Published on May 11, 2020

If you were unable to join Eddy Vataru when he recapped the fixed income landscape since the 2008 financial crisis and outlined a framework for assessing the risks and opportunities within investment grade bonds in the current market environment, you can watch the replay here.


Shawn Eubanks: Good morning everyone. I'm Shawn Eubanks and I'm the Director of Business Development at Osterweis Capital Management. We'd like to thank you for participating in our webinar today, titled A Roadmap for Fixed Income Investing in a Pandemic Environment. We appreciate you taking the time to join us. These are truly extraordinary times and I hope that you and your families are all safe and healthy. I'm pleased to introduce Eddy Vataru, who's the head of our investment grade fixed income team here at Osterweis, and the CIO of the Total Return strategy. Prior to joining Osterweis in 2016, Eddy worked in senior management positions at Incapture and Citadel, LLC. Before that, he spent 11 years at Barclays Global Investors and BlackRock, where his last position was Managing Director and Head of U.S. Rates and Mortgages. While in this role, Eddy was assigned to work with the U.S. Treasury department in implementing its agency MBS purchase program, buying back mortgages for the U.S. government from 2008 to 2009 to help stabilize the market.

Over the course of his career as a fixed income investor, Eddy has developed extensive experience in managing passive, active, and hedge fund portfolios for institutional clients. Mr. Vataru is a principal of the firm and the lead portfolio manager of the Osterweis Total Return Fund. After Eddy's prepared remarks, we'd like to address your questions directly, so please type your questions into the chat and we'll do our best to answer as many as possible. With that Eddy, I'll turn it over to you.

Eddy Vataru: Thank you Shawn, and I'd like to reiterate Shawn's request for questions. I'd love to have a healthy Q&A at the end of this. I hope that what I present to you will kind of stimulate some thought around how to approach the markets as they've changed, but using kind of the same framework that we use to really analyze all markets. It's just understanding kind of how risks have evolved, and kind of what's important in these markets, and how that differs from times past.

I'll also spend a little bit of time talking about my experience with Treasury, kind of what I call QE-0, even though it wasn't a QE program, it was really a mortgage market stabilization mandate. But it certainly provided me personally with a lot of insight as to how kind of official mandates are run, what the objectives generally are. Although like I said, QE's a little bit different, but kind of how they run and what I think you can expect from the experience that we're having now, and how it might be different than what we saw in QE-1 through 3.

So anyway, with that as a preamble, let's just dive right into the presentation. So to kind of lay the groundwork for where we've been, and it's funny, I use these Bay of Fundy slides regularly, although I have to say I've repurposed them for the particular case that we're in now. If you think about fixed income before, after the financial crisis of '08, we had a tremendous investment opportunity, whether you did active, index, anything, any way you were invested in fixed income or frankly in any risk asset, you had to be pretty pleased with your returns. Had a very favorable credit cycle. Obviously the market's being buoyed by QE 1 through 3, buying Treasuries and mortgages allowed investors to branch out into riskier assets or maybe you could say push them out into those assets.

But really collectively, all asset classes benefited. And we had the 11 or 12 year expansion that we've come to see in our rear view mirror. And this was the same bay, low tide, quite a different picture. COVID-19 has shut down the global economy. We've had job losses that just boggle the mind in terms of magnitude. I mean they're just unthinkable numbers, GDP estimates for the coming quarters could be negative double digits for Q2 in particular. And we've seen, I put an asterisk on this because as I say this, the NASDAQ is actually up year to date. But in general, you've had significant underperformance of risk assets. And in particular, those assets that are not specifically buoyed by Fed intervention. And I'll get to that in a little bit.

Oh, I would say that NASDAQ is not specifically buoyed by that, but that there's some other considerations around why tech has really benefited and I'll talk about that more in my outlook. Now, the tide is starting to come back. We've had QE4, which is really a magnitude of what we've seen of the QE1 through 3s in the past. We also have some substantial government programs intended to keep folks either employed or tide them over in terms of compensation, trying to keep small businesses afloat. The QE programs include corporate bond purchases, high yield, ETFs. I mean, they've really expanded the scope of what they're doing beyond what had been done historically.

However, and the reason the tide is not totally back is that we really don't know how long the shutdown is going to persist. We've seen signs of things reopening, but even as things reopen, there's kind of this concept of what the new normal is. It's not the old normal. So what does social distancing mean in terms of the viability of a number of different types of businesses? How's it going to impact travel? How's it going to impact a variety of businesses that have already been... The ones that have seen the greatest erosion of value both in fixed income and in equity space? Now, you've seen some asset classes have recovered and those are the ones that either have direct Fed involvement like mortgages, or they're ones that are not perceived to have any specific risks related to virus, the virus sticking around for longer than we're comfortable with. So that would include tech, businesses that benefit directly from the lockdown. Telecommuting, other behaviors that we've all adopted. Some staples, for example, Amazon, things that are that we tend to frequent more as our lives have changed. The real question will be as we return to some form of normal, what does that normal look like and how do we address that in making decisions for investing in our portfolio? Now, if you've seen one of my presentations before, I always come to this slide. They call it the matrix, and I think it's really a foundation for everything we do. And this is why I made the comment that investing in this market is really no different than other markets if you have the right framework to do it in.

