April 11 Webinar Replay - Osterweis Strategic Income Fund Q1 Update

Shawn Eubanks: Good morning, everyone. My name is Shawn Eubanks and I'm the Director of Business Development at Osterweis Capital Management. We'd like to welcome you to our first quarter update for the Osterweis Strategic Income Fund. Today I'll be moderating a panel discussion with Carl Kaufman, Craig Manchuck, Brad Kane, and John Sheehan.

Good morning, Carl, Craig, Brad, and John, thanks for being with us today. I'd like to start things off, Carl, with you and maybe your thoughts on the big picture of the economy please.

Carl Kaufman: Good morning, Shawn, and thank you everybody for calling in. Clearly the economy is holding up much better than most pundits would have thought, both at the end of '22 and the end of '23. In fact, as we wrote in our outlook, if Rip Van Winkle would wake up today after a 15-month slumber, I think he'd be very disoriented.

Heading into '23, just as he was getting ready to take his nap, markets were on edge following a dismal '22. Inflation was spiraling, the Fed was still raising rates, and almost every economist and strategist on Wall Street was forecasting some type of slowdown and Fed rate cuts. The only question was whether it would be a hard or a soft landing, and of course, economies aren't airplanes, as one economist we like says, they don't just land and stop. So what has happened in the last 15 months is that the economic cycle has found its footing and clearly the indicators are still trending positively and most importantly, unemployment and inflation are at healthy levels, so that belies any Fed cuts.

Of course, the stock market is near its all-time high, high yield has had a good rally, investment grade not so much so, but I think going forward, expectations are starting to change a little bit and there is some acceptance that the economy may continue to do well and rates may stay higher for longer.

Shawn Eubanks: Thank you, Carl. That's a great perspective. Brad, can you talk about some of the factors contributing to where we are now?

Brad Kane: Sure. Thanks, Shawn, for the question. As Carl mentioned, unemployment and inflation are two indicators that remain pretty healthy. Unemployment, in the most recent government release, fell to 3.8%, which is approaching the lowest levels since 1969. Inflation, although does remain above the Fed's target of 2%, it's still materially lower than it was at the peak. And as we saw in yesterday's CPI release, it's still stubbornly higher than the Fed would like. If you'll remember, we've mentioned in the past that the consumer is about 70% of the economy and there we're seeing estimates out that consumer spending will increase 2.5% in the first quarter. So consumers are still feeling that they have cash to spend, unemployment is low, so therefore keeping jobs plentiful. I would note that the mix has been spending a little bit more on services rather than durable goods. So we are seeing core and durable good prices dropping and that should help mitigate inflation, but services is still staying a little bit higher and that's holding up the inflation levels.

In addition, the consumer balance sheets have [not] been better since 2008, something we've talked about. Household debt service as percentage of disposable income, well below the 40-year average, and with moderation and mortgage rates, you're starting to see housing starts and existing home sales pick up and those are multipliers to the economy. So what we're seeing is the strong underpinnings of consumer spending are still there, inflation is eating a little bit of that savings, but something that we think is going to start to moderate.

Shawn Eubanks: Thanks, Brad. That's a lot of positive news. Are there any red flags out there for the consumer right now?

Brad Kane: I wouldn't say any red flags as of yet. We're starting to see some yellow, and that's what we're keeping our eyes on. As I mentioned, the CPI release was a little higher than the Fed would like. We also look at the Common Man's CPI, which is a statistic Strategas Research creates, and in the common CPI, they add in more items that you have to purchase as a consumer as opposed to discretionary. So, for example, things like homeowners' insurance and car insurance, which we've seen across the country skyrocket in rates. Those are things that are sticky and higher inflation that consumers are still spending on.

But with better employment, with wage growth, consumers are still having spending power, although with the stickiness of some of this inflation and spend, they're feeling like they may have less spending power. We are starting to see signs of consumer credit card debt rising, usage on home equity lines is also growing. So those are some maybe warning signs, but they're early on in the process. Something we're keeping an eye on, we're not seeing those really spike or consumers stop spending. So for now, we're still very constructive on the consumer and the economy.

