Published on July 13, 2020

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


Michelle: Thank you for joining our call today, Shawn Eubanks, you may begin.

Shawn Eubanks: Thank you, Michelle, and 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 second quarter update for the Osterweis Strategic Income Fund. Please note that the webinar is being recorded. I'm going to start the teleconference by showing fund performance, and then we'll turn it over to Carl Kaufman who will discuss our market outlook and portfolio positioning. We'll then open up the lines for questions. Carl, with that, I'll turn it over to you.

Carl Kaufman: Thank you, Shawn. And thanks everybody for joining us today Fortuna Redux was the Roman goddess of luck, who oversaw the safe return of travelers from long and perilous journeys. Given the pandemic's societal and economic uncertainty, has Fortuna failed to appear? Hopefully actions taken by the scientific and medical communities, governments, corporations, and individuals will yield more clarity and positive steps. We read that as sign posts towards finding our way back. While we won't rehash, the last few months, there are a few points we would like to highlight, which could aluminate our path forward. By the end of the first quarter, we saw shelter in place orders widely instituted, which effectively stopped economic activity in its tracks. As we cautioned in our last outlook, the downturn would likely be severe. And for the six weeks ending May 7th, over 33 million filed for unemployment benefits in the U.S. alone.

While we were sadly correct in our assessment, the reaction by the Fed, the European Central Bank, and governments across the globe was nothing short of Herculean. Globally, there have been at least 414 stimulus measures announced and or implemented since early March. In the U.S. alone, the Fed cut interest rates by 150 basis points back down to zero to 25 basis points, began a massive lending and asset purchase program, and reduced regulations on banks to free up excess reserve capital for lending. Unlike the limits of Fed placed on itself in 2008, the current program is open-ended and will be in the amounts needed to support the smooth and functioning of markets. The Fed is also once again, lending money to primary dealers to support the money market sector, including commercial paper. In late March, Congress passed the Coronavirus Aid Relief and Economic Security, also known as the CARES act, providing $2 trillion of stimulus to individuals, families, workers, hospitals, and businesses, large and small.

Unlike previous stimulus packages, which were targeted at large corporations in the markets, this one is also focused on helping individuals and small businesses weather the storm. Included in the package were direct checks to individuals as well as extended and enhanced unemployment insurance. These cohorts were basically ignored in 2008, when the focus was on saving banks from insolvency and supporting the damaged mortgage market. So far, the Fed's balance sheet has grown from 4.2 trillion in March to over 7 trillion, by the beginning of June. This includes a few additional security purchase programs that might have unintended consequences down the road. More on that later. Needless to say, the steps taken to-date should help to start us on our return journey to recovery. With employers incentivized by the CARES Act to keep many employees on the payroll, combined with enhanced and extended unemployment benefits for others, incomes were largely maintained and, in some cases, increased by those on the receiving end.

Mortgage and loan student services, some landlords, other creditors also are allowing for payment deferrals to help maintain incomes for individuals. While home confinement should help slow the pandemic spread, it is also sowing the seeds for a potentially powerful economic recovery. As reported by the federal reserve bank of St. Louis, personal consumption declined through the first half of the second quarter as individuals shrunk their purchasing to mostly essentials. The flip side is that the personal savings rate, which had been running at about 8% rose to over 30%. We view this as pent up demand once the economy reopens in earnest. Corporations have been enhancing their liquidity by raising massive amounts of capital in both the debt and equity markets to maintain their businesses, refinance pending maturities, and to weather the storm.

According to JP Morgan, high yield issuers raised over $142 billion in debt during the second quarter, which was the highest quarterly total of all time. And over 215 billion during the first half, which is also among the highest first half totals ever. Investment grade companies have been even more active, raising over $1.15 trillion in debt year-to-date, easily surpassing Barclays full year, new issuance estimate of 920 billion.

This doesn't include the common and preferred or convertible debt that has also been issued. But one differentiating factor in this recessionary event is that the capital markets reopened with a vengeance rather quickly, and trading resumed along with it. The markets are functioning normally, and seem to be receptive to almost anywhere the company raising capital. What does give us some concern is the recent Fed exuberance in purchasing assets they have not previously bought before. Specifically, non-investment grade debt and exchange traded funds.

ETFs do not have maturity. So they cannot simply be held until maturity or a refinancing event. When the Fed decides to unwind its positioned in an ETF, it will need to sell it, which could cause some hiccups in the markets. As an example, they are now the third largest holder of the iShares iBoxx Investment Grade Bond Index, and also the symbol LQD, having recently purchased 13 million shares worth $1.8 billion. At this point, their other ETF purchases have been more modest. So we hope that this is more suasion than swagger given the huge cash stockpiles on the sidelines of investors. This intervention is not needed by the markets now. Speaking of which, the S&P 500, which hit a new low of 2237 on March 23rd, rebounded, almost a thousand points to a high of 2332 on June 8th. During the same period, the BofA High Yield Index, yield declined from 11.41 to 6.43.