This matrix, which I'll walk through for a few minutes, provides that template for understanding what are the risks in this market? How do we value those risks? And how should we be invested? Now this matrix applies to fixed income, and I specifically identified the three major asset classes within fixed income, so that's Treasuries, agency mortgages, and corporates. Those are 90 plus percent of the Agg. And then on the top, the set of columns correspond to the various risk factors associated with each of those asset classes. And I've segregated these by interest rate-related risks and spread-related risks. And by that, I mean every bond really has some flavor of interest rate exposure. That's the definition of owning fixed income.

The various shadings correspond to how much sensitivity those assets have to those respective exposures. So Treasuries are darker than agency mortgages because they have more duration, they have more interest rate sensitivity than agency mortgages do. Corporates are kind of in the middle. If you look at the duration of the corporate index, I believe it's a little bit less than the Treasury index, although the corporate index itself has really become quite a bit longer than it has been historically with companies taking advantage of low rates and relatively tight spreads for a long time. You've seen a lot of termed out issuance over the last few years.

Now, reinvestment risk and inflation risk really impact all bonds. Agency mortgages have more reinvestment risk because they're amortizing bonds, and because they have a call option where if Treasuries are... Or I'm sorry, if rates rally and mortgage rates fall, there is a heightened sense of refinance activity that comes through, and that means investors are paid back at par and need to reinvest that money into the new mortgage that's created. So it's a slight gradation, probably in this market, I'd make it a little bit darker than it is right now. But the real risk on that side is it's isolating the amortizing component of the mortgage cashflow. The call risk and the volatility risk, which I'll get to in a minute, are the darker-shaded ones on the right. I'm just getting a little ahead of myself.

Finally, inflation, which I think is a hot topic, or the opposite of a hot topic right now, that impacts all fixed income. It even impacts TIPS, which kind of have their own idiosyncratic inflation basis, if you will. You might think of it as a call on future inflation, but there's a lot of technicals associated with the TIPS market that I would argue it's not a truly inflation-hedged treasury asset. But anyway, the point here is that all asset classes have exposure to inflation. If inflation were to rise, it would impact all of fixed income negatively and vice versa.

And that is part of why fixed income has actually done very well in recent weeks, is that the concept of inflation is an interesting one. And it's not a straightforward one, although the kneejerk reaction is that with the economies globally shut down, that creates a massive deflationary shock to inflation, certainly, for the short term. The question becomes, as things start to open up, and we start to think about altering supply chains, and we start to think about the economy normalizing, we start to see oil trade somewhere north of -$39 a barrel. Sorry, that was a little technical glitch with the oil future contract. But still, oil is snugly in the twenties, quite a depressed level.

What's going to happen is as things start to thaw? And that's a really important question to think about. Perhaps not today or tomorrow, but certainly in the months to come. Now, the real heart of this slide, so the four columns on the right, the four risk factors identified as related to spread-related exposures. These are the exposures that differentiate the three asset classes from each other. So if we start with Treasuries, that's kind of the null set here. There are no material risks in Treasuries. They're the most liquid, they're not going to default unless you want to be cynical about that, which I don't think is really going to be the case. Although, there is a rating agency or two that might have them below AAA rated. But for all intents and purposes, they're not going to default. Liquidity is best as I said, there's no call ability or volatility exposure in Treasuries.

And accordingly, you see Treasury returns over time are generally lower than those of agency mortgages and corporates. Stepping down to corporates first because it's slightly easier kind of to get your hands around what it is to drive corporate valuations. There's a little bit of callability in some corporate names, and as a result, there's some exposure to volatility in levels of rates related to that, but the real risk in corporates is a combination of default risk and liquidity risk. And these are two different risks. I think what you're seeing right now is an increase in default risk. There's an existential threat to a lot of companies that have issued a lot of debt in recent years, and that is the front and center bet that you're taking when you buy a corporate bond.

Liquidity risk is also important. And I think the better example of liquidity risk is if you go back to 2018, and think about how corporates did in 2018 with returns negative on the year, relative to positive returns as I recall, in Treasuries and mortgages. And I think equities are down about 10% in Q4. That was really more of a liquidity event. If you think about the individual companies that had existential threats to their existence and the idea that they might default, they were probably only a small handful, if any. Maybe a couple, but the real issue there was it wasn't a default event. It was a liquidity event.

You saw large exaggerated flows in ETFs. You saw that across the board for all risk assets that exacerbated, as ETFs have grown, kind of exacerbated some of these market moves. We saw a little bit of that this year as well. Actually we saw a lot, but this year is different because the actual fundamental driver of the dislocation is a problem, is a macro economic problem, not an idiosyncratic liquidity event. But with corporates, it's important to recognize that both exposures are important to monitor when you're thinking about corporates.

Now agency MBS, you have a little bit of liquidity risk, but being a kind of Treasury quality asset you don't have quite as much. And certainly with the QEs that we've had, including this one, liquidity issues and mortgages tend to be stopped up pretty quickly. Now, it's a different story in non-agency. And for some other parts of the mortgage market, I'm only focusing here on the agency part of the market. So that's an important distinction. So default risk is really not there, because even if borrowers default, that's borne by Fannie, Freddie, or Ginnie Mae. And like I said, liquidity is a pretty mild exposure. Your primary exposures are the call risk and the volatility risk.

