Listen to Eddy’s interview on the “Money Life with Chuck Jaffe” podcast to hear his thoughts on how he is managing the Total Return Fund to address the risks and opportunities in the current investment grade market.

Transcript

Chuck: Welcome to the Big Interview on today's show and I'm very pleased to welcome back to Money Life Eddy Vataru. He is portfolio manager at the Osterweis Total Return Fund. It's ticker symbol O-S-T-R-X, and if you'd like to learn more, osterweis.com is the website. Eddy Vataru, Thanks for joining me again on Money Life.

Eddy Vataru: Thanks for having me, Chuck.

Chuck: You were last on the show in late April, so we were about a month into the pandemic. At the time we were talking about, obviously not just the pandemic, but other big events that were on the schedule, and that of course included the election. I know from having followed your commentary and your outlooks through the rest of the year that you weren't going to be responding to the election. You had no anticipation even when we talked back in April of, ah, the election is going to turn out this way, and this is what we'll do with the portfolio. But I believe the word you used was "instruct," that the election was going to instruct what happened next in going forward with the portfolio. So I'm curious, as you look ahead, given what we've had happened with the election, but also what hasn't changed with the gridlock and some of those other sorts of things, what the situation is instructing you to do right now?

Eddy Vataru: It's an interesting situation, because obviously the election was about six weeks ago. While we learned a lot in terms of most of the outcomes, obviously it continues to be a contested election, albeit with what seems like some pretty weak legs on what is being contested. We have what appears to be a pretty sloppy transition and most importantly, we have two Senate runoff elections in Georgia. Those two seats are going to dictate whether or not the Senate remains Republican, or if it flips to Democrat. Those have two very different implications on markets.

If you turn back to November 5th, at that point, it seemed like Biden had won and it also seemed like the Republicans were going to keep the Senate. What you saw in the markets was Treasury yields fell, equities loved it, equities have rallied and done pretty well, even ever since. Because what happened then was you had a discounting of the possibility of a blue wave. So basically a Democratic sweep of the House, the Senate, and the presidency.

The reason that was important to markets is because along with a blue wave, there was a fear of increased taxation, but also increased fiscal spending, increased Treasury supply ultimately to pay for a lot of this, and just higher rates in general. So when you have more fiscal stimulus, that does generate inflation organically by putting money in people's pockets that ultimately would get spent. That is the most direct way to stoke inflation.

When you have gridlock, which is what we priced in on November 5th, that was a Republican Senate with the Democratic house and a Democratic president elect, that outcome, the gridlock outcome was what markets really favored because that meant less possibility for massive fiscal stimulus, less possibility for tax increases, which helped equities by virtue of not pricing in that possibility. Just generally, the idea of having gridlock meant that some of the more aggressive or progressive policies that could have been adopted by a blue wave outcome seem to have been discounted. That's why you saw that reaction November 5th.

Ever since then, we've kind of been waiting and seeing what's going on in Georgia. It seems like the possibility of Democrats winning both seats has increased since November 5th, but I still think it's not going to be the likely outcome, so I think the market reaction on November 5th is the right one. I keep saying November 5th, I don't know why I assume that was the day after the election, but the Wednesday after the election was certainly the day where the markets told us what direction we're going.

I don't think that's going to change. I do think that the Republicans will probably win at least one of the two seats and that will maintain the status quo. That, like I said, is a market-friendly outcome. I think we've seen folks deploy a lot of risk in equity since then. Bond yields have floated a little bit higher, but I think they would be significantly higher in the prospect of a Democratically controlled Congress. But we'll have to see for confirmation on that in January.

Chuck: By the way, November 5th was the Thursday, November 4th was the Wednesday after the election. But either way, it still makes the point that it's right after the election itself. You talk about inflation and I've been saying this ever since the stimulus went out, I've been asking everybody, well, you have this stimulus, I learned in economics class, you have a bunch of stimulus, expect some inflation. Almost everyone has said inflation, well, it may come to roost eventually, but it won't happen anytime soon. We said it instructs the portfolio, you're a fixed income manager. Is it making you look at inflation protected at all? Is that something that you think people should put their eyes on a little bit more because it's coming, or yes, you fear inflation, but you don't fear it for a while, like almost everybody else that we've had on this show.

Eddy Vataru: It's a tricky read. I think there were some forces in play that would create structural inflation, in terms of any continuation of the Trump policies of onshoring a lot of businesses that have been offshored. I think the pandemic itself has made us question, regardless of where you stand in the political arena, for having dependencies abroad when the pandemic forces you to look within and be able to be self-sufficient. Even as we move to a new administration, I do think that there is a movement generally to have some more onshoring of essential businesses and whatnot.

To the extent that that policy is adopted, that is inflationary because generally speaking, the reason these businesses have been offshored is that the costs of doing business in that manner is cheaper. The cost of labor in the U.S. has tended to be more expensive, and other associated costs has tended to be higher. So that's why a lot of these businesses were offshored.

To the extent that you're moving them back on, that is inflationary, but that takes time, so I think there might be some structural sources of inflation related to supply chain down the road, over a period of years. In the short term, you've have some pockets of inflation related to some disruptions in supply, but those have been, I think, relatively transient.

We'll have to see how this plays out in the next few months, as we get the vaccine and unlock the economy again, but it's tough to look at the TIPS market and say that that's the place to go to protect yourself from inflation, because in many ways that market seems pretty fully valued. The Fed has targeted a 2% inflation target, then 30-year TIPS are pricing in pretty close to a 2% break even. In fact, the entire TIPS curve is pricing in within earshot of 2%. So the TIPS market's saying, okay, the Fed is targeting inflation, they're going to create it. We've already repriced it. Maybe it has a little bit of room to go, but I think the easy money in TIPS has already been made.