Shawn Eubanks: Thanks, Brad. Craig, what can you tell us about corporate spending? Are companies feeling as flush as a consumer now?

Craig Manchuck: Morning, Shawn. Companies are continuing to spend, I would say spending is moderately strong, but they are getting a lot more selective about the projects that they're willing to finance right now. So we're seeing capital allocation decisions going back and forth between funding growth and repayment of debt. Obviously debt has become much more expensive for them in the last two years, and so consequently, the hurdle rates are higher for the IRRs on the type of growth that they're willing to finance. So, yes, they are still doing that. And yes, we also have, in addition to companies' own internally generated revenue in the capital markets, we have government financing which is out there and is pretty plentiful.

So, whether it's the infrastructure spending program or other programs to finance clean energy, we're seeing that money filter into the corporate spending profile right now. So debt is good, excuse me, debt is available, capital is available, but the projects that they're willing to fund, I think they're getting pretty selective out there.

Shawn Eubanks: Okay. Does that mean that corporations have been busy refinancing and taking advantage of the available credit currently?

Craig Manchuck: They definitely have been. Capital markets are open and particularly open for higher quality companies. They are not having a very difficult time refinancing debt and we're seeing the refinancing of debt in increasing frequency. There has been, for the last two years I would say, a lot of chatter about an upcoming maturity wall, something we talk about all the time. Carl's referenced it in the past and all the way back for 15 or 20 years, we keep hearing about this maturity wall and all the concerns and risks about that.

The refinancing that's happened in the last four to six months has, from what we understand, chewed through about 40% of that maturity wall, which is probably one of the fastest refinancings of that big chunk of debt that we've ever seen historically. So I think that the availability of capital and the ease with which companies are able to tap the capital markets is very, very positive and will continue. We don't see that ending. There is a lot of cash out there looking for yields. Yields are higher and even though corporate spreads may be a little bit tighter, the absolute level of yields is still at a very comfortable level from an historical perspective.

Shawn Eubanks: Thanks, Craig. That's a great segue way into my next question for John. I know we've been buying some bonds in the investment grade space recently and was hoping maybe you could talk about what's happening there and what types of issues we've been adding.

John Sheehan: Sure. Thank you, Shawn. The Fed policy has created an inverted curve where front-end maturities are actually yielding more than maturities further out the curve. So we've been following one of the tenets that we've long described of taking what the market gives us, and we've been buying investment grade bonds mostly that mature within a year, and also commercial paper where we've been getting in the neighborhood of five and three quarters to 6% on that type of paper. If you compare it to the overall yield of the Investment Grade Corporate Index of 560, you can see that we're not getting paid and actually you'd have to pay in order to take more duration and/or credit risk. So we've been focusing on that part of the curve and I think, especially if you look at some of Brad's comments around the CPI report, we think there's a very good chance that the inverted curve is going to be here for some time.

Shawn Eubanks: Thanks, John. On a related note, can you talk more generally about the overall portfolio positioning? I know you've been working on an Insight post that's going to be posted to our website that talks about the benefit of being patient in markets like this. Maybe you can just give us a preview of your thoughts around that.

John Sheehan: Sure, absolutely. Another tenet that we've talked a lot about is not taking risk when you don't need to, and in times where we see the market a little aggressive on how they're pricing risk, we're more than happy to use cash or short-term instruments as a tactical asset. And we've been doing that. So we've been letting our cash and cash surrogate position build, in addition to the one-year in investment grade bonds and CP, we've actually also bought some T-bills. And this, as I mentioned, of that kind of five and three quarters to 6% yield even compares favorably versus some of the tightest or lowest yielding high yield paper, which we've seen numerous issues come this year in the low six percents.

