January 11 Webinar Replay - Osterweis Strategic Income Fund Q4 Update
Published on January 17, 2024
If you were unable to join our quarterly webinar, watch the replay to hear updates on the Osterweis Strategic Income Fund.
Transcript
Shawn Eubanks: Good morning everyone and happy New Year. My name is Shawn Eubanks, and I'm the director of business development at Osterweis Capital Management. And we'd like to welcome you to our fourth quarter update for the Osterweis Strategic Income Fund. Today I'll be moderating a panel discussion with Carl Kaufman, Craig Manchuck, and Bradley Kane. At this time, all participants are in listen-only mode. Later, we'll conduct a question-and-answer session that you can participate in via the online Q&A or through your computer. We'll hold all questions until the end, but if you'd like to get in the queue, please raise your hand or enter your question in the Q&A at any time. Please note that this webinar is being recorded. So good morning gentlemen and happy New Year. It's great to be with you today. Hard to believe it's already 2024, but here we are. Carl, as usual, I'd like to start things off by asking you for your big-picture thoughts on the economy. But before we do that, I know you've got an exciting announcement to share with our participants. |
Carl Kaufman: Yes, thank you Shawn, and good morning everybody. It's great to be with you today. We are pleased to announce that we have John Sheehan, who will be joining our team as a portfolio manager. Some of you may know him from his tenure with our Total Return strategy. He's got over 25 years of fixed income experience, and we really look forward to working with him. He'll stay on for the Q&A in case you want to ask him some questions directly. |
Shawn Eubanks: Great, thanks Carl. Let's talk about the economy first. As we know, markets recovered very nicely in 2023 following a dismal 2022. Do you think that's a sign that the economy's in relatively good shape? |
Carl Kaufman: Thank you, Shawn. As we discussed last quarter, the economy has definitely been much more resilient than most prognosticators expected. At the same time, the market behavior was a little bit unusual in the most recent quarter. Treasuries rallied strongly alongside risk assets, which are stocks and high-yield corporate bonds. Normally when risk assets perform well, it's bullish for the economy. It's a bullish sign for the economy. People expect more growth, good earnings growth, et cetera. On the other hand, when Treasuries perform well, it's usually a bearish sign, meaning that they're expecting the economy to slow and the Fed to lower rates. So how do we read these tea leaves, especially with inflation moderating, but not yet at the Fed's 2% target. And for most of you who saw today's release, it was as we like to call, the tyranny of the 10th: 0.2 was expected, 0.3 was reported. We tend to think that the bulls are right and that the economy is in fact on pretty solid footing. And one metric that boosts our confidence is GDP growth. Both real and nominal growth have been doing reasonably well, with real GDP trending up for each of the past four quarters. So the growth is accelerating a little bit. It's not excessive, but it is getting marginally better every quarter. So we're chalking up the Treasury rally to the decline in inflation, and inflation expectations, and the expectation that the Fed will pivot to a more dovish stance. I mean, they already have indicated that they have stopped raising rates, so that in and of itself can be interpreted as more dovish. |
Shawn Eubanks: Thanks, Carl. That's a great segue into my next question, which is about the rally during the fourth quarter in particular. Markets were doing reasonably well throughout the first three quarters of the year, but then they got really hot in the fourth quarter. And do you think that was mainly because of the Fed, or were there other drivers involved? |
Carl Kaufman: I'm sure there were other reasons, but we think the Fed was the primary driver. In September, as I mentioned, the Fed did pause their tightening program. The narrative in the market switched pretty abruptly from how many more hikes we're going to have to how soon will they cut. Sentiment changed quickly and fear of missing out took over. And the markets got even hotter after the December meeting when they announced the possibility of up to three cuts in the next year. And we've mentioned these dot plots in the past. They're a terrible predictor of what the Fed will do in the future. I don't know if you want to show some numbers to put a finer point, not to put too fine a point on it. But as you can see from these numbers, the first three quarters of the year in the first column compared to the fourth quarter in the second column, as you can see, in most cases those were greater than or very close to the first three quarters. We had quite a rally in the markets. And as you can see, if you look at the last two years as a reference point, in other words, '22 was a down year, '23 was an up year, you can see we haven't made much progress in two years. So we can view this as sort of a fresh start. We're back to square one. And we'll see where we go from here. The only area that still has not recovered is the investment grade universe, represented by the Bloomberg Agg, which is still down over 8% in those two years. And that is just math. That's the Fed raising rates from a very low level. And we'll have to see where we go from here. |
