Can Junk Be Lofty?

Diane Keefe's Pax World fund mixes high yields with high ideals

Diane Keefe is a woman of conviction. After graduating from Wellesley College in 1979, she founded a nonprofit environmental group and went on to help implement the Clean Air Act at a regional planning agency in Middletown, Conn. Later, as an MBA student at Columbia University, Keefe launched Business Students For Social Responsibility. She's still passionate about the environment but now comes at it from a different angle. She runs the $50 million Pax World High Yield, the only socially responsible junk-bond fund.

It's no surprise that Keefe's fund is in a category of one. The issuers of high-yield bonds include many companies in politically incorrect businesses. The Merrill Lynch High Yield Index, the benchmark for junk-bond investing, has plenty of gaming, aerospace, and defense companies. Those industries, along with tobacco and alcoholic beverage makers, are off limits to social investing. So are companies with bad labor practices and those that use animals in testing. As a result, the universe of potential investments is restricted. Keefe says 28% of all companies she initially screens are rejected on social, not financial, grounds.

Can you make money this way? The four-year-old fund earned an average annual return of 5%, vs. 3.9% for the conventional high-yield funds from January, 2000, through December, 2003, according to Morningstar. Those numbers aren't exactly barn burners, but remember that high-yield bonds went through a bear market during that period, as did stocks.

Last year, Keefe's fund returned 17%, lagging the 23% posted by her peers. The reason? Keefe invests in the highest-quality junk bonds, those rated B and BB, while the lower-rated junk bonds made the biggest gains. "The CCC credits fueled last year's rally, and those are companies I don't buy," says Keefe. Now that commitment to quality may be her salvation. Many pros fear a bubble in the junk-bond market (BW -- Feb. 9), because the huge demand for junk has enabled companies with poor credit ratings to issue debt. Experts predict that defaults will start to rise again soon.

Keefe, 45, honed her high-yield expertise during 12 years at Dillon Reed. Although she started as an investment banker in municipal finance -- she said she wanted to raise money for the public good -- she transferred into high yield just before the 1989 crash and managed to hang on through the bear market. During maternity leave for her first child, Keefe, then 40, decided it was time to meld her social ideals and her financial expertise in a socially responsible high-yield bond fund. Pax World Funds, which runs social investing funds, gave her the seed capital to get the fund going.

SURPRISING SELECTION. With so much off limits, just what is Keefe buying? High-end retailers and clothing makers, a surprising selection since the garment industry has a reputation for not treating its workers well. That's why Keefe invests in St. Johns Knits, which keeps most of its production in the U.S. and permits third-party monitors into the factories. She also thinks St. John's wrinkle-free apparel for professional women who travel a lot is a great product -- and wears it herself. Another favorite is upscale clothier Barneys New York (BNNY ). Barneys, which recently emerged from Chapter 11, is a comeback play. Keefe bought its bonds for 86, or $860 for a $1,000 bond; the retailer's bonds now trade slightly over par.

Health care is also a natural for social portfolios, and indeed, it makes up 12.7% of the fund. One winner: National Nephrology Associates, a private company that does kidney treatment, was bought out by Renal Care Group (RCI ) in early February, and her bonds jumped from 106 1/2 to 115 in a day.

Keefe remains sanguine about her fund's prospects. "Her mild-mannered, conservative approach to high yield sets her apart from her peers," says Shannon Zimmerman, a junk-bond analyst for Morningstar. That assessment suits Keefe just fine.

By Toddi Gutner

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