And the Barclays U.S. aggregate U.S. Index, the Agg, declined from 1.96 to 1.41. Alternatively spreads have tightened in the ICE High Yield Index, from 1,087 basis points to 551 basis points. And for the Agg, spreads declined from plus 123 to 63 basis points. All positive signposts. With only limited reopenings in the second quarter, we can already see the potential of U.S. recovery as stir crazy consumers emerge and spend. Companies begin to rehire and supply chains reboot.

This is evidenced by the most recent May and June jobs reports. In May, the U.S. economy added 2.7 million jobs. And the most recent June report shows 4.8 million jobs added. The unemployment rate has fallen from a high of 14.7% to 11.1%. While still elevated, the trend is favorable. Also, new home sales are on the rise, as University of Michigan's Consumer Sentiment Index increased for two straight months.

Evercore ISI's company surveys have steadily improved from the lows in early April. And the Evercore ISI trucking companies report has continued to improve as economy reopens. Mobility statistics are showing steady improvement as well. According to the Federal Reserve Bank of Philadelphia, both their current and future general activity indexes have been steadily increasing off the lows. This is not just the U.S. restart, but a global one as well. In China, the first company hit by the pandemic, airline passenger traffic and vehicle sales have been improving. And steel and coal production, an unwanted but reliable indicator of industrial output, has also been rising. In some cases surpassing 2019 levels. All of these are signs of economic recovery. Companies are not only shoring up their balance sheets, but also reexamining how they do business. They're streamlining their operations, rationalizing costs, and revamping supply chains, which hopefully begets more profitable growth in the future.

For example, the Wall Street Journal reported that restaurants have been streamlining their menus by removing slow-selling items. Pepsi's food business has cut a fifth of its product line. Even Harley Davidson is cutting some motorcycle lines. Companies likely should have taken these actions earlier, but they have spent years trying to please everyone. And now the pandemic has helped them realize that this was inefficient and unnecessary. Initial reactions by consumers may be negative, but do we really need 40 types of toilet paper, 60 varieties of Lays potato chips and 400 types of Campbell soup? Maybe not. We think people will adapt. Markets will allocate capital to attractive areas of the market if more choices are demanded by consumers. While we are optimistic over the medium and long term, we are keeping an eye on some possible unintended near-term consequences of the shelter in place restrictions and government largess.

The most notable recently is the rise in day trading by small investors. With the absence of live sports, including sports betting and other outside entertainment and distractions, people have been looking for creative outlets. Spurred perhaps by a very high savings rate, a growing number of retail investors have begun the day trading stocks. Fostered by websites, such as Robinhood Trading, from which they get their collective name, which offers trading with no transaction fees, coupled with the ability to purchase a slice of a share of stock now, we are witnessing unbridled increases in less-than-informed trading activity that gives us some pause. One only needs to look at the trading in Hertz Rent-a-Car recently, post its filing for bankruptcy, as a sign that people need to get back to their regular schedule lives.

Led by blogs, such as Barstool Sports, these Robinhood traders drove the bankrupt stock up 525%. Stocks in bankrupt companies are typically wiped out. But these new levels drove bankers to consider raising more bankrupt stock for Hertz, essentially feeding the ducks while they quacked. Thankfully the SEC stepped in and cooler heads prevailed. And the stock have since receding in price.

Even large pension funds are not immune to seemingly irrational decision making. According to the minutes of the recent CalPERS pension fund board, the Chief Investment Officer mapped out a plan to add leverage and make additional investments into private equity, and private credit, in order to achieve its targeted returns. It will remain to be seen if this works out for them or not. We hope as social activities normalize, craziness subsides. We do not expect the recovery to be a straight line, however. There will be speed bumps and detours ahead, but the trend should remain positive.

As we have seen recently, following a sunny Memorial Day with many crowded beaches, and weeks of densely populated protests around the country, there has been a resurgence in COVID cases and a commensurate dialing back of reopening plans by many states and cities. This second wave was not a surprise, but its timing is earlier than the September spike originally anticipated by medical experts.

Additionally, our healthcare system has learned a lot since the outbreak about treating the disease, and we have made progress in securing protective gear for healthcare workers. Hopefully this curve flattens as well without much disruption to the momentum we have seen so far. In sum, we believe that the dark days of March are behind us. And while the recovery will not be V-shaped, companies with the ability to raise capital will make it safely to the other side. So far, signposts for the return journey from our perilous pandemic detour appear to point to recovery. We have taken advantage of the market volatility to find good companies at cheaper valuations across both the bond and convertible markets. And continue to retain a fair amount of cash for additional opportunities on retrenchments. We thank you for your continued confidence, and look forward to continuing our relationship. We welcome any questions and comments you may have now, Shawn.

Shawn Eubanks: First of all, we have a question from Randy Ray. We've heard concerns from some clients about the risks of holding names, such as United Airlines, or American Airlines, NCL, or Royal Caribbean. Are these holdings that they should worry about?

Carl Kaufman: You know, we made a conscious decision to try to find the best companies in those areas. We would call them the COVID names. We think that... Well, first of all let me point out that, companies like Carnival, that's the 800 pound gorilla in the industry, and while they are on the sidelines right now, they did raise an enormous amount of capital early on and were able to do that. So the ability to do that was impressive to us. The stock price had gotten absolutely hammered. And we took a much larger position in the convertible than in the straight bond, which was yielding 11 and a half percent for three years.