By these, I mean, the easiest way to think about these is the call risk is kind of the level of rates. So the further rates fall, the more likely a borrower is to be able to refinance. That's the call risk. That's the homeowner's option to refinance. The volatility risk, because that option, if you think about just true valuation theory of options, and you remember back to business school, you might remember when there's a sigma here, the volatility of rates impacts them valuation of that option.

And that's intuitively correct also, because if you think about it, if I give you an example, if interest rates fell to 2.5% and stayed there, everybody would refinance to 2.5% mortgage rates, and it would be one and done. If mortgage rates were to average 2.5%, but oscillate between two and three or even more widely than that, the mortgage broker is going to get calls every time not that it hits the 2.5%, but every time it hits a low of two. So the more rate volatility you have, the more intense that impulse is for borrowers to really hit that low and get that best rate and lock it in. So, increased volatility of rates is also a driver of valuation and mortgages. So the more volatility you have in rates, the more of a negative that is for mortgages. So lower rates and higher volatility are both bad for MBS.

Owners of MBS prefer rates that are relatively not volatile, and also rates that are relatively, I wouldn't say higher, but certainly one where they don't have prepayment risk for the portfolio that they own. And the interesting thing about this slide is, if you think about it, what is the correlation of these risk factors between mortgages and corporates? We know that Treasuries are not correlated because they're kind of the risk-free flight to quality asset. Of course, they're going to have negative correlation related to these risk factors. And that's the purpose that they generally serve in portfolios. Mortgages and corporates, you're getting paid for owning kind of this risk, but it's a very different risk. So to kind of bring it back to my original point of bringing up the slide, this is a framework by which I think is important to look at a market where regardless of condition, you can overlay QE, you can incorporate what QE flows will do or how they'll impact valuations or skew them, but in terms of looking at market risks at any given time, it's the same playbook, it's just a different page in the playbook when you incorporate QE. And for us the real balance is, which risks are we more comfortable with taking? Are we comfortable taking prepayment and volatility risk here or are we more comfortable taking default and liquidity risk that you see in corporates? And the right answer is that it really depends on the levels of both. And I'm going to step through what we've seen over the last two months and our thoughts on where value is now.

So moving onto the next slide, I'm just going to touch on this briefly. These are historical returns for the asset classes that I've shown. And the primary point here is to highlight two things. One, these are the respective total returns of each asset class, and in the right column, I've taken the max minus the min of those columns. So if you look at 2000 where Treasuries returned 1352 and corporates returned 908, Treasuries delivered almost, well, actually delivered, 4.44% more return. To me that is an alpha source for a sector rotation type of a strategy. Now, the actual alpha is greater intra-year because these are just annualized returns.

And understand I'm not including the duration component of this, but what I would acknowledge is that the volatility intra-year, whether it's week to week or month to month, is substantially greater than the alpha that you're seeing on the right. But it does highlight that regardless of market conditions, even when you look at markets like 2016, 17, 18, where yields are relatively low, you still had pretty decent dispersion across these asset types. And I think this is a very important feature. Obviously in 2020, we've seen Treasuries outperform corporates at least through the first quarter by 11%.

Now, we know some of that has reversed, but it just highlights how the order of magnitude or the greatness that the opportunity that you have in generating alpha in fixed income, not necessarily by owning an asset with a yield that's particularly compelling as an investment, but owning, say a fund, or having the acumen to be able to make this decision based on market factors, potentially using a framework like the one I provided in the previous slide, to generate that return systematically going forward.

So when I think about what the opportunity set is in fixed income, and I look at Treasuries that, 60 basis points on the 10-year, I think 63 basis points right now, that doesn't sound very good. And I would agree as a standalone investment in Treasuries, that is a pretty poor return for a 10-year period. I have a more constructive view on shorter Treasuries, which have less long-term interest rate risk and long-term inflation risk.

But the interesting thing is, when you look at corporate spreads, or you look at mortgage spreads, currently corporate spreads are about 207 basis points in option-adjusted spread over Duration-Matched-Treasuries. That's a multiple of the underlying Treasury yield itself. So clearly there's still money to be made in fixed income, and there's also money to be made by timing rotation between sectors in a market that you think might otherwise be somewhat starved for yield, there really is opportunity.

The final point I'll make on this slide is the following. If you look at the average returns over time, what you'll see is that Treasuries, mortgages, and corporates, corporates generate the highest return, 6.2% annualized, but with a higher standard deviation of return, higher risk, 5.6% annualized. Mortgages, to me, I think are a great cornerstone for any portfolio in fixed income you do not have that credit risk that you otherwise see in corporates, but also this duration component of mortgages I think makes it a very, very attractive asset class over time.

If you look at the 20-year period, it only lost money in one out of the 20 years, that'd be 2013, that was taper tantrum year, and actually in the year that it lost money, it was the best performing asset class of the group. So I think it just sheds light on why, as an asset class, mortgages really have a nice niche as a core holding in any investment grade portfolio. And you see that really borne out on the standard deviation of returns, where the actual return is slightly higher than Treasuries, but the standard deviation of those returns are materially less. Certainly this year, they're lagging, but I would say in the long-term it's a great cornerstone to any investment grade portfolio.

And the reason is the following, because of the duration component of mortgages, they extend in selloffs and they contract in rallies. The duration contracts, or shrinks, in rallies because that call risk is elevated, borrowers can prepay. And while that sounds like a bad thing, and certainly re-investing prepayments at lower yields sounds like something you wouldn't want to do, at a portfolio level, the prepayments are contained enough where the actual performance of the underlying assets that you own, most of which are still in the portfolio despite prepayments, shortens in duration and rallies and extends in selloffs in a way that really cushions the volatility that you see in the Treasury market.

