Fixed Income Investing in a Low Rate Environment with Carl Kaufman & Eddy Vataru

Shawn Eubanks: Welcome everyone. First of all, I hope everyone is well and staying healthy. I'm Shawn Eubanks, and I'm pleased to introduce Carl Kaufman, our co-CEO and the lead portfolio manager of the Osterweis Strategic Income Fund. And Eddy Vataru, the lead portfolio manager of the Osterweis Total Return Fund. Given the volatility in the bond market in 2020 in the low yield environment, many advisors are rethinking their traditional benchmark oriented, fixed income strategies. We hope that this short Q&A with Carl and Eddy will be useful in navigating this environment for your clients. I'd like to start with Carl. Carl, you came into this pandemic with a very high allocation to cash and short term bonds. How did you deploy that cash during the selloff, and where are you finding value today?

Carl Kaufman: Thank you everybody for tuning in. As you know, Shawn mentioned we did come into this with very high levels of cash and short term debt, because as you remember, the bond market and the stock markets were at their highs, and we weren't finding a lot of value. We tend to let cash build in periods like that, which generally serves us very well when you do get a correction for whatever reason. During the correction, we made a conscious decision, knowing that pandemics do end. We did a balance of some companies that would go through the pandemic without any pain at all, or actually come out stronger the other end. And companies that were affected by the pandemic, but that would survive. Typically the strongest companies in their peer group. Given the fact that this was very unusual, and that capital markets opened very quickly after the selloff due to Fed action, we had a real large choice of names which to choose from. From the new issue market, as well as bonds in the secondary market that had traded off. We did do some buying. Now, fast forward to today. We have a situation where the markets have rebounded. They're almost as tight as they were pre-pandemic. In some cases in the equity market are higher, we have decided to revert back towards the more defensive posture, buying shorter term paper. Buying intermediate paper in companies that are stronger. We have upgraded the portfolio as well. We'll wait for another correction to do some more aggressive longer-term buying because we think that rates will remain low for many years to come. Now is the time to grab some yield, so to speak.

Shawn Eubanks: Great. Thank you, Carl, can you share some current statistics on the portfolio positioning, fund yield duration, et cetera?

Carl Kaufman: Sure. Yield to maturity is roughly six and a half percent. Yield to worst is about lower 6%. The current yield is still a little bit over 5% and the duration is about 1.6, and the years to maturity is about 3.3. We're capturing yields that are very similar to the high yield market, but with much less duration.

Shawn Eubanks: Great. Thank you, Carl. Eddy, I know you've been speaking virtually to advisor groups kind of across the country about the challenges of managing fixed income portfolios in this low yield pandemic economy. Can you share your thoughts about the risks of benchmark investing in this environment?

Eddy Vataru: Sure. We've basically had a pretty protracted run in an investment grade fixed income of lower rates, and increasingly tighter spreads over time. What that's done is especially with the last three or four bouts of quantitative easing that we've had over the last decade, including the big one we're in now, is a lot of issuers have been pretty cagey and have issued much longer maturity debt; certainly the Treasury has increased its issuance. But in particular, corporate issuers who are capable of taking advantage of lower interest rates have been very proficient at doing so. What that's done is it's changed the composition of the aggregate index in a pretty material way.

Right now when you look at the aggregate index, the yield of the index is barely north of one. Again, largely because Treasury yields are basically 50 basis points at the index level. Corporate bonds have increased in terms of their size on the index, but also note that the maturity, or the duration, of corporates that is their interest rate sensitivity, has also increased materially. The duration of the index as a whole is north of six, which is the highest it's been. It's actually 50% higher than it was during the crisis 12 years ago. What that means is you're getting paid one, one and a half percent for something that has a materially higher interest rate sensitivity than we've seen historically. And just to put that into kind of a back-of-the-envelope terms, if rates were to rise a hundred basis points from here, that would mean a 6% loss at the bond portfolio level, at the index level.

If you're only earning one to one and a half percent on your index, that's going to take you several years to earn your way out of. That risk-reward profile is very different than we've seen for fixed income historically. And that creates a lot of issues if you're looking at bonds at investment grade fixed income as a meaningful part of your allocation or your portfolio.

Shawn Eubanks: Eddy, given the total return strategy's not constrained to the benchmark allocations, and duration targets, how do you manage downside risk and lower volatility while staying invested in the investment grade sector?

Eddy Vataru: I'd say we do two major things that look different than your traditional investment grade bond fund. Number one, because of that risk-reward profile for Treasuries we substitute a lot of our treasury exposure into Agency MBS, which has pretty much the same credit quality in my mind as a Treasury.

Certainly part of the mortgage index is full faith and credit, the Ginnie Mae part of it. But even Fannie and Freddie, which are currently under conservatorship and figure, even in the worst scenarios to still have their legacy mortgages protected, you're not taking a huge downgrade in terms of credit quality. You certainly don't have this kind of corporate, or pandemic risk, if it's something that concerns you.

The other nice thing about mortgages is their durations are materially shorter than Treasuries. The treasury index has a duration in the context of about eight, and the mortgage index has a duration of about two. And yet you're still able to generate a yield that's two or three times what the Treasury index. Somewhere in the one to one and a half percent area for agency MBS. That risk-reward profile of owning agency mortgages instead of treasuries is a good place to start.

Now, for corporate bonds, we find ourselves invested in some corporate names where we do like 10 or 20, or even 30 year bonds in corporate space, in the cases that we have high conviction in the corporate name itself. In those cases where we find those particular issues to be cheap, we hedge out our interest rate exposure for anything that has say 10 or 20 or 30 year rate exposure that at times we don't think we're not comfortable with. Certainly these days, given how low rates are in general, we find ourselves doing that a little bit more. I would say that the combination of owning a mortgage substitute versus treasuries, as well as owning hedged corporate exposure for some of our longer corporate names, allows us to run a portfolio which has much less interest rate exposure than the index.

Shawn Eubanks: Thank you. With yields being so low, some clients are actually questioning the role of investment grade bonds in their portfolio. The old 60-40 allocation. Can you share your thoughts on that, Eddy?

Eddy Vataru: Yeah, I mean, it's a valid concern. Treasuries have, in general, bonds as a whole, but Treasuries in particular, have served this role as ballast against downdrafts to the equity market. Historically the correlation between bonds, and stocks, has basically made the 60-40 portfolio kind of this golden rule of allocations and investing. Certainly over the last 30, 40 years that's held true. The problem is now Treasuries basically have nowhere left to go. With treasury yields approaching zero, if we have another leg down in equities, what does that mean for bonds? Can bond yields go negative? We've seen a lot of dialogue out of the Federal Reserve that says, "We're not interested in having negative rates in the U.S." That's a little bit different than what you've seen abroad where rates are negative, particular in the EU.

But I think the Fed has looked at their experience and said, "We don't really see what the value is domestically of having a policy that embrace negative rates." What that means is it's very difficult for treasuries to provide that ballast, or provide a positive return in the context where they're only yielding 50 basis points and have no more room to run. It is the right time to ask that question. I think the trick is going to come in, in trying to figure out what that substitute for that Treasury asset class is. Now, we use agency MBS because we're not, in my mind giving up credit quality, but we're earning more yield and taking less interest rate risks. I think that's a great substitution, but certainly others are looking at different types of approaches. I think the only caveat I'd give is that you really want to maintain some asset that performs well in a flight to quality. In my mind, mortgages can do that as well as Treasuries at this point, if not better.

Shawn Eubanks: Thank you Eddy. Thank you Carl, for your time today. We really appreciate it.

Carl Kaufman: Thank you for calling in.

Eddy Vataru: Thank you.