Published on April 3, 2020

If you were unable to join our quarterly teleconference, listen to the replay to hear updates on the Osterweis Strategic Income Fund.


Kellianne: Hello and welcome to the Osterweis Strategic Income Fund First quarter conference call. Operator assistance is available at any time during this conference by pressing star zero. At this time, all participants are in a listen only mode and later we will conduct a question and answer session. Please note that today's call is being recorded. Performance data quoted represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that investor shares, when redeemed, may be worth more or less than the original cost. Current performance of the Fund may be higher or lower than the performance quoted. Performance data current to the most recent month-end may be obtained by calling shareholder services toll free at (866) 236-0050. And now I'd like to turn the call over to your host, Shawn Eubanks. Shawn, please go ahead.

Shawn Eubanks: Thank you Kellianne and good morning everyone. We'd like to thank you all for joining the first quarter conference call for the Osterweis Strategic Income Fund. I'm going to start the call by reading performance and then I'll turn it over to Carl Kaufman who will discuss our market outlook, the fund's performance and portfolio positioning. And then we'll open up the lines for your questions. In terms of annualized returns for the one year period ended March 31st, the Fund was down 5.63% compared to the Bloomberg Barclays, U.S. Aggregate Bond Index, or the Bloomberg BC Agg, which was up 8.93%. For the five year period the Fund was up an annualized 2.11% versus 3.36% for the Bloomberg BC Agg. For the 10 year period, the Fund was up an annualized 3.99% compared to the Bloomberg BC Agg, which was up 3.88%. The first quarter of the Osterweis Strategic Income Fund had a total return of negative 7.17% and that compares to the Bloomberg BC Agg, which was up 3.15%. And the Fund's gross expense ratio was 0.85%.

Carl, with that, I'll turn it over to you to start with the outlook. Thank you.

Carl Kaufman: Thank you Shawn, and thank you for joining us. First of all, I want to wish you all a safe passage through this uncertain time and the health and safety of you and your loved ones should be your primary concern right now. After devastating fires in Australia, a locust infestation in Northeast Africa, and now the worldwide pandemic that is shutting down large swathes of the global economy, one might think the apocalypse is upon us. We've seen a very rapid and severe downturn in many markets, a predictable reaction given the heightened uncertainty surrounding the Coronavirus crisis. We spend our days and nights trying to figure out how best to navigate this storm and we believe keeping calm is essential. We appreciate it can be difficult right now, particularly as we're constantly inundated with alarming headlines, but it is necessary to prevent knee jerk reactions, which may result in the wrong actions at the wrong time.

Businesses will eventually reopen and daily life will normalize in time, perhaps incorporating some lessons we've learned from this unprecedented chapter. Markets, as a rule, abhor uncertainty. Market prices typically discount future expectations. As John Silvia, former chief economist at Wells Fargo, pointed out in his recent publication Dynamic Economic Strategy, the Atlanta New York F ed offers excellent reviews of where we are now economically speaking, but in contrast market prices discount the future. As new data becomes available, outlook expectations and prices change. This lag in economic data is such that it is no longer relevant to the market in predicting future trends. Mr. Silvia points to a few glaring examples. The leading economic indicator for January released on February 20th was positive 0.8%. Followed by the New York Fed's Nowcast, a first quarter GDP (Gross Domestic Product) growth released on February 28th, of 2.14%. The second quarter forecast was downgraded on March 13th to positive 1.08%. I don't even think that's in the realm of possibilities now, given what has happened globally in the past few weeks.

So how does one build an investment framework when economic information is so dated as to be virtually useless? One typically invest with an awareness of economic trends. Strength or weakness in those trends will dictate the ease or difficulty of businesses to allocate capital effectively and operate profitably. We also take economic trends into consideration when making investment choices. The expectations of these trends will continue to play a large part in allocating capital both for companies and investors. When expectations are upended, plans change. In the recent upheaval, investors sell and search for higher ground and what are perceived to be safe havens. Corporate leaders make plans to preserve cash, plan for layoffs, seize capital investments. Those actions have no doubt had a deleterious effect on both market prices and business conditions. We cannot remember a time when so much business activity has come to a virtual stop, say for a short time following the attacks in the World Trade Center almost 20 years ago.

Travel, dining, hospitality, entertainment, sports, retail, shipping, and a host of other industries and their suppliers have come to a near standstill. They employ many people, most of whom are typically not among their top earners, will likely be furloughed, many without pay. This is where a government response is urgently needed. When China closed down in response to the virus, it created a supply shock to the world. What has happened since to the above industries in the U.S. and abroad as well as to their supply chain has created a demand shock. In combination, they create the perfect storm where economic activity has nowhere to go but down. The magnitude and duration is unknown at this time, but it will likely be severe. The decline in the price of oil should not be a surprise given the sudden cessation of so much economic activity, especially among heavy users of fuels such as airlines and cruise operators. The Saudi/OPEC/ Russian feud is symptomatic of both ample supply of a commodity and the demand shock, but it's not causal in our view.