So we've been continuing to take advantage of that. I think it is important to note though that the overall high yield market, the index is yielding close to 8% right now, so we still think that compares favorably versus the 10-year average of about six and a half percent and even the 20-year average of about seven and three quarters percent. So I'd best describe it as a little bit of a barbell approach where we're letting cash build in very high quality short paper and selectively using good credit selection to continue to find high yield opportunities.

Shawn Eubanks: Thanks, John. Carl, I want to come back to you for a moment. It seems like the economy is still on solid footing and the markets are in good shape, but what is keeping you up at night?

Carl Kaufman: Well, my hip's hurting a little bit, but other than that, I'm sleeping pretty well these days. I think there is one issue that the markets are starting to pay a little attention to, which is the federal debt. They keep on adding to it at a pretty aggressive rate. And in the fourth quarter, I think the U.S. GDP grew 334 billion, while at the same time federal debt grew 834 billion. So government spending is the largest input to GDP growth in the same period.

Of course, the U.S. economy is the biggest in the world and our tax revenues are enormous, over 4.5 trillion last year. So we have the means to service the debt, but over the next 30 years, the net interest expense of the U.S. will rise to approximately 20% of federal spending if we continue on this course. And we certainly hope saner heads in Washington find a way to reverse this trend. But other than that, things are pretty darn good in America and in the bond market.

Shawn Eubanks: Thanks, Carl. Before we open up the floor to Q&A, I just wanted to put up our performance slide and just remind everyone that this webinar is being recorded. Carl, do you have anything to add?

Carl Kaufman: No, I think we've covered most of it. I think we can just open it up for questions.

Shawn Eubanks: Okay. As we begin the Q&A, I did want to share a few statistics on the portfolio. The weighted effective duration at the end of the quarter was 1.69. The weighted average years to maturity was 2.55 and the 30-day SEC yield was 6.07.

Carl Kaufman: Thank you, Shawn. I see we have a question from the audience. Probably along with many other people on the call, I'm being pitched private credit pretty relentlessly. Would be interested to hear views on private credit from a market impact perspective and also from an investment perspective. Thanks. I'm going to let Craig take that one since he has been pretty outspoken about it internally.

Craig Manchuck: Yeah. Well, private credit, the argument that I make against private credit currently is that the returns on private credit continue to come down. There have been billions and billions and billions of dollars raised in private credit. There's a lot of dry powder out there and the market has become much more competitive. As a result, we are seeing private credit lenders lowering the hurdle rates, terms on which they would lend. They're softening some of the covenants, so their protections are coming down a bit. And essentially the person who ends up making a loan is the person who's willing to give up the most, and that's what's going on out there. So these deals have become increasingly competitive and there's all kinds of cash out there chasing this return.

The other thing that's difficult about private credit is essentially you have to hire a team of bankers to go out and source these deals. The deals don't necessarily just come to you, so they have to go out and find people to do that. And a lot of these people are maybe somewhat inexperienced because they haven't been around all that long so they're chasing deals and they're hustling to try to get these names into the portfolio because that's how they get paid. So essentially, they may be pushing a deal into a portfolio, or attempting to, that might not be in the best interest of the portfolio overall, but it's in their best interest in order to get paid.

Lastly, the problem is the illiquidity. And if you're investing in private credit, I know that there have been some structures that have been created to provide some intermediate liquidity for some of these cases, but a lot of times, in order to get out, you have to hire somebody and sell your interest in a private credit fund through the secondaries market and you may take a 10% to 15% hit to your NAV in order to get liquidity. So given the yields we have in the public market that are available across the credit spectrum, but given those yields, it doesn't seem like it's the right time right now. It's become a fairly crowded trade. And even if things don't get horrible from the credit side, I just don't think that the risks you're taking will give you the incremental returns to justify taking those risks right now.

Carl Kaufman: Thank you, Craig.

Shawn Eubanks: Thanks, Craig. So the inverted yield curve is a big negative for bank profitability and net interest margin. Any thoughts on bank exposure this year?

