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Socially Responsible Bonds

by Stephen Taub

Can you still make money in junk bonds?

So far, the answer seems to be yes.

Junk bonds surged on average by 28% in 2003 and are off to a strong start this year, climbing 2% through the first two weeks of this year, according to Merrill Lynch, topping all other US fixed income asset classes.

Among the reasons: The economy continues to strengthen, the default rate is plunging and investors recently added money to junk bond mutual funds for the 11th straight week, further fueling demand.

Even so, experts warn investors not expect to enjoy similar returns as those racked up last year. ?With yields so low and spreads so narrow, it will be difficult for either the investment-grade or high-yield market to follow up on the gains of last year,? warns Merrill fixed-income strategist Martin Mauro.

And, with the economy strengthening, there is that underlying concern that interest rates will begin to move up from their 45-year lows.

Even so, Mauro stresses he is not negative on the corporate market, primarily because the underlying fundamentals are positive. ?Corporate balance sheets are improving and we expect healthy gains of 4.3% in real GDP and 15% in S&P 500 operating earnings,? he explains.

Adds a recent Morgan Stanley report: ?It?s (junk bonds) the best house on a bad block.?

One person who is taking a cautiously optimistic approach is Diane Keefe, the manager of the Pax World High Yield Bond Fund, the only socially-conscious junk bond fund.

First of all, about a quarter of her 70 holdings are made up of BB-rated companies, with the rest concentrated among Singe-B paper. And many of those are what she believes are BB quality, even though the rating agencies don?t seem to agree.
She is also seeking companies that are de-leveraging position. ?We watch them like a hawk,? Keefe stresses.

Keefe is also currently avoiding virtually all new issues, since most of them were priced too tightly due to the recent strong rally in junk and distressed securities. She also doesn?t want to be stuck with these lower yields should rates rise.

Rather, she has shortened her maturities. Of her top 20 holdings, nine mature between 2006 and 2009. They all have high coupons that can be called.

Her plan: As this paper is called away, she?ll reinvest the proceeds in higher yielding bonds going forward rather than be stuck with the lower-rated new issues.

?If rates stay stable, it?s not probable there will be big returns going forward, so it?s important to select healthy companies,? warns Keefe, noting that her fund?s current yield is around 5.8% and Citicorp is only looking for 6-8% total returns for the year.

Indeed, she cautions that some of the high-yield bonds that did especially well in 2003 are overvalued landmines for 2004 and notes that her fund will not participate in this speculative buying. "The rating agencies still have whole industries on watch for downgrade, not upgrade," says Keefe. "The quality of financial reporting is still questionable--it remains to be seen whether these companies are as good as the prices of their bonds suggest."

One silver lining: The global speculative default rate has fallen to around 3.4%. ?Traditionally, when the default rate falls or stays stable, there are positive returns in the high yield bond market,? she adds.

Indeed, she stresses companies that refinanced their debt in 2003 have been able to lock in low long-term rates that will improve their cash flow after debt service, which will cause their high-yield bonds to be more appealing.

The Pax World High Yield Bond Fund?s charter prohibits investments in the unusual cast of sin companies?tobacco alcohol, military contractors that produce weapons and gaming. ?About 28% of the companies are rejected on social grounds,? she acknowledges.

Even so, it racked up better than a 16% return in 2003. Although this was seven percentage points fewer than the group as a whole, it was the first time in its more than four-year existence that it lagged its peers.

Keefe singles out four high-yield bonds of socially responsible corporations that her fund currently owns.
St. John's Knits is a family-owned, high-end retail supplier, and Keefe believes that high-end retail is more recession-resistant, due to the fact that more economically stable customers continue to shop despite recessions. She also expects more mid-range customers to shop at higher end stores as the economy continues to improve.

Keefe bought the fixed rate bonds of Simmons Mattresses when interest rates were higher. Now that rates have fallen, Keefe has purchased the company's floating rate notes, which will pay more cash as rates rise.

She also likes Nature's Bounty, the vitamin company whose products are sold through Wal-Mart and other stores, manufactures its own vitamins and also sells them online. Keefe notes that the company sells online to repeat buyers who are consistent and loyal customers.

Then there?s Blue Ridge Paper. The privately held company makes packaging for Minute Maid Orange Juice and is owned by its ESOP (employees) and a private equity firm sympathetic to the needs of unionized rust belt industries.

"It's important to note that three out of four of these companies are owned through private equity,? Keefe points out. ?Because of this, the only way to participate in each of the companies is through their bonds. For social investors, this is an important distinction--being in the high-yield market helps you participate in dialogue as a bond holder in companies that you might not otherwise be able to affect." 

Stephen Taub is Contributing Editor to BondsOnline. Stephen has been covering financial markets for more than 20 years with Financial World magazine, Individual Investor.com, CFO.com, and others.