The price of the commodity would have inevitably fallen over time. Their actions just made it happen faster and maybe added a little bit of fuel to the fire. Sorry, I couldn't resist the pun.

Investors usually respond to massive shocks and declining prices by selling after a certain pain threshold has been reached. And it's been our experience that maximum pain usually creates selling climaxes in market bottoms. As wiser successful investors have tried to teach us, this is the time when one should be buying, not selling.

Humans and some machines seem to be hardwired to do the opposite. The odd thing about the current pandemic is that we all know that at some point it will run its course and be over. We will then begin to pick up the pieces and return to a world where we can once again use economic and company data to make more rational investment choices. What we do not know is when. This could happen quickly if we have a medical breakthrough or it could happen a little more natural pace as the disease runs its course as others have done in the past. We think it's fair to say this is not a permanent condition. As we write this, it's kind of old now, but the government has not yet passed their stimulus bill. They have, so we're waiting for that to filter through to the economy.

Nor has there, since we wrote this, been a massive rise in testing or a meaningful increase in the supply of safety and medical equipment for our health care system. There has been little coordinated effort as seen in some countries of local, federal, and health agencies. The responses have mostly been at the state and local level, and that has predominantly been of the shelter at home, social distance and wash your hands variety. While this may turn out to be enough, we simply do not know at this time. The federal response seems to have had both good and bad aspects to it, but we believe there is little we can do to improve the bad ones for now but wait. In the future we must address the inadequacies that led to being so unprepared as a nation to deal effectively with a pandemic of this severity.

This will likely require a massive investment in domestic industries which have largely been seeded to other countries such as the manufacturer of antibiotics. This will create some opportunities for investors, and as a firm, we will be watching these closely. What gives us comfort is that in the past, high yield sell offs of this magnitude on certain levels of reach, future returns are generally quite favorable. In a blog post by Barclays, they remind us, for historical purposes, the high yield spreads above 800 basis points have led to attractive return opportunities. In the cases even more profound above 900 basis points, the median annualized return over the next 12, 24, and 36 months for high yield as spreads cost 900 basis points, is 36.9, 25.5, and 20.8%. In fact with a horizon of a year or more, as investor has never lost money historically in 25 examples buying high yield bonds as reds cross the 900 basis points.

We reached that spread in late March and have since receded a bit. While history rarely repeats, it usually rhymes, and we hope that ceteris paribus, poetry will be our friend again. Fortunately our cautious approach to keeping a large cash buffer in the past few years has paid dividends in this downturn, although we have still taken our share of mark-to-market hits. As we have been able to start buying during the panic selling, normally in past market conditions we have focused on redeploying cash into shorter term investments, but given the near certainty that this will end at some point and you've weighed economic normalization, we are looking for great companies who will not only survive, but should rebuild quickly and may even come out stronger on the other side.

Their bonds were much too dear for us prior to this selloff, but have since corrected to levels representing exceptional value in our view. Given the lower coupons and longer maturities of these bonds, some of these price declines we've seen have been quite large. So we hope you'll join us in preparing for the eventual return to market normalcy and, as always, we truly appreciate your support through good markets and bad, and we welcome any questions or comments you may have. Kellianne, why don't you open it up for questions?

Caller: Hi, how are you doing Carl? Thanks for your effort. Hope the team's all safe and handling this as well as can be expected. My question is I typically think about the type of portfolio you construct there as having a shorter duration. Or at least in recent years, been very short duration. That last comment you just mentioned, were you indicating that you are willing to extend the duration of the portfolio given the opportunities you're seeing? And then can you give an example or two of the type of opportunity you're seeing? Understanding you want to maintain the ability to efficiently buy any security. So if you want to withhold names, that's fine, but what type of return prospects are you seeing?

Carl Kaufman: Sure. Very good question and we're all fine. Thank you very much. All working remotely. Our spouses we have to worry a little bit more about, but they'll get over it. Hopefully. Yeah. I mean we haven't released the portfolio so I can't talk specific names, but there are many companies out there that are... I can give you an example of one that we added to for example, where we had a small holder position. There are many companies here that brought bonds in the last couple of years that have 4 to 5% type coupons or seven to eight years to maturity. And those bonds, needless to say, are trading down 20, 25 points and now offer yields or did when we were buying them before the end of the quarter and now, nine, 10, 11% type yields. So it made sense now to add those companies. One company that we own, for example, where we've taken a mark-to-market hit but have since rebounded.