I think as we get closer to a reopening or a vaccine, these companies will do fine. They're already seeing a lot of inquiry for next year's bookings. I mean they have a cohort that is basically gung ho on cruising, pandemic or not. But that being said, they have a ton of liquidity to see them through the other side. Same can be said of companies like Ford Motor Company, which is starting to see a ramp-up into demand.

Shawn Eubanks: Great. Thank you. Carl, looking forward over the next two years, what are your expectations for the duration of the portfolio and credit quality? And are there any specific sectors that you're avoiding currently?

Carl Kaufman: Sure. In terms of the duration, what we tried to do, what we talked about last quarter, was we have tried to buy longer-dated to companies, higher quality names, longer-dated bonds and higher quality names. Because we feel that this is an aberrational type of recession and that it was caused by an outside agency, rather than a buildup of excesses in the economy. So we do think it will get back to its slow growth at some point.

So we are trying to lock up higher yields for longer periods of time. So even though we had a lot of cash coming in and a fair amount of short dated paper, the duration has been moving up a little bit, but we'd like to move it up some more opportunistically. So I would like to see the duration get a little bit higher, maturity a little bit longer. Because I think rates will stay near zero for a long period of time. The Fed has already pretty much said that.

So the first thing they said was they'd normalize quickly. They said, "No, we're going to keep it low for at least two years." So in that type of environment, if you can take a good company that you know will survive. I mean, there are companies we have, for example, we have one of the larger ATM network operators, and ATM machine makers, NCR. I mean, are people going to stop going to the ATM? I don't think so.

So there are companies that don't necessarily get hurt by the pandemic, but when you can buy their bonds, when they're throwing out the baby with the bath water, I think you're supposed to do that. And you're supposed to buy the longest bond you can. So I think that, you'll probably see the quality of the portfolio move up. You'll probably see the duration, maybe move up a little bit. And that's about it.

Shawn Eubanks: Okay. And can you also talk about any, kind of the general inflows and outflows for the fund?

Carl Kaufman: Sure. As always, in these type of selloffs, you see outflows and we did, we saw outflows. As we have seen the last two, three events like this, you see the biggest outflows to the day at the bottom, which we did. Lately, we have been seeing inflows into the fund and we are starting to see more people, I think most of the people went to cash. Which, it's fine. I mean, we were trying to get people to buy when the market was getting hammered. But it's always tough to do when emotions take over. And now that things have stabilized a little bit, we are seeing more inflows on a daily basis.

Shawn Eubanks: And maybe you could talk a little bit about your current cash position in the portfolio. I know you have cash and kind of cash alternatives. Maybe you can break that up and share kind of where you're at in terms of your liquid bucket.

Carl Kaufman: Shawn, these questions sound suspiciously like they're coming from you.

Shawn Eubanks: No, they're not actually.

Carl Kaufman: These are questions, for those of you who don't know, these are the questions that Shawn asks me almost every day. We came into the... Let's take a step back. We came into the selloff with about 35% cash in what we call cash equivalents, which was a record for us. Because the market, we felt, the unusual thing about this recession is it happened from the all-time highs in the equity market. And pretty much, not quite the all-time highs in the high yield market, but pretty close to low yields. So we had been stocking up on cash and we were in a very good position.

We currently have roughly 27% in cash and cash equivalents, but a lot of that is not static. So we got down to about 20%. And as companies continually come in to, A, refinance their bonds, or given that we have a lot of short term paper, they just mature and you don't have something to invest in. We keep on building cash. So, we've been building cash back up somewhat, sometimes involuntarily, sometimes voluntarily. So that's where we stand right now. And that cash consists of what we consider cash is obviously Treasury money market funds. We have some very short-dated investment grade, floating rate notes. We have bonds that mature within a year, both convertibles and non-convertibles. And bonds that have been called already.

Michelle: Hi, John. We have you ready to ask your question to Carl Kaufman.

John: Yes, Carl, John Bossler, how are you?

Carl Kaufman: Hey John.

John: Good. So 27% currently in cash would still be, I would assume a historically higher level for you. So are you holding this level of cash currently anticipating another event? Or why not rapidly buy at these levels?

Carl Kaufman: Well, the companies that we want to buy, have rallied back pretty strongly and we're waiting for better prices. Only about eight and a half percent of that cash is actually Treasuries. So some of it has kind of things that are okay on the short time, especially the short dated paper that we've been buying. So we have been actually deliberately buying paper under... As I say, we started out buying longer-dated paper during the correction. Now that things have rallied almost all the way back, we've pivoted back to buying shorter dated paper. So some of that's showing up in the cash.

Shawn Eubanks: we appreciate your interest and confidence in the strategic income fund. And please feel free to reach out to us at (800) 700-3316, whenever we may be a resource. We appreciate your confidence. Thank you very much. And we look forward to speaking to you soon.

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

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.

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.

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

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.

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. [46163]