Carl Kaufman: Well, it depends whether you're talking money center banks or regional banks. Certainly regional banks, it does hurt them. Combine that with the fact that many of them are also very deep into commercial real estate office buildings. They're going to have a tough time. Money center banks have many other income streams they can draw on, such as investment banking, trading, et cetera. But inverted yield curves typically are not the best environment for banks making money, borrowing at the short end and lending long. So, as long as that remains, I think bank profitability will remain constrained. We have no bank exposure.

Shawn Eubanks: Okay. Are there any concerns about tight spreads generally in the high yield space?

Carl Kaufman: No, I'm not too concerned about it. The spreads will move one of two ways, either because the underlying risk-free rate, i.e., Treasury yields, move up and high yield bonds move up less so spreads will tighten. The absolute yield we're getting in high yield is high enough that it makes sense. I mean if you compare today where yields in the high yield market on average are close to 8% with what they were at the end of 2019 when they were closer to 5%, but spreads were larger back then because you had no yield in the investment grade universe. So, which would you rather have; tighter spreads at eight or wider spreads at five? I'll take the tighter spreads at eight for $1,000.

So I think that looking at one factor like that can be a little bit skewed. Clearly, if we have an exogenous event and the Fed comes in and starts lowering rates aggressively and we're going into a recession, clearly spreads will widen. If the Fed lowers rates only because they think that the natural rate is too high and it's more technical than economic, then high yield may continue to perform well while spreads widen.

John Sheehan: Yeah, and I would just add that if you look at what the spreads are calculating, it's the difference between the yield on high yield and the difference between risk-free Treasuries. The 10-year Treasury this year has sold off 80 basis points while the yield of high yield has remained relatively stable. So, the spread tightening is more from Treasury selling off than it is a move in high yield. That's probably unusual in that the risk-free rate is more volatile than high yield is.

Craig Manchuck: And just one other thing, Shawn, remember, we invest in individual securities, not in a market per se, so we're always finding pockets of cheapness out there and names that we think we can find that are mispriced. So, while the spread level provides us with a guideline to use, it just tells us more about the market's risk appetite, we're finding really attractive individual securities that we can put money to work in.

Shawn Eubanks: Thank you all. So I do have a question about the yield to maturity of 6.83% as of quarter end. And the answer to that, they asked if that's gross or net, and that's actually gross. So, it would be that yield minus the expenses of the fund, of course. And then could you talk a little bit about your total cash and your maturities shorter than a year and that portion of your portfolio?

Carl Kaufman: Sure. The total cash and commercial paper is about 16% and maturities 12 months and in is closer to 13%, 14%. So that's where we stand right now. About 30% of the fund is under three duration. We're pretty defensive at this point.

Brad Kane: And in that cash and CP, we also do own a couple of short T-bills that we've been buying.

Carl Kaufman: Another question here. Why do you believe there is such a disconnect between the Fed and the market for interest rates?

Well, I think part of that is recency bias on the market's expectations. We've had so many years of zero rates and so many times the Fed has come in to save the markets every time there's been a wobble. It's not the case now because we have high inflation. So I think the expectations are slowly changing. I think this week's CPI number kind of put a dent in those beliefs, and I think people are starting to shift more towards, "Hey, maybe rates are going to be higher longer. Maybe the Fed isn't going to cut so soon and so much." So I think that disconnect will gradually narrow.

Shawn Eubanks: Okay. Any noteworthy risk areas that you're observing in lower rated high yield credits?

Carl Kaufman: Craig, you want to take that one?

Craig Manchuck: Media, cable, and telecom, we're seeing an awful lot of situations where there are either renegotiation discussions going on, potential liability management exercises, in particular one of the largest LBO transactions out there in the high yield market, Altice, which is a French cable company and it owns significant cable assets here in the United States, has a very complicated cap structure and they've gotten themselves heavily, heavily indebted and over-levered, and those bonds have traded down a lot. That's been a big point of pain in terms of market returns for most of the benchmark investors.