That's why if you look at the table, just comparing mortgages and Treasuries, the returns seem a little bit damp, but they're much more consistent over time. Treasuries had, I guess, just two down years over that period, although I can tell you going forward, with a 10-year Treasury yield at 63 basis points, there are probably are going to be more in the future. And I think just as an asset class mortgages right now have a fraction of the interest rate sensitivity and exposure that Treasuries do.

So, moving on to where we are, what we've seen over the last few weeks, let me actually step forward to an overview of what's happened, and then walk through each asset class. So investment grade spreads have responded sequentially to stimulus measures. So the Fed has had a variety of policy announcements. I've narrowed them down to three critical dates, but they're certainly, they seem to be active almost every day in some way, shape, or form. On March 15 we had the Fed cut to zero and begin QE4 with Treasuries and mortgages.

A week later they announced their purchase and financing plans to include corporates, TALF, which includes asset backed securities, CP, they included some small part of the CMBS market, but it's not totally comprehensive, but certainly the combination of the measures announced on the 15th and 23rd are certainly intended to provide significant support to markets, and they have. On April 9, the Fed did provide more details to the 23rd announcement, specifically around the corporate piece, which is important, just when you look at historical spreads, which I'll walk through, it brought a little bit more substance to what was announced on the 23rd, which had few details.

Now, in terms of market observations, the 10-year Treasury actually reached its lowest yield on March 9, which was before any of these announcements. Here's the 10-year Treasury yield. You see the low is on March 9. So even though the Fed has stepped in and launched QE to buy Treasuries, their purchases of Treasuries have not lowered the market below where it was before the announcement was even made. So it was really a statement. Having Treasury yields go as low as they did is what propelled the Fed in many ways to do what they did as quickly and forcefully as they did. But it's not their purchases that have specifically helped Treasury yields edge to the lowest rates on record. That happened before anything was announced, and it was really was a function of the shutdown in the economy.

Now, in terms of agency mortgage spreads, it's an interesting picture that actually reminds me a lot of my experience in 2008. Agency spreads actually got to their widest levels on two different occasions, once right before QE was announced and the purchase plans were announced, and then once again a couple days after purchases were made. So here's mortgage spreads, and so you can see that there are two peaks. The first peak was right before QE4 was announced. We had a natural knee-jerk rally in mortgage spreads tightening after that.

But that was met with ferocious selling, because as you might remember in that week in March, really there an incredible amount of selling across all asset classes, mortgages being one of them. And in many cases, mortgages were the asset class of choice to sell because corporates were doing so poorly and your relative transaction costs of selling a mortgage was that much lower that if you needed to raise cash for whatever reason, it would... If you needed to raise cash for whatever reason, mortgage is really the cheapest way to do that. So here you see mortgage spreads really peaking two or three days after the original QE was announced.

And going back to my own experience, when I went to DC on September 17, 2008 to help pitch what I thought would be a program that would help stabilize the mortgage market. And speed was of essence and we were hired very quickly, this was back when I was at Barclays, and we were implementing and purchasing within a week. Now, the plan wasn't actually announced until early October. October 3rd I think was when TARP was fully announced and our program was announced as a part of that, but the purchases were starting to be made and we were buying about 10 billion a month in agency MBS. And the interesting thing about that mandate was we had the same experience, where two or three weeks in, it didn't look like it was working. We were buying, but there just seemed to be more selling and you know the markets were getting into a meltdown mode.

And this is where it's important to think about what is the true benefit of QE, what is it achieving, how does it achieve it? And there are two components to that. One is the purchases that you make on a daily or weekly basis, and the other is the accumulation of the stock that you have purchased over a certain period of time, because that stock is taken out of the flow, it is taken out of the market. That's key. It's the ultimate buy and hold type investor if you think about it. Obviously, the Fed can let bonds go in the future, my mandate was actually sold in 2011, as it was part of the Treasury mandate and it booked again, and that was great, and the Treasury no longer owned MBS after 2011.

But what was a difficult concept to understand certainly in October of '08, and I think the market gets it a little bit better now, is that it's not so much the flow day-to-day that drives the tightening of an asset class or the performance of the asset class, it's the accumulation of that asset in a strong hand that allows spreads to tighten. So certainly the pace of purchases in QE4 was astronomical, and certainly addressed in why you saw a huge gap tighter in mortgages in late March, and now we've stabilized relatively close to pre-crisis levels, they might be a touch wider, certainly with prepayment fears elevated, I think that makes some sense, and certainly some questions around forbearance and how that plays out is part of that as well. But generally speaking, if I looked at this chart, I'd be pretty impressed that within two weeks, mortgage spreads had narrowed back to pre-crisis type levels, actually even quicker than that.

Now, moving on to corporates. So corporates actually reached their widest point a little bit later than mortgages. And I highlight this to bring up my overall thesis that each asset class is different and behaves differently for different reasons. The correlations are not... They're correlated by their exposure to interest rates, but that's it. The spread-related exposures can actually be quite different. Until March 23rd, there had been no explicit support for corporate bonds. On the 23rd, you saw that, and the 23rd marked the exact tight that you saw in corporates, the widest levels, I'm sorry, up near 400 basis points.

