John L. Nichol and Joseph M. Balestrino, managers of the Federated Capital Income Fund, are outpacing the Standard & Poor's 500-stock index for the first time in five years by investing in European telephone companies and bonds.

Nichol purchased shares of Hungary's Magyar Telekom Rt., Eastern Europe's No. 2 phone company, and TDC A/S, Denmark's biggest phone company, for their high dividends. "The first thing we look at is valuation," Nichol said. Balestrino is focused on buying top-rated corporate bonds.

The Pittsburgh-based fund, formerly known as the Federated Utility Fund, was battered in 2001 and 2002 by the collapses of energy-trading company Enron Corp. and long-distance phone company WorldCom Inc.

The fund changed names and investment approach by eliminating restrictions that it focus only on gas, electric and telephone utilities. About 62 percent of the fund's $505 million was in fixed-income securities on Sept. 30 and the rest was in stocks.

"It's a completely different fund," said Arijit Dutta, an analyst at Chicago-based Morningstar Inc. "The bond side is what's made a big difference."

The Federated fund has risen 3.8 percent since the start of the year, exceeding the 3.3 percent advance of the S&P 500, including reinvested dividends. It rose at an average annual rate of 13.9 percent in the past three years, beating the 12.8 percent gain of the benchmark index and the returns of about 85 percent of competing U.S. "balanced" mutual funds tracked by Bloomberg.

Balestrino, 51, made money for investors this year from his bet that yields on 10-year Treasury bonds would rise more slowly than the Federal Reserve's benchmark lending rate. Since June 30, 2004, the yield on 10-year Treasury bonds has slipped a tenth of a percentage point, compared with the 3-percentage-point increase in Fed's overnight bank lending rate.

Balestrino started to unwind the trade last quarter before 10-year Treasury yields rose to a 16-month high.

He said he is shifting the fund's corporate-bond holdings to safeguard against shrinking corporate profit margins because of higher energy costs. About 24 percent of the fund's bond holdings were in "AAA" securities as of Sept. 30, up from 9 percent on Nov. 30, 2004. Bonds rated "BB," one notch under investment grade, are now 27 percent of bond investments, down from 45 percent.

"Our expectations for earnings growth aren't as positive as the rest of investors'," Balestrino said. "Margin pressures will show themselves in the fourth quarter or the first quarter because of rising costs."

Balestrino, a 19-year veteran of Federated's corporate-bond department, received a master's degree in urban planning from the University of Pittsburgh. Nichol, 42, started his investment career in 1992 at the Public Employees Retirement System in Ohio and joined Federated in 2000.

Nichol scouts for companies that pay large dividends relative to their stock price, and then determines whether their balance sheet and prospects for earnings growth suggest payouts may increase. He has devoted 12 percent of the fund's equity assets to telephone companies, four times their weighting in the S&P 500.

The dividend yield of the S&P 500 Telecommunications Services Index is 4 percent, making it the highest-yielding industry group in the S&P 500. The S&P 500 Utilities Index is the second highest, yielding 3.5 percent.

Nichol holds 192,000 American depositary receipts of Budapest-based Magyar Telekom, according to the fund's reports. The company, majority owned by Deutsche Telekom AG, has a dividend yield of 7.4 percent, higher than all but two companies on the S&P 500. Its ADRs closed at 22.45 each on Friday.

"They are growing in Eastern Europe where the regulatory environment, compared to the U.S., is very positive," said Nichol, who has met with the company's top executives twice this year. "And in Deutsche Telekom, I've got a watchdog looking over the company. There's also the potential they'll decide to go and buy them out."

Magyar Telekom's ADRs, which are the fund's eighth-biggest holding, have fallen 7.3 percent this year. On the Budapest exchange, Magyar's stock rose 3.1 percent in dollar terms in the same period.

Shares of TDC, Nichol's largest telecom holding, have risen 34 percent since the start of the year, fueled by takeover speculation. Two buyout firms have made bids to buy the Copenhagen-based company, the Wall Street Journal reported on Nov. 15. The rally in TDC's stock has reduced the company's dividend yield to 3.8 percent. It ended the week at 29.16.

Nichol also owns shares of SBC Communications Inc., the largest U.S. telephone company after buying AT&T Corp. SBC's planned $16 billion purchase of AT&T in January was followed two weeks later by Verizon Communications Inc.'s $8.44 billion deal with MCI Inc.

Consolidation "will be a huge benefit for cost reduction, and lowering the competitive environment in the enterprise market," he said.

SBC shares are down 7.6 percent this year, and Verizon's stock is down 23 percent.