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Inflation Protection with a Nice Payback

Certain fixed-income portfolios have stood out this year, given that bonds have delivered much better returns than many equity funds. One of them is the TIAA-CREF Bond Plus Fund (TIPBX), which has greatly benefited from its exposure to U.S. Treasury Inflation Protected Securities, otherwise known as TIPS. Lisa Black has been the lead portfolio manager of the $354 million fund since it began in October, 1997.

In the 12 months through Sept. 30, Black's fund gained 8.5%, while the average intermediate-term high-quality bond fund rose 6.73%. For the three-year period, the fund delivered an average annualized return of 9.5%, vs. 8.05% for its peers. The fund's benchmark, the Lehman Brothers Aggregate Bond Index, gained 9.48% over that period. Standard & Poor's recently upgraded its

overall rank for the fund to 5 STARS from 4.

Palash Ghosh and Daniela Valle of Standard & Poor's Fund Advisor recently spoke with Black about her fund's investing strategy, top holdings, and portfolio moves. Edited excerpts from their conversation follow:

Q: How do you construct the portfolio?

A: We use our benchmark, the Lehman Brothers Aggregate Bond Index, as a starting point for asset allocation. However, we are not an "index fund" per se. For example, we hold about 190 long-term securities, whereas the index has about 6,600 securities.

Q: What's your current asset allocation?

A: As of the end of the third quarter, we had 33.2% of our assets in government securities, which includes both Treasuries and agencies, vs. a figure of 34.6% for the index. We had 34.5% in mortgage-backed securities, vs. 37.7% for the index. We had 27.9% in corporate bonds, vs. 26.1% for the index. And we had 3.8% in asset-backed securities, vs. 1.6% for the index. We also had a 0.6% position in cash.

Although these exposures don't vary widely from the index, these absolute percentage figures don't fully reflect the nature of our holdings. For example, from a

duration basis, we have a significant underweight in agency securities, an 8% overweight in corporate bonds, and a 15% underweight in mortgage-backed securities. Thus, we can deviate significantly from the benchmark.

Q: What's your duration?

A: We tend to keep the fund's average duration within a very narrow range -- that is, plus or minus 5% -- relative to the index. At the end of the third quarter, the fund's duration was 3.8 years, vs. 3.9 years for the index. We make some bets around the

yield curve. Most of the year we've had more of a

"bullet" portfolio as opposed to a

"barbell", heavily overweighted to the intermediate part of the curve.

Q: What are your top individual holdings?

A: As of Sept. 30, our top 10 holdings were: U.S. Treasury Inflation-Indexed, 01/15/07 (16.83% of the fund); U.S. Treasury Inflation-Indexed, 01/15/08 (4.72%); U.S. Treasury Bond, 05/15/10 (4.35%); GNMA TBA, 10/15/31 (3.59%); Freddie Mac, 08/01/32 (3.53%); FNMA TBA, 11/25/31 (3.24%); FGLMC, 11/25/31 (2.70%); U.S. Treasury Bond, 05/15/30 (2.08%); FNMA, 07/01/32 (1.74%); and Freddie Mac 07/01/32 (1.71%).

Q: Do you avoid high-yield bonds?

A: By [our] prospectus, we can purchase high-yield bonds. Our high-yield exposure has been as much as 8% in the past. Currently, we have less than 1% in high-yield bonds.

Q: Why is your fund doing better than its peers?

A: 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 [Oct. 17], 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're not expecting the U.S. economy to enter a deflationary downward spiral.

Q: Assets have been pouring into bond funds as stocks and interest rates have declined. [Through the end of August, 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?

A: 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.

Q: Discuss your exposure to mortgage-backed securities.

A: 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.

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

A: 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 [holding]. 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.

Q: What's your outlook for the bond market?

A: 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.

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