So this is a dramatic underperformance, going from about a hundred basis points to nearly 400 in a period of, call it about a month, late February to early March or mid-March. And we've since retraced, I would say, a little more than half of that widening. Like I said, we're at 207 right now, so not too far from where we were when this graph was published, but in reality, the risks in corporates are quite different now than they were in January or February, early February.

We have many constituents in the corporate index that either have been downgraded or are candidates for being downgraded due to their clearly diminished prospects for, A, success of their enterprise or, B, a lot of these entities have significant debt burdens that need to be serviced and they don't have income to offset those at present levels or present times. And so even with government intervention, it is natural to assume that corporate spreads should be wider than they were just three, four months ago.

So I think what will be interesting to think about is the balance between official purchases against fundamental values specifically as it applies to corporate bonds, and specifically as it applies to individual names within the corporate index. There're some names that have done tremendously well just like there have been in the stock market, but there're some names, airlines and travel among them, that are really, really challenged and I would expect to continue to be challenged as the days and weeks and even months go on.

And finally, I'll touch briefly on a couple other asset classes that have not seen really strong recoveries, they've seen partial recoveries, but not complete ones. Non-agency MBS, Credit Risk Transfer securities, some CLOs, we've seen dramatic improvement from the wides as investors try to lock into some pretty lofty potential yields here, but I don't expect these markets to recover to pre-crisis levels in quite the way that agency MBS have. And I think it'll be interesting to see as we move forward in the progression of our resolution to the virus and moving back to normal, what does that mean for these different asset classes?

So stepping into our outlook going forward, the recovery really depends on the speed and manner by which the economy reopens. You've had winners and losers and that is going to persist. Industry sector is directly impacted by the virus, we'll really see shallow recoveries and some may not fully recover. It really depends on, obviously, if we have a vaccine or some form of improving health outcomes when folks contract the virus in terms of treatments, if not having a vaccine, but also just behaviors of individuals after things reopen, how willing they will be to engage in the activities they might have before. Now, certainly we all watch the news and there are a lot of people that want to get out there and do everything immediately, but there are a lot of people that don't. It's important to remember, prior to the crisis, there was no notion of social distancing, there was no notion of avoiding crowds or being fearful for contracting the virus for which there still is no cure. I would expect even in a more normal period that we're going to see, there's still going to be a significant portion of the population that will not engage in the level of activity that they had prior or the same types of activities.

Now, in terms of performance within asset classes and fixed income, I continue to think that asset classes that are directly supported by the Fed will do well, with the note that Treasuries obviously are at valuations that are quite rich compared to kind of longer term views on where inflation is going to go, but certainly in the short term as a flight to quality asset and being buoyed by the Fed, I do expect rates to remain low. And because I expect short term inflation to be very, very low or negative, quite negative actually. I think, fixed income, being long duration and being invested in Treasuries, is okay in the short term.

Areas to monitor and I think this is important. How do we know how deep the economic crisis really is? The number one place I look, is going to be remittance reports on a variety of different securitized products. So, non-agency mortgages, credit cards, wireless receivable bills, commercial mortgages, anything that requires kind of a monthly payment for maintenance of credit. Those asset classes will really tell me what is the magnitude of job losses, how much damage has been done to the economy. We haven't seen that yet because really if you think about it, there are requests for forbearance to kind of buy some time for a lot of borrowers, especially those that have lost jobs. But on top of it, you don't really get true delinquency data until these loans have had a chance to go delinquent. And as long as the lockdown has felt for probably all of us, it really has only been about a month and a half.

So, you're only going to start to see nonpayments of April receivables come through in the middle to end of May. So even though we've started to see a little bit of headlines around performance, we won't really see it until a couple of weeks from now at least. And these tend to take ... If 2008 is any guide with the unemployment levels, where they are and whatnot, this could take a really long time to play out. So, I would pencil in later this month. That's when non-agency mortgage remittances come through. That's a day where, if you think back to the crisis in '08, February 26, 2007, I think was the first day that we really saw some hints of the bad lending practices and inability to pay by some borrowers or strategic defaults, frankly in some cases in 2007. That was the first hint that we had.

Even though this particular market is not waiting for a mortgage crisis, the nature of the job loss, the nature of the economic downturn, is going to manifest itself in the same space with nonpayments. And I think it's important to really find or really dig through and understand, the depth of this crisis will really come through, in terms of looking at these reports.

Now, the other piece is employment and we do get the unemployment number tomorrow. We had ADP yesterday, which I think showed -21 million job losses. I mean, the numbers don't even make sense, they're very difficult to get your arms around. I think the main point here is, that unemployment is expected to be in the double digits. And one thing that's important to remember with unemployment, if you look at a 50 year chart of unemployment, every time you have a recession, you have sharp rises in unemployment, followed by gradual declines. It's impossible for jobs that are lost to just be magically reinstated. A lot of the businesses that had those jobs, that created jobs for individuals, will no longer be in business. And even though the PPP that the government introduced through the small business administration is intended to help tide over a lot of these businesses and people. In reality, and how in practical terms, it's not really ... it's impossible to assume that all of these companies and every restaurant and every business that we know, will come back just as it was before.