And of course, as we've said for years, we are not investing in these types of LBO transactions because the huge amounts of debt, the complex capital structure, and the advantages that are teed up in favor the private equity guys. But there have been numerous other media and telecom names, the change from cable to streaming is causing a lot of long-term concerns about how to really value these businesses over the long term. And I think, on a levered basis, if you own something in that space that's highly levered, you've seen your prices of that debt come down dramatically.

Carl Kaufman: But also generally speaking, private equity leveraged buyout transactions are an area of risk.

Shawn Eubanks: Okay. The team had a perspective last year that was kind of less sanguine than what we're hearing today and wondering what the allocation might look like if we had a year similar to last year with respect to tight spreads?

Carl Kaufman: Well, we talked about spreads a little bit. I think that if we have another year like last year, we'll get even more defensive, because the more time goes on with markets rallying, that means the closer you are to a top and as you know, we like to buy when there's a market correction or disruption, and we like to add longer-term, higher yielding paper into the portfolio at that point. So we just continue to be defensive until we see more opportunities, which goes back to John's mentioning of our mantra of, we take what the market gives us and if it's not giving us much, we're going to be defensive. But we're getting paid to do it now, so it's actually okay.

Shawn Eubanks: If there's not a lot of obvious opportunities in high yield now, is the team still looking for more bespoke opportunities in specific credits?

Carl Kaufman: Not so much so. There aren't that many out there that are interesting at this point, but we do buy occasional deals that are smaller and under the radar, not so much bespoke, but under where the benchmark players would buy. And so we tend to get better yields on those. They tend to be better companies because they don't want to pile on debt. So we are always looking for those and we have added a few.

Craig Manchuck: Yeah. Where we have the opportunity to exercise our desire on structure, we certainly will do that and we do have opportunities to do that at times in some of the small, medium-sized deals. It's much harder to do in the bigger, more widely syndicated deals because if it's in the benchmark, then people are going to buy it regardless of structure. And those are the places that we just don't want to leave ourselves that exposed. But structure is really, really important to us, particularly now in terms of protecting us against bad outcomes and bad actors.

Shawn Eubanks: So in previous quarters, you all talked about bonds selling below par and how that created not only an attractive yield opportunity, but the accretion back to par opportunity in the portfolio. Can you provide any sort of update on what the portfolio looks like now and what the opportunity set is?

Carl Kaufman: Sure. Because we are buying mostly short-term bonds, those tend to trade closer to par. So that discount is a little bit less, I think at quarter end we had about a five point discount to par, so we still have that plus our coupon to call upon. So we still have some upside from a pull to par, but it's not as large as it was say in the fall of 2022.

Craig Manchuck: No, but the coupons are higher that we're getting now today too, so that's the offset, right? If we're seeing some of the names that we're buying with eight, nine, sometimes even double digit coupons, that makes up for some of that lack of discount.

John Sheehan: And also, we will often own the first maturity in a company's capital structure. So they will hopefully refinance when they can, not when have to. So a lot of times they'll be in a position, if they want to take our bonds out early, they either have to pay us par or a premium to par. So we have had a couple of situations where we've captured that pull to par or even above par earlier than maturity.

Shawn Eubanks: Can you talk about your exposure to the IT sector in the portfolio? And are there pockets that you find cheaper in that sector?

Carl Kaufman: Sure. It looks high, but what they call IT and what we categorize as IT, sometimes it's different. Things like Xerox probably get categorized as IT. We own a number of outsourced companies, companies that outsource services like a Conduent. Every time you pass through a tollgate, they read your license plate, send you the bill. They do all Medicare outsourced. So we do those type of companies that are really hard to replace and are very important to their clients.

Shawn Eubanks: Are you finding any opportunities in CMBS or is that untouchable because of the commercial real estate risks?

Carl Kaufman: I'll let John answer that one.

John Sheehan: We are not. I think commercial real estate is going to be an ongoing headwind for risk markets. We are not looking at CMBS, nor do we expect to.

Craig Manchuck: There was a massive dislocation at some point. It might be worth spending the time to investigate, but right now we haven't seen that massive dislocation and we all still believe that we're in the early innings of what's a long-term repricing and revaluation in the commercial real estate markets.