Chuck: Is there easy money to be made any place else in fixed income? Because Lord knows every investor seems to be looking for, but maybe not stretching for, yield.

Eddy Vataru: Yeah. Well, let me give you an interesting statistic that my colleague, John kind of uncovered yesterday, and it's fascinating. If you look at the yield of the corporate index and you compare that to projected inflation, the yield of the corporate index as a whole, so this includes bonds that are five, 10, 30 years to maturity, and you look at five-year inflation expectations, the yield of the index is actually lower than the inflation expectations are, which means that in real terms, companies can borrow at negative yields. Companies, not the Treasury, which it's doing in TIPS already, but companies.

So think about the implications of that in terms of the future of stock buybacks and whatnot when the availability of capital to corporations is at such a low level. So when you're asking me as an investor, we're kind of on the other side of that coin, where's the easy money to be made? I think the easy money to be made is by a corporation that has the wherewithal to be able to borrow at these kinds of rates and redeploy that capital in a way they see fit. It just speaks to the fact that yields are so low and spreads are relatively tight, but it is a very challenging market for investors. It is the kind of market I relish as an investor. I like a more difficult problem to solve, but a lot of the easy money has been made in the fixed income market over the last couple of years.

Chuck: So in the limited time we have left, where are you investing? Where are you taking up the challenge? What are the parts of the market that you are investing in?

Eddy Vataru: We remain invested in corporates and we remain invested in agency MBS. With regards to corporates, the reason we think spreads are tight, but could get tighter is the fact that the Fed has basically eliminated liquidity risk from that market through the actions that they took earlier this year as part of QE4. Again, I'm a bit tepid overall at the level of yields that we're seeing, but it's very difficult for me to see a scenario where yields shoot higher or spreads get a lot wider, given the effective backstop that the Fed has provided over the last few months.

In terms of mortgages, it's the same thing. During QEs where the Fed is actively buying agency MBS, you've been paid to follow along the Fed. It's kind of a different flavor of the old, don't fight the Fed. Here it's kind of, go with the Fed. The Fed has created a little bit of a technical squeeze in the mortgage market, so it allows you as an investor, basically the Fed is hoovering up all the bonds. So basically as an investor, you're paid to let the Fed own the mortgage bonds and you own mortgages synthetically using TBA market, which is probably the subject of a much longer call, digging into the mechanics around that.

But effectively you're earning somewhere between 50 to a hundred basis points over the stated yield of your mortgage assets, if you're willing to own them synthetically rather than in CUSIP or Pool form. The Fed has engineered that outcome, it's done it in prior QEs. It helps mortgage investors make more money in markets like this. I think it helps overall to lower interest rates, which the Fed is pleased with doing because it makes mortgage spreads tighter. They don't see a problem squeezing the mortgage market and I think they'll continue to do this for the next year.

To me, it's a great substitute to own mortgages instead of Treasuries, because you're not really giving up credit quality and you're earning a multiple of yield, two or three times the yield in mortgages that you might earn in Treasuries while taking less interest rate risk or less duration. That's a big substitution for us that we've had for a few months and I think we'll continue into the new year.

Chuck: Eddy, great stuff as always. I never have enough time with you, but I know that you will come back and chat with us, so we will talk to you again in 2021. Until then, stay safe, stay healthy, have a great holiday. Again, I look forward to the next conversation already.

Eddy Vataru: All right. Thank you. You too.

Chuck: That's Eddy Vataru, everybody. He is portfolio manager for the Osterweis Total Return Fund. If you want to learn more about it, well, osterweis.com and it is ticker symbol, O-S-T-R-X. Okay, we just hit the halfway poll on the Monday December 14th edition of Money Life. Up next ...

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The Bloomberg Barclays U.S. Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers.

Treasuries (including bonds, notes, and bills) are securities sold by the federal government to consumers and investors to fund its operations. They are all backed by “the full faith and credit of the United States government“ and thus are considered free of default risk.

Yield is the income return on an investment, such as the interest or dividends received from holding a particular security.

Treasury Inflation-Protected Security (TIPS) are a type of Treasury security issued by the U.S. government that is indexed to inflation in order to protect investors from a decline in the purchasing power of their money. As inflation rises, TIPS adjust in price to maintain its real value.

A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.

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

Fed refers to Federal Reserve.

To be announced, or TBA, is a term describing forward-settling mortgage-backed securities (MBS) trades.

Duration measures the potential volatility of the price of a debt security, or the aggregate market value of a portfolio of debt securities, prior to maturity. Securities with longer durations generally have more volatile prices than securities of comparable quality with shorter durations.

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

Mutual fund investing involves risk. Principal loss is possible.

The Osterweis Total Return Fund may invest in fixed income securities which are subject to credit, default, extension, interest rate and prepayment risks. It may also make investments in derivatives that may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. The Fund may invest in 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. Investments in foreign and emerging market securities involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks may increase for emerging markets. Leverage may cause the effect of an increase or decrease in the value of the portfolio securities to be magnified and the fund to be more volatile than if leverage was not used. Investments in preferred securities have an inverse relationship with changes in the prevailing interest rate. Investments in Asset Backed and Mortgage Backed Securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. It may also make investments in derivatives that may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. 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. [OSTE-20201214-0081]