And even the ones that do, will look very different than they did before this all happened. So, in my mind, it really could take years to reemploy those that have lost jobs, especially in hard hit industries, you might see a reallocation into other industries. You might see, anything along those lines of improving kind of the employment picture is going to take time. And so, I just want to be, with the NASDAQ hitting the levels that it is today and some of the optimism around things reopening, I just think it's important to be careful about being overly optimistic. It's nice to be wishful, I would love for everything to recover tomorrow, but as an investor I really need to be realistic around what our prospects are. And I just think that a lot of the damage that has been done, is going to take frankly, months to years to really fully work our way out of.

So with that, I'm done with my prepared comments. If you have any questions, please submit them, and be happy to answer them.

Shawn Eubanks: Okay Eddy, we do have our first question. So obviously rates are really low, especially Fed funds rates. What do you think the Fed will need to see before they get/go back towards normalization?

Eddy Vataru: Well, I mean they've always talked about having inflation ... targeting 2% for inflation, but also 2% is not an upper bound, it's a symmetric level. So, I think what they would want to see is not just inflation get back up to 2%, which we're pretty far from, we're going to be even farther from that shortly. But I think they'd have to see inflation print north of 2% sustainably, before they would even think of hiking again. I think our next hike is probably years away, I don't see it happening this year or next. An interesting thing is, this morning Fed funds futures market actually printed negative for 2000, I think 2021 the first or second quarter of next year. So, there's the market expectation for Fed funds is actually negative for the first time that I know. There are a lot of reasons why I think that may not be sustainable.

I think, there's some considerations around money market funds and some things that I discussed around the mortgage market, that I think make it very difficult to see Fed funds go negative, but the market is actually pricing that this morning. And I think, we're pretty far away from having the Fed hike rates here.

Shawn Eubanks: Thank you. And we have another question about kind of the costs going up for some of these industries that have been the hardest hit. If airlines stop selling middle seats and hotels and restaurants have to change the way that they're organized in terms of the number of people and their cleaning that they need to do in between customers. Would that create potentially more inflation or do you think that we're still going to be kind of in a deflationary environment for some period of time?

Eddy Vataru: Well, it comes down to the equilibrium of demand with that supply. So, what the inflation shock here would be that your supply is curtailed because you have fewer airlines seats or restaurants have fewer tables. Those are obviously real supply side constraints, but if, you know, a third of the people in the population are not willing to go out to restaurants or fly, then that's a net zero. It really is going to come down to whether or not we ultimately have a cure for the virus or at least containment to the level that gives a majority of the population confidence in resuming kind of normal life. But certainly in isolation, if there was robust demand, then yes, you would have inflation if those types of policies went into place and you had supply constraints that would drive it. The other reason you would have inflation, is if we had, say, supply chains that relied on production of materials in China and we decided we wanted to onshore those or move them closer to our shores.

If the cost of production of those items were to increase and certainly that would provide an inflationary pulse too, but you will not have inflation until you have the demand that creates that inflation. And right now I think, demand is absolutely on the floor.

Shawn Eubanks: Do you think some of the asset classes that have been propped up, like ... and those that have been protected permanently, have been protected, like agency mortgages, will continue to be protected going forward? Or what would be the unwind process for some of these asset classes?

Eddy Vataru: Okay. So, I would say it's kind of a two-tiered question, the way I think about it. In terms of being propped up, when I think about agency mortgages in particular, in 2008 they underwent the conservatorship and we've spent the last couple of years trying to figure out how we're going to unwind that. I think this particular event is going to really put that on the back burner, but there's two parts of the question. One is, do agency mortgages somehow lose their cache as a Treasury quality asset because they lose the explicit government backing? I don't see that happening anytime soon. And even for assets that were created, any assets that exist now, for example, even if down the road things got better and Fannie and Freddie were unwound from the government, did not have the explicit support, those assets would still be grandfathered. So, there's no concern on that side.

Now in terms of the portfolio itself, the Fed buying mortgages to kind of prop up or provide liquidity, it'd be a kinder way to put it, in those markets. When I did the Treasury mandate years ago, I purchased with the idea that those assets would be held to maturity. I did not envision that two years later they would be sold, and I certainly didn't buy them with the idea that ... I don't know that it would have changed what I bought, because in my mind I bought what I thought were the cheapest assets, because I was really investing all of our money collectively, it was taxpayer money. So I took that very seriously. But here, we've seen QE kind of come and go and we've had QE buy huge portfolios and then taper them off. I think the prevailing view around bloated balance sheets, has improved or how to put this, maybe my view has not necessarily improved, but the collective market view of the Fed kind of carrying a large kind of bloated inventory of these assets, I think has seemed less risky than it might've been perceived in 2008. Now that said, I think when things improve you might see the same kind of phenomenon that we saw when we started to unwind QE3 and that kind of the balance sheet unwind, which I think happened in a very methodical and stable way. You could see that happen, but we're years and years away from that. I mean, I think we're years away from a Fed hike and we're years away from the Fed reducing its balance sheet, because things have started to normalize. So I expect, the answer to both questions is, I think you'll see government sponsorship for the asset class continue both in terms of explicit... The conservatorship continuing, but also just a continued presence in the market as an investor in the market.

Shawn Eubanks: Thank you.

