Published on July 20, 2022

2022 has been a rough year for fixed income investors (among others), as most bonds have experienced double digit losses. Perhaps the only silver lining to this situation is that many securities have declined in price even though the issuer’s credit quality has not materially changed, which has created some excellent buying opportunities for active managers like us.

In downward trending markets as we have seen for much of 2022, it is important to distinguish price declines which may present similarly. Both index and active fundamental portfolios have moved, but not all securities move for the same reasons. Some investments move because fair value has declined; others move because they are getting “cheaper.” Because indices are designed to be measures of the current market, any market declines experienced in indexed portfolios are inherently a decline in fair value. However, it is the job of the fundamental investor to isolate those securities in which the underlying value is less volatile than security prices, buying as instruments get cheaper and selling as they reach or exceed fair value.

To this end, the job of the value investor is not just to find good companies but to find misunderstood companies. It is a sort of analysis arbitrage. The most attractive securities are those that are not just issued by strong companies but are also cheap. In an undulating market, a value discount can sometimes offset market movements and mitigate volatility. In a rising market, earnings can reveal the additional value to be found in an underpriced security. And when the market or economy is facing headwinds, that is the opportunity to separate the fundamentally challenged from the fundamentally cheap — to avoid the issuer which has experienced a fair value decline in favor of the issuer who has experienced merely a price decline.

When we look at the economic environment today, this distinction is particularly notable. The first half of 2022 has been a headwind to all credit portfolios, fundamental or not. And there is no way to sugarcoat why. The risk of a recession in the near- to medium-term future is not low. Wage gains have not yet caught up with recent inflation, and the impact is being felt all across the country. However, that consumers are so aggrieved about higher prices tells us less about the purported opportunism of the small business owner as it does about the visceral impact of higher prices on people’s fiscal confidence. In fact, there is no shortage of indicators to show just that (see Figure 1).

Figure 1: As of 3/31/2022, both the PG Peterson Foundation Fiscal Confidence Index (top) and the University of Michigan Consumer Sentiment Index (bottom) show a decided drop off in the financial confidence felt by consumers, as low as or even lower than at the depths of the Covid-19 pandemic. (Source: Bloomberg Finance LP)

As we have moved through the current earnings season, however, we are struck by two significant observations. First, we have seen the same dynamic we saw in mid-2020, where fundamentally attractive bonds which are not members of an index experienced price declines proportionate to the indices but have not yet experienced the same level of recovery. After all, issuers whose strength is demonstrated through earnings and not through the supply and demand of market indices get their momentum from quarterly earnings reports rather than inreal-time based on market correlations. In addition, the types of value-oriented investors who buy such bonds in between earnings tend to be more opportunistic, taking more time to accept that the right price to pay is higher than the lowest price paid recently. This means the recovery period of these bonds is not as immediate as higher beta securities. As a result, yields in securities with a fundamental investment thesis are currently higher on average than the yield in market indices. This is not always the case and shows the relative opportunity through careful security selection in the current environment.

However, this brings us to our second observation. Babies are getting thrown out with the bathwater, often for the very misunderstandings that fundamental investors aim to exploit. For example, recently, poor earnings from the company Bed Bath & Beyond caused the market to sell bonds issued by Michaels in sympathy. On the surface, the reasons were logical. Costs were higher, and supply chain issues were front and center. However, also evident in the resulting analyst reports was a failure to appreciate the difference in the two issuers’ underlying customers or the dynamics that drive those customers to shop. The comparison stopped at platitudes: They are both brick & mortar retail businesses with potential cost and supply issues due to inflation.

However, what Michaels demonstrated during the Covid-19 pandemic and resulting quarantine(s) is that it is a business which does well in economically challenged times. Despite the impact of recessionary fears and uncertainty on retail as a whole, crafters and other artists lean into their hobbies in such environments. Even more so than the shoppers looking for the types of basic supplies found at Bed Bath & Beyond, which can also easily be found on Amazon or at Target, the Michaels core customer has few alternatives. Meanwhile, where the Bed Bath & Beyond customer’s discretionary spending may be curtailed, the equivalent at Michaels tends to be seasonal or holiday. This does not mean consumers will not cut back, but as we’ve seen over the last two years, celebrating occasions where possible can be a release valve to the general feeling of strain on the pocketbook.