Shawn Eubanks: Thanks, Carl. That was definitely a very strong finish to 2023. Craig, my next question is for you. Given the strong returns and the Fed's more dovish stance, does that mean inflation is finally behind us and we can turn the page? |
Craig Manchuck: Not exactly. We just had some numbers today, CPI numbers came out and the market has been leaning still pretty heavily into the fact that they expect these numbers to come down and to give the Fed the ammunition to be cutting. And in fact, they were surprisingly strong. So inflation continues to be a little bit more resilient and more difficult to tame. It was 6.5% coming into 2023, and now we're down around the very, very high three. So getting to two certainly doesn't seem like it's a straight line or a particularly easy path. In addition, we are also paying attention to the Goldman Sachs Financial Conditions Index, which really measures how easy or readily available capital is for people out there. And that Index has actually fallen sharply here with rates coming down and the rally in the market. So the market has actually already created this easing of conditions. It's fallen faster than it has in the last 40 years. And the concern is that that will actually provide more fuel to enable inflation to stay higher for longer. So the market is actually working against the Fed a little bit here, and it's somewhat trying to force the Fed's hands to play into what it wants. But in fact, the data does not support what's been going on in the market of late. So it gives us pause and continues to have us believe that it will probably be higher for a little bit longer, and that the Fed does not necessarily need to cut as imminently. So the market somehow today seems to be taking it all quite well in stride. Equities are up a little bit, but Treasuries not so much. And we just think that the cut side of the equation probably gets pushed out further into the future. |
Shawn Eubanks: Thank you, Craig. That makes sense. And Brad, can you talk a little bit about the current portfolio positioning? It seems like there's still some uncertainty regarding the direction of inflation and interest rates. And kind of how's that impacting how the portfolio's positioned today? |
Bradley Kane: Yeah, thanks John. Well, as Craig said, I mean there are different views on where inflation's going, when the Fed's going to cut. But as we've been saying for the last, well almost the last year, the inverted yield curve, with short rates much higher than long rates, has really been kind of a boon for us. I mean, we're leaning heavily into the shorter end of the curve. You got three-month short maturity rates, the three-month T-Bill's over 5%, investment grade commercial paper's 6% on one month. So we're getting paid to take a lot less duration risk and wait for better opportunities in the long term. So when you're getting rates that are on the short side pretty commensurate with longer high-yield rates, why move out on the curve? You're getting a fair return to sit and wait for some better indication of which way the economy's going, which way the Fed's going. We've been maintaining a healthier cash balance this year with cash and commercial paper. And actually the last six or nine months, we've also added one-year investment grade. One-year high-yield notes that are giving us above average yields, and they're very short maturity. So if the rally reverses, if we get a correction, we'll be in a good position to lock in longer maturities with higher yields because our shorter portfolio, we can turn over pretty quickly. And if rates remain elevated and the market doesn't correct any, we're still going to generate pretty solid returns with the shorter tenors that we have. So I think we'll wait and see when the Fed begins to cut, whether it's when they do, we'll start to move the portfolio out into longer duration if that makes sense. That's the hallmark of how we've been doing it for the last two decades, is wait for the opportunities to come to you, don't have to stretch, don't try to create something that doesn't exist yet. Wait for it to be there, and then you can take an opportunity for it. So the one thing that is a little different also is in the last year with the rally in the equity market and the rallies, we've been able to really take advantage of selling off some of our equity-sensitive convertibles. So that's come down as a percentage in the portfolio. But as always, we continue to stand by our philosophy of look at what the market's giving you and try to look for the safest place, the most attractive area in the market, and take the safest way to play that market. And that's really right now been the inverted curve and staying on the shorter end. |