Eddy Vataru: And let me add one thing. Even if the Fed were to stop and only were to stop actively buying, the fact that they're holding enough selling, is also a pretty, the stock argument of narrowing spreads, I think is a very key part of this. So they might re-invest runoff, re-invest coupon, but they don't need to buy more assets to keep spreads where they are. That's an important distinction. They will do that. Even if they were to stop purchases, they will absolutely maintain reinvestment for a long time to come.

Shawn Eubanks: During the '08/'09 recession, the high yield spreads peaked out around 20%. This year, they've gotten up to about 10% or so before the Fed stepped in. Is high yield too expensive, given the risks of downgrades and defaults in that sector?

Eddy Vataru: I think Carl would love to step in and answer this one. I'm sorry he's not on. But, I really focus more on the investment grade side. What I can tell you that's different now versus 2008, is kind of where your risk-free rate was. So in 2007/8, remember Treasury bills were yielding 5/5.5%. Certainly rates fell to zero, when high yield ballooned out to 20% during that period. But, we came into this period with rates near zero to begin with. So it doesn't surprise me that a 10% yield against a 0% cash rate, is different than what an appropriate yield would have been back in 2008, when cash was yielding 5/5.5%. So, that part of it's different, but also, I don't think about sectors as, as sectors per se. You really have to dig within the sector and understand the actual assets.

So, there are some high yield names that are there because they're fallen angels out of investment grade. They're high yield names that are small businesses that are very viable, good businesses, but they just are penalized whatever reason, sometimes due to size or other considerations. And there are just some losers in high yield, frankly. So, I think that in terms of spreads for the sector, and in terms of kind of what is the right level, I don't know that I would say there's a specific high yield that I would target for the sector, insomuch as I would tell you that it's more important now than ever to focus on, if you're interested in high yield, buying specific names that have value. So even if that name might only yield 6 or 7% against the benchmark of 10, that's more important than kind of targeting the overall yield.

And I'll answer ... I'll give one other way to think about it, with investment grade. If you go back to the slide that I had around spreads, this one. So March 23rd marked the widest investment grade spreads, do I think we could revisit March 23rd spreads in investment grade? Probably not that wide, but I could see spreads widened from where they are now, given even with Fed purchases, just given how weak the underlying economy might be. I mean, at the end of the day, as an investor, you do have to worry about fundamentals and you have to worry about whether you're going to be made whole on your investment. So we certainly could see levels get back to, maybe not the absolute wides, but certainly wider than here. And by extension for high yield, if they're not going to be propped up specifically by the government outside of purchases of junk ETFs, whatever the two ETFs that buy high yield that's focused specifically on only the names that are in that kind of subsection of high yield, yeah, you could see yields get wider. But I think the winners will win, and the losers will lose. It really is a time to focus on security selection and picking the right business models and the right companies that are able to survive and be profitable as we kind of play through this crisis.

Shawn Eubanks: So I've got a question about the triple-B university investment grade corporate market, and I know John Sheehan on your team has written a number of different papers on this topic in the past, but given that the triple-B market is approximately 50% of the overall investment grade corporate market, should we expect a number of those triple-B's to fall to junk status resulting in a much bigger high yield market and a smaller investment grade corporate market?

Eddy Vataru: In a word, yes, you probably will see more Fords and more kind of energy names that were triple-B get downgraded. Again, the amount is going to depend on how long we're in this shutdown. I think every week we're in a shutdown is that much worse for kind of our prognosis for coming out of it at least in terms of how quickly we can come out of it. Whether I would expect most triple-B to fall to junk, I would not expect most of it to fall to junk, but I certainly would expect some. And again that's another kind of vote as to why it's important to look at name by name. In my mind some common sense tests I think really help here. If you think about the business models of the companies you're invested in, those are the business models, which ones are best or most immunized from a protracted viral shutdown versus which ones have the most significant exposure. I mean, I've touched on a couple already, but I think that type of metric is going to really help kind of determine what are the right names to own.

So if you own the index ETF, you're going to own some names you don't want to own. If you own kind of an actively managed fund that avoids some of those, I think those are poised to do a little bit better in this particular climate.

Shawn Eubanks: And given that the Fed is actively buying back in the market, are they primarily using ETFs to do their purchases or buying individual securities, and how would they determine which ETFs to purchase?

Eddy Vataru: I don't have a lot of clarity in terms of the ETFs they actually can choose to purchase or how they go about it. I think the primary reason they included ETFs had to do with kind of some of the distress that you saw in the ETF market in March. Now, a lot of ETF vendors are quick to say, "Well actually, the reason that ETFs looked distressed is because they had better price discovery than the underlying." So you saw corporate ETFs traded several percent below NAV. Certainly for ETFs that traffic in illiquid securities, that is a plausible argument for some of it, but when you're looking at TLT a 20 plus Treasury fund or other Treasury funds that are trading at similar discounts to NAV, even the TIPS funds, that argument doesn't really hold that much weight.

So I think there was a real wake up call for everybody, the proliferation of ETFs. I mean, I can tell you from experience, I was in the very first meetings of the mortgage ETF at Barclays. I mean, this was back in 2001. When they work there, they're really good products, but the problem is they require balance sheet to maintain that kind of arbitrage relationship that allows them to price near their NAV. And yes, if you have an index like say high yield bonds that maybe don't trade as often, yes, they might be correct in saying that they have better price discovery than the actual underlying, in some cases. But I think more often than not, the real issues that ETFs had, especially in liquid products like mortgages and Treasuries where you saw the same phenomenon, you can't make that same argument.

