since Greenspan has been in office following the crash of '87.

Have they been aggressive enough? Never has he cut 200 basis points in the span of four months. And they've put out verbiage to suggest that they will continue to do so, if need be. I think the market is reading the fact that this guy is going to be as aggressive as he feels he needs to be. I think they'll move again in May with another half point. If that doesn't happen, I think you'll see another major stock selloff. The bond market is in more equilibrium, but stocks need more help.

There's usually a nine- to 12-month lag between cuts and their effect on the economy, and I think we're probably halfway through that. By late this year, the economy should be moving up at a fair pace.