Shawn Eubanks: Thanks, Brad, that's really helpful. I appreciate that update. Craig, what's been happening in the new issuance calendar? Did the fourth quarter kind of buying frenzy trigger a wave of new supply in the high yield market? |
Craig Manchuck: Actually, not hugely. There was some activity and there were some deals that probably wouldn't have been able to get done that otherwise did get done. But looking at the numbers, aggregate issuance in the fourth quarter in the U.S. high yield market was 49 billion. That's up from 47 billion in the third quarter, but down from 56 in the second quarter. So activity really didn't pick up all that much. A lot of it was refinancing. And I think one of the main reasons behind the relatively light calendar has been the lack of LBO transactions and the lack of private equity activity out there. That generates a lot of new paper for the market and satisfies a lot of demand for people. And the fact that rates have moved up has made the P/E cohort have a difficult time finding deals that they can actually get done that make sense at the rates that they would have to pay in the current market environment. And I also think that there's been ... We've been very negative on that entire cohort for a long time, scenario we've stayed away from. And there have been a few more bad actors that have reared their heads in that space and done some things that have hurt bondholders. So I think the marketplace has grown a little bit more suspicious and cautious of the P/E cohort. And as a result, they're demanding even higher rates than they would've typically in the past. And plus, as you get into this higher rate environment, you can't put as much leverage on the company. So that's part of the reason that they can't drive the IRR. So they can't make these deals work and the numbers just don't add up. As a result, we see very low levels of P/E activity. There is a lot of stuff in the print and in the media that suggests that this pent-up demand for deals is going to heat up this year. And we'll see. I think with the private credit availability out there, there are alternatives to the high yield and the leverage loan market for them to raise capital, but it comes at a price. So it remains to be seen whether that activity really does pick up as much as is expected, unless we do see a material change in the level of longer term rates. |
Shawn Eubanks: Thanks, Craig. Carl, right now I'd like to come back to you and ask you about something you wrote about in the most recent quarterly outlook. You had some interesting points about spread duration and why investors should be focused on that right now. Can you share a little bit of that insight with our participants? |
Carl Kaufman: Sure. I'm going to put up a slide here so people can see it. For those of you who don't know what spread duration is, spread duration is the movement in a bond price related to how much the spread moves. So if you have a spread duration of one and spreads go from 400 to 500 over, that bond price is going to move down a point. Based on that alone, there's also the interest duration, which also impacts the portfolio. So you have to be aware of that, because that measures the outlook that investors have for economic health. In other words, spread is what investors demand over and above Treasuries to take the risk of investing in a company's bonds. And in high yield, when you expect a stronger accelerating economy, that demand goes down; i.e., the spread demanded by investors goes down. When you're going into a recession, typically the spread demanded goes up. So you should be aware of that, especially if people are calling for a recession, which I don't think is on the near-term horizon. But one should be aware of that. But looking at this chart, we're taking very simple measures here. So if you look at, I've divided it by maturity band. So on the first column you can see that the top row is high yield bonds that are under three years of maturity. So the spread duration for that cohort is 1.28, meaning that for every hundred basis points move, you should lose about one and a quarter points. For the three-to-five year maturity band, it's double that at two and a half. For the five-to-seven, it's just about triple