Often, when one thinks of opportunistic investors, one imagines hedge funds taking outsized risk and profiting if they are correct. However, there is another brand of opportunistic portfolio management which lies more in exploiting misunderstandings in the fundamental nature of a business. In this example, the underlying dynamics of these two companies are different, but the current market has treated them the same. It seems the conclusions of most analysts stop at a superficial view of a business and credit metrics. But therein lies the opportunity.

Venk Reddy

Chief Investment Officer – Sustainable Credit

Featuring

Venk Reddy

Chief Investment Officer – Sustainable Credit

Venk Reddy

Chief Investment Officer – Sustainable Credit

Venk Reddy joined Osterweis Capital Management in 2022 as part of the Zeo Capital Advisors team transition. Prior to founding Zeo Capital in 2009, Mr. Reddy was a co-founder of Laurel Ridge Asset Management, a multi-strategy hedge fund, where he managed the credit, distressed, and event-driven portfolios. Previously, he structured derivative products and was head of delta-one trading as a portfolio manager within Bank of America’s Equity Financial Products group (EFP). Mr. Reddy also managed investments in event-driven situations, convertible instruments, and options at Pine River Capital Management and HBK Investments, where he started his career.

Mr. Reddy is a principal of the firm and a Portfolio Manager for the sustainable credit strategies. He is also a portfolio manager for the growth & income and flexible balanced strategies.

He currently serves as a Trustee of Lick-Wilmerding High School in San Francisco. He previously served as a Trustee and officer of the Katherine Delmar Burke School in San Francisco.

Mr. Reddy graduated from Harvard University (B.A. in Computer Science with Honors).

Invest With Us

For more information about this strategy, please send us an email or call us at (800) 700-3316.

Sustainable Credit Fund Quarter-End Performance (as of 3/31/23)

  1 MO QTD YTD 1 YR 3 YR 5 YR 7 YR 10 YR INCEP
(5/31/2019)
ZSRIX -3.61% 0.13% 0.13% -6.43% 2.64% - - - -0.62%
ICE BofA Single-B U.S. HY Index 0.88 3.81 3.81 -3.86 5.51 - - - 1.90
Bloomberg U.S. Aggregate Bond Index 2.54 2.96 2.96 -4.78 -2.77 - - - -0.43
Swipe Table for Full Data

Net/gross expense ratio as of 10/10/22: 0.99%/ 2.22% The Adviser has contractually agreed to waive certain fees through October 10, 2024. The net expense ratio is applicable to investors.

30 Day SEC Yield as of 3/31/23: 10.55%

The benchmark is the ICE BofA Single-B U.S. HY Index.

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 calling shareholder services toll free at (866) 236-0050.


Rates of return for periods greater than one year are annualized.

The ICE BofA Single-B U.S. High Yield Index is a subset of ICE BofA U.S. High Yield Index including all securities rated B1 through B3.

Effective 6/30/22, the ICE indices reflect transactions costs. Any ICE index data referenced herein is the property of ICE Data Indices, LLC, its affiliates (“ICE Data”) and/or its Third Party Suppliers and has been licensed for use by Osterweis Capital Management. ICE Data and its Third Party Suppliers accept no liability in connection with its use. See https://www.osterweis.com/glossary for a full copy of the Disclaimer.

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.

Source for any Bloomberg index is Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg owns all proprietary rights in the Bloomberg Indices. Bloomberg does not approve or endorse this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

References to specific companies, market sectors, or investment themes herein do not constitute recommendations to buy or sell any particular securities.

There can be no assurance that any specific security, strategy, or product referenced directly or indirectly in this commentary will be profitable in the future or suitable for your financial circumstances. Due to various factors, including changes to market conditions and/or applicable laws, this content may no longer reflect our current advice or opinion. You should not assume any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from Osterweis Capital Management.

There is no guarantee that securities investments will result in favorable Environmental, Social, or Governance (ESG) outcomes.