Shawn Eubanks: Okay. And are there any potential upcoming tax policies that you think could impact corporate bonds going forward?

Carl Kaufman: Not if their lobbying remains strong, but you never know in an election year what will happen. Clearly, I think the tax regime today has been fairly stable. I think that if the administration continues, that will remain stable. If the other candidate wins, who knows? I mean it's a wild card, but typically tax policy doesn't come out of the blue. It generally is debated, negotiated, lobbied, and it ends up being something palatable. Nobody gets exactly what they want, but business continues.

Brad Kane: And the other thing is the way we construct the portfolio is we're trying to pick good credits where we get paid, but you can't really set your portfolio up for one election result or the other because if you did that, you'd be changing also with the Fed every month or every two months when they have their meetings, you'd be repositioning.

So really what you want to do is set up a portfolio that's hopefully insulated from any major issue that pops up, but other than exogenous events like a World War or something like that, at the end of the day when you get down to an election, both parties are going to end up sadly being big deficit builders. And so what's going to end up happening, whether it's from tax cuts or from government spending, you're going to see it and we're going to be able to react to it over time. If you try to make a bet on who's going to win the election or which way policy is going to go, you're setting yourself up for a one or a zero. You're going to be right or you're going to be completely wrong and you're going to be scrambling. The way we're set up, especially with a shorter duration portfolio, we can absorb and weather any kind of market disruption and then redeploy cash to take advantage of it.

Shawn Eubanks: That's great.

Carl Kaufman: And also, elections cycles and economic cycles rarely coincide. The economy and markets have done well and poorly under both Republicans and Democrats. So the election is not the be all end all for the markets or the economy.

Craig Manchuck: Right. And our view has remained consistent for a long time that rates are going to stay longer, excuse me, stay higher for longer, which is partly informed by the fact that either side of the government that wins here is going to create higher deficits. There's more supply out there. So it's not just up to the Fed to be able to determine the level of rates. They can affect the short end of the curve, but if supply continues to be high, then the long end will probably continue to stay higher than people think. And that's why we've avoided the trap that many people fell into this year of trying to play Fed cuts, trying to lengthen duration. We've heard numerous economists and other strategists say, "You should be lengthening duration." And we've resisted because it just didn't make sense to us at the time. And here we are today. Now, today the news is out and people are starting to think, "Oh, well maybe we'll go to 5% in the 10-year." Whereas four and a half percent was unthinkable three months ago.

Shawn Eubanks: Okay. Well, thanks. I know you guys discussed the election issue and there's nothing specifically that you're looking at potentially coming out of this election that would change your strategy?

Carl Kaufman: No.

Shawn Eubanks: Okay. Okay. If you believe recency bias in the markets will subside, then it appears that the yield curve will likely normalize more from the intermediary rates rising than the Fed cutting rates. Is that true in your outlook?

Carl Kaufman: Probably true for the intermediate term, yes.

Craig Manchuck: Yes.

John Sheehan: And that's what we've seen thus far. The very front end of the curve hasn't budged this year and, as we said earlier, the 10-year note is up 80 basis points, so we've already seen that happening and market's still pricing rate cuts for this year. If we end up getting zero rate cuts, you'd have to imagine the intermediate part of the curve reprices further.

Shawn Eubanks: Okay. We have one last question. Anything happening at Osterweis from a firm perspective that affects you and your team and your strategy?

Carl Kaufman: Nothing at all. It's a great firm and we love working here, well, I love working here. And we just continue to work for our clients.

Shawn Eubanks: Well, any closing remarks, Carl?

Carl Kaufman: No. Thank you all for calling. Thank you for your confidence in us. We invest pretty much one way and it's the same way we've done it for 22 years. It's an absolute return common sense approach and I don't see us changing that at all.

Shawn Eubanks: Thank you, gentlemen.

Brad Kane: Thank you.

Craig Manchuck: Thanks.

John Sheehan: Thank you.