Things like NCR. It's a company that manages and owns large ATM networks. Are people are going to stop getting cash from the bank? I don't think so. But their bonds took a nice hit. There's a whole bunch of others like that that are really not as impacted by this, that did correct and should rebound and in some cases already have. But yeah, we're willing to buy these longer-data portfolio-type companies in really good credits so we can lock in these 8, 9, 10% rates for a longer period of time rather than buying the short paper, which has also come in where you only get a 10, 11, 12% return for six months annualized. Which doesn't really move the needle long term. Because I think rates are going to stay very low for a long period of time.

Caller: You commented on having substantial cash coming into this dislocation and the ability to put some of that to work. Can you characterize the change in the cash position?

Carl Kaufman: Sure. We came into it with about 35% in what we considered cash and very short-term securities, mostly basically. We had more commercial paper. We no longer have commercial paper. It's all rolled over. We still have investment grade floaters, very short dated. We have bonds that either are maturing or have been called. The recalled bonds obviously coming due within 30 days and the maturing paper below a year, so that's about 35%. That combination now is about 26%.

Caller: Okay, and then can you talk about what's happened to the overall duration of the portfolio as you have taken advantage of some of the longer term opportunities you mentioned?

Carl Kaufman: Sure. The official numbers moved up. It was about 1.8. It hasn't moved up dramatically as we still have a large part of the portfolio was still in the sort of the two- to three-year duration, so that hasn't rolled over yet. But we are trying to increase the weighting in the longer-dated bonds as we practice.

Caller: And then lastly, how about the yield to maturity?

Carl Kaufman: Yield to maturity is roughly about 9.2% right now.

Caller: Wow.

Carl Kaufman: It's gone as high as 11.

Caller: It was about four or five-ish, right, at year end?

Carl Kaufman: Yeah, absolutely. It was about five-ish year end.

Caller: Okay. Thank you.

Carl Kaufman: Pleasure

Caller: One question we get a lot from our partners is what is the market really pricing in right now? We all know it's going to get worse. How much of that has already been priced in the market that you see and how much of it is kind of perhaps optimism or undue pessimism on behalf of the market participants?

Carl Kaufman: That's a really hard question to answer, but I'll try to answer it this way. Typically when you have a severe change in direction in a market or economic statistics, generally the cause of that sometimes is an exogenous event as it is here, and in 9/11. Sometimes it's an accumulation of excesses that bursts very suddenly and people say, "I shouldn't have been surprised, but I am."

I think the initial reaction and discounting to that event or realization that you should've been more prepared is greatest in the early part of the selloff. And what I mean by that is I think when people started realizing that this thing was serious and were starting to lock down parts of the economy, people just sold. Now I don't think there's anybody that doesn't know that we have a panel and every day people are now looking at what's my hospitalization rate, what's my ICU rate, what's my new case rate? What's the testing rate? Starting to look at numbers and move away from the purely emotional to the analytical. I don't know if that makes sense, but in terms of discounting, I can only go with my gut, and my gut tells me that the market has discounted worsening data for about another month. I think if the data continues to worsen beyond that, depending on the magnitude of the worsening, I think you might have some weakness in the market, but it will be less emotional than the first selloff. I don't know if that answers the question or not.

Caller: It does. Thank you.

Carl Kaufman: One other item on that is that as evidence of that, when we look at the investment grade corporate markets or the high yield corporate markets or even the convertible markets, what we are seeing are some pretty interesting inverted yield curves, where the short end of a company's debt stack is trading much cheaper than the longer paper. That is usually a sign to me that things will normalize and the market is discounting that. They're much more worried about the near term than they are about the long term, and we have had a couple of occasions last month where we have owned bonds that also have convertibles outstanding with the severe weakness in the stock. The convertibles sold off so hard they yielded more than the bonds and had shorter maturities. That type of irrational behavior is a sign of pure emotion. Those have since corrected and now yield less than the non-convertible bonds.

Caller: Carl. Question here. You said that, if I heard you correctly, you moved the cash and cash equivalents down from about 35% to about 26%. Just kind of wanting to get some idea on why those numbers moved the way they did. And why when things were bottoming a little bit, you guys didn't put a little more in. Are you still expecting things to come in further and then put more cash to work? Are you simply holding cash and cash equivalents to be able to meet massive redemptions that you guys expect might be coming? Can you kind of provide a little color on that?

Carl Kaufman: Sure. Don't forget that we have a fairly short-dated portfolio. We have also had cash inflows into the portfolio from bonds that have gone away, believe it or not, in the last month, so that's not a static number from end of the year to now. We have had a fair amount of cash creation in the portfolio, a) from the bonds that have been called since. We actually had an IPO (Initial Public Offering) done last month of one of our portfolio companies and they called one of our bottoms. So that went from long term to short term. So you can't think of it as a static number. We always have cash being created by the portfolio itself. We did have some redemptions. That seems to have leveled off now. We actually had inflows a couple of days this week. So I think the discussions, so part of that reduction was inflows and part of it was we were doing some buying. But also it was bolstered by cash coming into the market from places that weren't deemed cash before.