that, which is 3.78. Now you look at the yield to maturity and current yields in each of those cohorts, and you can see where the inverted curve positioning that Brad talked about helps us here, because the yield to maturity in the shorter cohort is actually higher than in the other two. So taking a simple measure of how many units of duration, how many units of yield am I getting for every unit of duration; i.e. the yield to maturity divided by the spread duration, I'm getting six units of yield for every unit of duration in the under three bucket. As you can see in five-to-seven, I'm only getting two. And if you were to go to investment grade, it would be negative, or very close to zero. If you look at just the current yield, what am I getting in terms of current yield, numbers are kind of the same. That's the second to the last column and the last column. So you can see in under three, I'm getting five units of protection. Meaning that spread could go up 500 basis points, and over the course of a year I would break even in the under three duration bucket. I get 2.7 on the three-to-five, and 1.7 on the five-to-seven. This is what Brad was talking about. There's no reason to take the extra risk of going long-dated at this point in time given the uncertainty of the economy and the market. Now this cuts both ways. If the economy were to strengthen meaningfully and the spread were to come down, clearly you'd make more money in the longer duration paper, but we just don't see a reason to do that. Right. Shawn, you can probably take that visual down. |
Shawn Eubanks: Thanks. That's a really compelling argument for how the fund's positioned currently. Before we open up the floor to Q&A, here's a performance slide for everyone to view. Carl, do you have anything that you'd like to add about this? |
Carl Kaufman: It was a pretty good year. I think it was better than most people expected. I think it's time to take a more cautious view, which is our normal view of course, for people who have known us for many years. But I still think that 8% yield for the high yield market, that's not a bad absolute yield. Usually we back up the truck when you get to double digits, and we unload that truck when you get to the five, five and a half percent. So it's still a very good yield. So I think high yield is still the place to be, depending on what the Fed does. I don't see them ... I don't see, other than an exogenous event causing a very deep and severe recession, I just don't see the Fed cutting rates all that much this year. So I think the opportunity is still in non-investment grade, except at the short end where you can find some really high-quality companies, some of them investment grade, that will give you the type of yields that makes sense. |
Shawn Eubanks: Yeah, that yield is definitely very compelling if you kind of compare it to what probably a lot of people's views are for the equity markets going forward in 2024. |
Carl Kaufman: Correct. |
Shawn Eubanks: Yeah. So now we'll begin the Q&A. And as noted on the slide, please ask a question through the Q&A window or raise your hand if you have a question over computer audio or by phone. Also, here are a few key stats for the fund at quarter end. The weighted average coupon was 5.5%. Weighted average effective duration was 1.9. Weighted average years to maturity is 2.74. Weighted average yield to maturity was 7.27. 30-day SEC yield was 6.64. And the income distribution yield was 5.72. So I know we had a couple questions come in advance, so maybe I'll start with those and then we'll go to the questions in the Q&A box. First, Carl, it looks like the AUM has increased meaningfully over a quarter or so. How much is too much for the existing team to invest effectively? And any plans to expand the team, or any retirement plans going forward? |
Carl Kaufman: Well, too bad he didn't wait to ask that question before we introduced John. But assets at the end of the third quarter were 4.7 billion. They ended the year at about 5 billion. So it's about the same as the market, what we improved in the quarter from performance. So it hasn't increased all that much, although it is going up a little bit. Keep in mind that almost 10 years ago we ran about over 7 billion dollars with three people, and we were not breaking a sweat then, we're not breaking a sweat now. But we did add John to the team, so that should even solidify our position further. I hope that answers that question. |
Shawn Eubanks: Great. And cash has increased in the portfolio. Does this reflect internal market challenges or strategic positioning? How would you describe that? |
