Pax World High Yield may be poised to outperform its peers, but it faces strong headwinds. January 22, 2008 Even top-quality junk bond funds are feeling the squeeze. Pax World High Yield, a top performer in 2007, has already lost 2.4% since the beginning of the year through January 21 as investors continue to flee high-risk debt investments.Although this fund focuses on higher-quality junk bonds, it is unlikely to perform well as long as sentiment remains negative on high-yield IOUs. (See Junk Bond Investors Beware). Manager Mary Austin invests conservatively. She looks for bonds from companies that aren't stretched by existing debt and that generate robust free cash flow (earnings plus depreciation and other non-cash charges, minus the capital expenditures needed to maintain the business). Austin, who meets with managements of bond issuers whenever possible, prefers companies with improving profitability. As with all of Pax World's five funds, companies must meet a set of social, environmental and corporate governance criteria to make it into the fund's universe of potential investments. Advertisement The fund showed its high-quality colors in 2007 when it earned 5.8% -- the second-best return in the junk-bond-fund category. Austin attributes the fund's stellar performance to an absence of bonds from home builders and a light weighting of IOUs from financial companies. The fund's overseas holdings also helped boost its performance. Austin can invest up to 40% of the fund's $97 million in assets in foreign debt. Currently 27% of assets are stashed abroad, with the largest stakes in Mexican and South African telecommunications companies. Long-term performance reflects the fund's low-risk approach. Since its inception in 1999 through January 21, Pax World has returned 5.2% annualized, an average of one percentage point per year less than the Lehman Brothers U.S. Corporate High Yield index. The fund has lagged its peers in years when high yield is in favor. In 2003, for example, the average junk bond fund returned 29%, while Pax World returned 16.9%. But the fund has shined in down years -- in 2000, for example, the average junk bond fund lost 5.9%, while Pax World lost just 0.6%. Advertisement Austin isn't optimistic about the near-term prospects for junk bonds. The difference, or spread, between yields on junk bonds and ultra-safe Treasuries is a good indication of investor sentiment. A wide spread means investors are demanding greater additional yield to justify extra risk, while a narrow spread signals investors are readily accepting extra risk for little added gain. Since last summer, investors have been flocking to quality bonds, driving Treasury prices up (and yields down) and junk prices down (and yields up). That's pushed spreads to more than 7 percentage points from their historic low of 2.4 percentage points in June 2007. Even though spreads are now much wider than normal, they could have further to go, Austin says. "I think people are reacting to fear, and that has as much of an impact on prices as fundamentals right now, if not more," she says. Austin also says defaults on junk bonds will increase for years to come. Even so, she says, analysts expect default rates in 2008 and 2009 to be below the historic average of 4.4%. But it can take time, she adds, for deteriorating financial conditions to trigger a default on debt. "This won't hit us until a few years down the line -- they don't instantly jump from one year to the next," she says. Pax World High Yield (symbol PAXHX) currently yields 7.7%. It requires just a $250 minimum initial investment and charges 1.15% in annual expenses.