Institutional interest, declining defaults may sustain junk rally, says Pax World manager Keefe

By Paul A. Harris

St. Louis, April 9 - The sizable cash inflows and declining defaults that kindled the high yield rally last October look set to remain in place through 2003, according to Pax World High-Yield Bond Fund manager Diane Keefe.

"The high yield market is experiencing a powerful rally, with multi-billion dollar inflows since October 2002," Keefe noted during a media conference call on Wednesday.

"When the stock market was faltering in early March because of war fears, the high yield rally continued," she added.

The causes, she said, include Pimco portfolio manager Bill Gross's late 2002 forecast predicting the demise of attractive returns from all fixed-income classes except spread product, which includes emerging markets and high yield, Keefe said.

She also cited billionaire investor Warren Buffet's recent plays in distressed debt.

"Those are factors that have perhaps been motivating individual investors," said Keefe.

"However," she added, "institutions and their consultants have been making a more studied choice in favor of high yield.

"They are selling out of some stock positions at significant losses because they have determined that the current income needs of their foundations, universities and pension funds are not being met, and require that fiduciaries consider a more risk-averse posture, with the heightened potential risks of terrorism and corporate fraud in America today."

Keefe said that there is currently a trend among institutions to reallocate toward high yield and away from purely interest rate-sensitive sectors within the fixed-income portion of their portfolios because of the current low level of interest rates and the risk of significant loss of principal should rates rise.

She cited three reasons for believing that this institutional reallocation will continue:

* Research of historical data indicates the risk of the high-yield bond sector is far lower than stocks and much closer to other sectors of the bond market;

* Widespread expectation that default rates will continue to decline; and

* The current wide spread over Treasuries. At the end of March the high yield market had an average spread of 7% over the comparable Treasury note against the historical average of closer to 4.5%, with the period of 1993-1998 achieving average spreads below 4%, she noted. "If the economy has a moderate recovery based on restored international stability and domestic stimulus, high yield could rally toward those historical average spread levels," Keefe said.

Institutional money coming into high yield should help to stabilize allocations to the asset class because institutional money is slower to move than so-called market timer money, Keefe said.

The Pax World portfolio manager also said that although the present dramatic declines seen in the global default rate may moderate somewhat there are reasons to believe that defaults will at least remain stable and perhaps continue to decline though 2003.

"The global decline in junk bond default rates fell to 6.9% in March from 7.7% in February - the 12th drop in the 14 months since the annual default rate peaked at 10.7% in January 2002, according to Moody's," Keefe commented. "The default rate is falling at a rate not seen since the quarter ended June 1992.

"Thus the recent rally has been led by the triple-C distressed sectors within the high yield market, which will benefit most from the decline in defaults.

"I think the default rate will continue to decline, but it won't decline as fast as it has been declining," she added.

"We don't have great visibility on what is going to happen to the economy after the war with Iraq. We're already one quarter through the year 2003, and a lot of the industries that are troubled now have special situations that will probably lead them not to default in 2003. For example, in the independent power producer segment a lot of these companies were able to sell their healthier assets to people like Warren Buffet. And they were able to get bank debt secured, which weakens subordinated bondholders' positions.

"So ultimately if they have problems with their businesses in 2004 they may run into financial difficulties at that point and the default rate may increase later.

"But for 2003 I think we're in a fairly benign environment for defaults relative to what we have seen over the past three years.

"Also the liquidity in the high-yield market assists companies at getting more efficient by decreasing their interest costs, and refinancing a lot of the bonds that were created five years ago and are becoming callable this year."

Keefe also said that the present market rally created circumstances for the socially-conscious Pax World High Yield Bond Fund to do some opportune selling.

Recent sales include Cinemark, a B3/B- rated theater company trading at less than an 8% yield, and United Auto Group, an auto dealership company trading at 9 5/8% yield.

"We took profits in each case because we anticipate that these companies will encounter weaker business fundamentals in 2003 than they saw in 2002, hindering their ability to generate free cash flow," Keefe said.

"We expect that the auto industry will continue to weaken through 2003 relative to 2002, so we are underweight that industry generally. Also we believe that Ford, which is already trading at a junk bond spread of over 400 basis points over Treasuries, will continue to have problems this year."

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