Carl Kaufman: Mostly strategic positioning. As is typical for us, and I'll just to review, total cash, commercial paper, and bonds that mature under one year increased from about 20 and a half percent at the end of the third quarter to 25% year-end. So it did increase a bit. Part of that was a couple of really big issues that got sadly taken away from us by the issuers. And some of it was just what we normally do is when we have a strong equity and high yield rally, we let cash build as bonds roll over. So that is not unusual for us at all, and just standard operating procedure. |
Craig Manchuck: But it's not entirely cash though as well. We have been finding, and I think we talked about this in the last quarter, because we started moving in this direction. We have been finding some attractive short paper inside of maybe 18 months, and it's now maybe rolled down inside of one year in certain cases, in both the IG and high-quality, high yield markets. So we are still getting very attractive returns in the under one-year bucket. |
Carl Kaufman: Yes, under one year is about 9% of that 25. |
Bradley Kane: And that cash isn't stagnant either. It changes as CP rolls off, as we find new one... shorter bonds, we'll reinvest and then other things will mature. So it's a constant movement within that. It's almost like running on a treadmill, at least in the cash side. |
Shawn Eubanks: Great, thank you. So we answered the question about the asset growth here, but there's kind of a follow-up question about the expanding the team. Is that based on asset growth or other reasons? How would you describe that, Carl? |
Carl Kaufman: I would say it was opportunistic. As many of you know, we did close the investment grade strategy at the end of last year. And John has been a terrific partner when he was on that team, and we felt that it was an opportunity for us to bring him on board to add not only investment grade expertise, but just another pair of eyes looking at the market. That's pretty much it. Other than that, it was just we weren't looking, but there was John and I think he is a very solid investor. And glad to have him on board. |
Shawn Eubanks: Great, thank you. Does the IG spread duration by maturity band look similar to what you showed in the high yield bands? |
Carl Kaufman: Those are high yield bands. |
Shawn Eubanks: Would the investment grade look similar though? |
Carl Kaufman: It would probably look similar, yes, because of the inverted yield curve. |
Shawn Eubanks: Okay. Okay. And I have a question here about the yield to worst for the fund, currently. |
Carl Kaufman: Do you have that stat up? There are official numbers and ... |
Shawn Eubanks: Let me see. |
Bradley Kane: I show 7.14 at year end. |
Carl Kaufman: Okay. |
Shawn Eubanks: Okay. |
Bradley Kane: But Carl, you had mentioned that investment grade, spread duration would've had negative impact- |
Carl Kaufman: On the long end, the duration is so much longer because the coupons are so much lower. Smaller movements and rates have much larger movements. |
Craig Manchuck: And historically- |
Carl Kaufman: Whether it's spread or rates, it doesn't matter. |
Bradley Kane: Which is why we saw the Agg so negative in '22. |
Carl Kaufman: And why it's still negative now, because you've moved rates up. Although spreads are very tight, I can let John talk to spreads, but ... |
Craig Manchuck: Within the high yield world, we almost never see bonds issued with maturities over 10 years. And even 10 years is the very long end. Whereas in the IG world, they often go out 20 and sometimes longer than that. So that really magnifies the duration and that will really skew that. |
Carl Kaufman: But if you were going to do the five-to-seven year maturity band, you would have similar characteristics. I think that was the question. |
Shawn Eubanks: And Brad, do you happen to have the par weighted price on the portfolio as of year-end? |
Bradley Kane: Yeah, 94.93. |
Shawn Eubanks: So there's still some pull to par? |
Bradley Kane: Yes. Yeah. And I think given the shorter duration and that discount to par, you can still see reasonable return even if the market just kind of sits still. |
Shawn Eubanks: Well, we don't have any additional questions, so thank you all for being here today and thanks to our participants for joining. We appreciate your support. Any final comments? Carl? |
Carl Kaufman: See you in three months. |
Shawn Eubanks: Okay, sounds good. |
Carl Kaufman: Thank you. |
Shawn Eubanks: Bye. |
This commentary contains the current opinions of the authors as of the date above which are subject to change at any time, are not guaranteed, and should not be considered investment advice. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
The Bloomberg U.S. Aggregate Bond Index (Agg) is an unmanaged index that is widely regarded as the standard for measuring U.S. investment grade bond market performance. This index does not incur expenses and is not available for investment. The index includes reinvestment of dividends and/or interest income.