Companies that have decided to call their bonds early or buy them in the open market for example. We had one bond, we sold that we sold a quarter of a point below par. Sold it because the company wanted to take them out. They had the cash on the balance sheet. Wasn't doing them any good. So that's how I think of that. And we're pretty selective about what we do buy. And surprisingly even in this sell off, even though we've taken large mark-to-market hits, the sell offs have not been on big volume. It is rare when you see 10 million bonds looking for a bid. Usually it's one to 3 million bonds that's looking for a bid that jumps. So we haven't actually been able to put a ton of money into the market in names that we really like.

Caller: Great. Thanks for that color.

Carl Kaufman: My pleasure.

Caller: Hey guys, thanks so much for the call. I'm just curious on your thoughts on inflation with the significant stimulus?

Carl Kaufman: That's a two-edged sword. We've been giving it a lot of thought lately. It could go either way. Obviously the government is keeping rates very low and very stimulative. They're adding a lot of debt to the balance sheet. Typically that would get people really, really nervous about inflation. I don't think we're going to get huge inflation, but I think for a short period of time after we come out of this, we could get a bout of inflation. When I start hearing talk about this is war, and we should be financing like war, if you remember back post world war two, and some people think I was actually there to see it, but I wasn't. Inflation got the double digits. Three, four years out in the U.S., but people forget it because back, then the Treasury market was not what it is today.

And the Fed basically said 10 year rates will stay at one and three quarters or whatever they mandated them to be and never let that affect rates. Now with what we're going to see coming out of this, is you're going to see corporations get second supply sources, move their supply chains, make investments in geographies that they haven't been as big in prior to move away from dependence on Asia. And that's going to cost and that's going to be passed along I think. Partly at least to consumers. So you may get a bout of inflation, how much that is reflected in Treasuries, I don't know. But I think you should see a move, a snap back in rates for a while and that'll cause people some worries. But I don't think it'll be long lasting. I think the demographic trends are still present, which act as a sort of a counterweight to inflation. Hopefully that answers the question.

Caller: Yeah, thank you.

Carl Kaufman: Well, thank you very much for joining us today. Let us hopefully get some bluer skies in the next few months and keep washing your hands. Thank you very much. We'll talk to you in three months.

Note: This is a teleconference replay. There is only one slide.

Opinions expressed are subject to change, are not intended to be a forecast of future events, a guarantee of future results, nor investment advice.

Data other than performance are preliminary.

The Bloomberg Barclays U.S. Aggregate Bond Index (BC Agg) is an unmanaged index which 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.

The Conference Board Leading Economic Index® (LEI) for the U.S. are the key elements in an analytic system designed to signal peaks and troughs in the business cycle.

Investment grade includes bonds with high and medium credit quality assigned by a rating agency.

Yield to maturity is the rate of return anticipated on a bond if it is held until the maturity date.

Fed is short for Federal Reserve.

A basis point (bp) is a unit that is equal to 1/100th of 1%.

Yield to maturity is the rate of return anticipated on a bond if it is held until the maturity date.

Duration measures the sensitivity of a bond’s price (or the aggregate market value of a portfolio of bonds) to changes in interest rates. Bonds with longer durations generally have more volatile prices than bonds of comparable quality with shorter durations. Effective Duration is a duration calculation for bonds with embedded options and takes into account that expected cash flows will fluctuate as interest rates change. Effective duration is calculated only on the Fund’s fixed income holdings and cash.

A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.

Spread is the difference in yield between a risk-free asset such as a U.S. Treasury bond and another security with the same maturity but of lesser quality.

OSTIX annualized returns: 1 year, 5 year and 10 year periods, ending March 31, 2020 were -5.63%, 2.11% and 3.99% compared to total returns of 8.93%, 3.36% and 3.88% for the BC Agg, in the same periods respectively. Gross expense ratio as of 3/31/2019 was 0.85%.

Performance data quoted represent past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the Fund may be higher or lower than the performance quoted.

Performance data current to the most recent month end may be obtained by clicking here.

SEC yield as of 3/31/2020 is 6.48%.

Fund holdings and sector allocations are subject to change at any time and should not be considered a recommendation to buy or sell any security.

The Fund’s top 10 holdings, credit quality exposure and sector allocation may be viewed by clicking here.

Earnings growth is not a measure of a fund’s future performance.

One cannot invest directly in an index.

Click here to read the prospectus.

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. [44615]