Complete holdings of all Osterweis mutual funds (“Funds”) are generally available ten business days following quarter end. Holdings and sector allocations may change at any time due to ongoing portfolio management. Fund holdings as of the most recent quarter end are available here: Sustainable Credit Fund

Short Duration Credit Fund Quarter-End Performance (as of 3/31/23)

  1 MO QTD YTD 1 YR 3 YR 5 YR 7 YR 10 YR INCEP
(5/31/2011)
ZEOIX -3.29% 0.10% 0.10% -6.75% 2.64% 0.64% 1.36% 1.78% 1.98%
ICE BofA 0-2 Yr Duration BB-B U.S. HY Index 0.25 2.38 2.38 1.74 4.36 2.78 3.33 3.26 3.65
Bloomberg U.S. Aggregate Bond Index 2.54 2.96 2.96 -4.78 -2.77 0.91 0.88 1.36 1.89
Swipe Table for Full Data

Gross expense ratio as of 10/10/22: 0.85%.

30 Day SEC Yield as of 3/31/23: 12.35%

The benchmark is the ICE BofA 0-2 Yr Duration BB-B U.S. HY Index.

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 calling shareholder services toll free at (866) 236-0050.


Rates of return for periods greater than one year are annualized.

The ICE 0-2 Yr Duration BB-B U.S. High Yield Constrained Index contains all securities in the ICE BofA U.S. High Yield Index rated BB1 through B3 with a duration-to-worst of less than two years.

Effective 6/30/22, the ICE indices reflect transactions costs. Any ICE index data referenced herein is the property of ICE Data Indices, LLC, its affiliates (“ICE Data”) and/or its Third Party Suppliers and has been licensed for use by Osterweis Capital Management. ICE Data and its Third Party Suppliers accept no liability in connection with its use. See https://www.osterweis.com/glossary for a full copy of the Disclaimer.

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.

Source for any Bloomberg index is Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg owns all proprietary rights in the Bloomberg Indices. Bloomberg does not approve or endorse this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

References to specific companies, market sectors, or investment themes herein do not constitute recommendations to buy or sell any particular securities.

There can be no assurance that any specific security, strategy, or product referenced directly or indirectly in this commentary will be profitable in the future or suitable for your financial circumstances. Due to various factors, including changes to market conditions and/or applicable laws, this content may no longer reflect our current advice or opinion. You should not assume any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from Osterweis Capital Management.

There is no guarantee that securities investments will result in favorable Environmental, Social, or Governance (ESG) outcomes.

Complete holdings of all Osterweis mutual funds (“Funds”) are generally available ten business days following quarter end. Holdings and sector allocations may change at any time due to ongoing portfolio management. Fund holdings as of the most recent quarter end are available here: Short Duration Credit Fund

Venk Reddy is the Chief Investment Officer of Sustainable Credit Strategies at Osterweis Capital Management. Established in 1983, Osterweis Capital Management is an independent asset manager with $6.6 billion under management as of June 30, 2022. The firm provides investment management services to institutions and individuals through mutual funds and separate accounts, offering both equity and fixed income investment strategies.

 

Important Disclosure Information

Past performance is no guarantee of future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by Osterweis Capital Management, (“OCM”) or any non-investment related services, will be profitable, equal any historical performance level(s), be suitable for a specific portfolio or situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.

OCM is neither a law firm, nor a certified public accounting firm, and no portion of its services should be construed as legal, tax or accounting 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. You should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from OCM. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. Existing clients should remember that it remains your responsibility to advise OCM, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing, evaluating, or revising our previous recommendations and/or services, or if you would like to impose, add, or modify any reasonable restrictions to our investment advisory services. A copy of our current written disclosure Brochure discussing our advisory services and fees is available upon request or at www.osterweis.com. The scope of the services to be provided depends upon the needs of the client and the terms of the engagement.

Neither recognitions by publications, media, or other organizations, nor the achievement of any professional designation, certification, degree, or license, membership in any professional organization, or any amount of prior experience or success, should be construed by a client or prospective client as a guarantee that he/she will experience a certain level of results if OCM is engaged, or continues to be engaged, to provide investment advisory services.