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The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance.
The S&P 500 Equal Weighted Index is an unmanaged index composed of the stocks held in the S&P 500 Index using an equal-weighted approach instead of market cap-weighted.
The Goldman Sachs Financial Conditions Index is a weighted average of short-term interest rates, long-term interest rates, the trade-weighted dollar, an index of credit spreads, and the ratio of equity prices to the 10-year average of earnings per share.
Earnings Per Share (EPS) is a company’s earnings per outstanding share of common stock.
The ICE BofA U.S. High Yield Index tracks the performance of U.S. dollar denominated below-investment grade corporate debt publicly issued in the U.S. domestic market.
The ICE BofA 0-3 Year U.S. High Yield Index is the 0-3 year segment of the ICE BofA U.S. High Yield Index.
The ICE BofA U.S. Cash Pay High Yield Index tracks the performance of U.S. dollar denominated below investment grade corporate debt, currently in a coupon paying period, that is publicly issued in the U.S. domestic market.
The ICE BofA 3-5 Year U.S. Cash Pay High Yield Index is the 3-5 year segment of the ICE BofA U.S. Cash Pay High Yield Index.
The ICE BofA 5-7 Year U.S. Cash Pay High Yield Index is the 3-5 year segment of the ICE BofA U.S. Cash Pay High Yield Index.
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Yield is the income return on an investment, such as the interest or dividends received from holding a particular security.
A yield curve is a graph that plots bond yields vs. maturities, at a set point in time, assuming the bonds have equal credit quality. In the U.S., the yield curve generally refers to that of Treasuries.
Treasuries are securities sold by the federal government to consumers and investors to fund its operations. They are all backed by “the full faith and credit of the United States government” and thus are considered free of default risk.
Spread is the difference in yield between a risk-free asset such as a Treasury bond and another security with the same maturity but of lesser quality.
Price-to-Earnings (P/E) Ratio is the ratio of a company’s stock price to its twelve months’ earnings per share.
Coupon is the interest rate paid by a bond. The coupon is typically paid semiannually.
Duration measures the potential volatility of the price of a debt security, or the aggregate market value of a portfolio of debt securities, prior to maturity. Securities with longer durations generally have more volatile prices than securities of comparable quality with shorter durations.
Consumer Price Index (CPI) reflects the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care.
A leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company.
Investment grade (IG) bonds are those with high and medium credit quality as determined by ratings agencies.
Earnings growth is the annual rate of growth of earnings from investments. Earnings growth is not a measure of future performance.
Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period.
Price-to-Earnings (P/E) Ratio is the ratio of a company’s stock price to its twelve months’ earnings per share.
The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments. IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.
Yield to maturity is the rate of return anticipated on a bond if it is held until the maturity date.
Years to maturity is the remaining life of a bond, the number of years until the bond matures and the issuer repays the bond principal. Weighted averages are by security market value.
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financial statements.
The yield to worst (YTW) is the lowest potential yield that can be received on a bond, assuming there is no default.
Par weighted average price is computed by weighting the price of each bond by its relative position size (face value) in the portfolio.
Pull to par is the movement of a bond’s price toward its face value as it approaches its maturity date.
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The Osterweis Strategic Income Fund may invest in debt securities that are un-rated or rated below investment grade. Lower-rated securities may present an increased possibility of default, price volatility or illiquidity compared to higher-rated securities. The Fund may invest in foreign and emerging market securities, which involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks may increase for emerging markets. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Small- and mid-capitalization companies tend to have limited liquidity and greater price volatility than large-capitalization companies. Higher turnover rates may result in increased transaction costs, which could impact performance. From time to time, the Fund may have concentrated positions in one or more sectors subjecting the Fund to sector emphasis risk. The Fund may invest in municipal securities which are subject to the risk of default.
Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [OCMI-478553-2024-01-10]