Lisa Black of TIAA-CREF Bond Plus Fund

BLACK: I would cite three main reasons. Firstly, we have a very strong credit culture here. We use a team of about 20 credit analysts following both investment-grade and below investment-grade securities. The fund has an average credit quality of AA-1.

Secondly, the fund has low expenses. And given that returns from bond funds don’t gyrate dramatically, low costs certainly help our performance.

Finally, from the perspective of portfolio fundamentals, we have had a significant position in U.S. Treasury Inflation Protected Securities, otherwise known as TIPS, which have been the best-performing asset class of fixed-income securities this year. We accumulated an approximate 8% position in TIPS at the end of 2001, and then we sold it in March 2002 after they had performed extremely well. Then we repurchased TIPS in the summer, and they now represent about 15% of the fund’s assets. The break-even inflation rates on these securities still merit holding onto them.

For those TIPS which mature in 2007 and 2008, this morning, the break-even inflation rates are 1.27% and 1.22%, respectively. If you look at the 12-month annualized inflation rate, it’s at about 1.81%. So, we think TIPS are still undervalued. We are not expecting the U.S. economy to enter a deflationary downward spiral.

S&P: Assets have been pouring into bond funds as stocks and interest rates have declined. [Through the end of August this year, taxable bond funds had already received about $88.7 billion in net new cash flow.] Has your fund received a huge cash inflow this year?

BLACK: We are a direct-sold fund, and we haven’t really seen a dramatic increase in net assets. We started the year with about $285 million in net assets.

S&P: Discuss your exposure to mortgage-backed securities.

BLACK: We began the year with an overweight in mortgage-backed securities, but we started reducing our exposure in July. Mortgage securities delivered very strong performance in the first half of the year, relative to similar-duration Treasuries on an excess-return basis. But as interest rates continued to fall and prepayments came in at very high levels, we felt that mortgages would have a tough time continuing those good returns, so we pared it back a bit to an underweight position.

S&P: What kind of exposure do you have to foreign corporate bonds?

BLACK: We have only about 1%, and those are mostly in higher-quality sectors in Mexico and Canada, and these are dollar-denominated securities. Foreign bonds have never been a large portion of our assets.

S&P: How do you answer people who say this is a bad time to buy bond funds because interest rates will surely rise next year?

BLACK: If investors expect interest rates to rise, they would probably better off in shorter-term bond funds. But we have a significant position in higher-premium mortgage-backed securities, which should perform well regardless of a rise in interest rates. Our most powerful hedge against a rate rise is our TIPS. If rates rise because inflation concerns heat up, TIPS will protect the investors by virtue of having the principal value adjusted every month relative to the monthly changes in the Consumer Price Index.

S&P: What is your outlook for the bond market?

BLACK: Looking at it broadly, when the economy improves, interest rates generally rise and bond funds will obviously have a tough time. Although they have a coupon cushion for any price decline, if bond yields rise more than 100 basis points, you may see very low absolute returns from bond funds.

With respect to the corporate market, we have seen, and will likely continue see, companies experiencing stress, particularly in sectors such as telecom, energy and autos. We are cautious about the corporate bond market, and therefore we’ve had a modest overweight in corporate bonds. If things start to stabilize on the economic front, we would probably add more exposure in high-yield bonds, since they tend to perform quite well when the economy comes out of a recessionary environment.