So I think I probably meandered from the original question, which I probably need a reminder of, but I think ETFs are tricky here because I think some of the arguments made about their liquidity really got challenged in March. And now I remember, which ETFs are being bought. I don't know that the Fed is actually going to be actively buying ETFs in the way that they thought, simply because these things are actually trading a lot. With all the other measures we've seen, they're trading a lot closer to fair value. So it doesn't make a lot of sense to distort value by buying ETFs, specifically those that have specific names. And you can go a step further and say, "Why are they buying these high yield names in particular that certain companies that might've been bad actors, taking a ton of leverage or whatever?" It's going to be interesting and it's going to be very highly scrutinized. They have not made any purchases yet, and I think ETFs may be a primary step or an intermediate step before actually buying explicit corporate bonds themselves. But that's another question, which corporate bonds are they going to buy and what metrics do they use to do that? That's a big question mark to me. I don't have any particular color on that and I am concerned about some of the moral hazard issues around what they buy there and how they do it. So we'll have to see how it plays out but there have not been any purchases in that space yet. And I think just the mention of being able to buy has triggered most of the response that the Fed is looking to achieve anyway. So we'll see. We'll see what happens.

Shawn Eubanks: Can you share any thoughts on kind of the muni market, whether that's an area that you would potentially look at for this strategy for the Osterweis Total Return Fund?

Eddy Vataru: I've not really looked at Munis. I think munis are really tricky right now. I mean, we hear about folks basically asking the government for assistance. The one thing that the U.S. Treasury has and the federal government has is the ability to print money. States can't do that. So I don't know. Muniss are not at kind of the top of mind for me in this market and I think given what's going on in terms of reduced tax receipts and reduced revenues just generally, I think it could be pretty tricky here to really be invested in munis. Not to say there's not some value there, but it kind of falls outside of where we find the most obvious and easiest way to add value in this market. There's so much to do just within investment grade that kind of taking a state-dependent risk doesn't seem as attractive now.

Now, when we launched the fund in 2016, it did seem a little more interesting back then for sure, and maybe when things normalize it's something that we'll look at again. But I think this is a pretty difficult landscape to look at munis for our fund.

Shawn Eubanks: And given that you have kind of a very flexible mandate, which has generated risk, excellent risk-adjusted return since inception, how are you positioned now in terms of the biggest sub sectors within the investment grade space in terms of exposure to, say, mortgages, corporates or Treasuries and how has that been changing over the course of the last I guess year-to-date?

Eddy Vataru: Right. So it's been a pretty active few weeks for us. I mean, we came into the crisis about overweight mortgages, slightly overweight credit, and underweight Treasuries, which obviously hurt in the early stages of the crisis. What we're able to do is sell some mortgages, not at the tremendously wide levels in the midst of that March period, but taking advantage of liquidity and buying corporates at very wide levels. We kind of expressed that more in buying long corporates. So without having as much market value invested but really focusing more on the duration of the corporates. We bought some high quality corporate names that have rallied significantly and recouped a lot of whatever we had lost in early March. Actually, we recouped all of it.

My view's changed though. We've maintained an overweight to mortgages that, if anything, that's grown in the last few weeks. Corporates, we've gone from I would say slight overweight to quite overweight, pretty big overweight, for call it two, three, four weeks, and then back to kind of a neutral weighting a couple of weeks ago and now we're actually slightly underweight. There's a ton of supply coming through. I think the last two months have been the two biggest supply months in corporates that we've ever seen and this week and this month are slated to continue that trend. So there's no shortage of opportunities to add back corporate risk if that's something we want to do, and we can be very picky about the names that we buy in that space. But like I said, I think the supply in corporates is going to be pretty substantial and weigh down the sector a little bit in the short term, especially as some of the rosiest expectations of recovery start to diminish.

So I think being underweight corporates here is the right thing, overweight mortgages. And within mortgages we have kind of an interesting portfolio. So it's a combination of kind of TBA, kind of lower coupon mortgages that don't have much prepayment risk coupled with some mortgage positions that are in very seasoned, very high coupon, very little refinance or propensity to refinance or rate sensitivity type assets. That's something I added a lot in March, end of March, early April. And that's done really well for the portfolio. We just had the prepayment report come out and speeds increased about 25 to 30%, and on the assets that we own they've actually decreased. So you really are seeing originators focus more on kind of newer production, more kind of higher credit quality, lower credit risk type borrowers, which would be folks that borrowed in the last couple of years, not folks that borrowed 10 years ago.

It would be folks that borrowed at 3.5% to 4% refinancing down to 3, not folks that borrowed at 6% 10 years ago. So we've really kind of bifurcated the portfolio between current coupon, buy what the Fed is buying, with some of these really seasoned, I call them museum pieces. They're really some interesting positions in kind of non refinanceable bonds. So if I had to characterize the portfolio, it's overweight mortgages with that kind of barbell low coupon with seasoned, and then in corporates are slightly underweight looking to get back to neutral or maybe overweight when the spreads widen a little bit. And we do own Treasuries and we have a significant allocation to Treasuries now, kind of waiting for that corporate piece to recover. Or I should say, to widen to levels that we would want to kind of add back into corporate. I shouldn't say recover.

Shawn Eubanks: Thank you Eddy for your time today. We're after 11:00, but we really appreciate it and if you have additional questions, feel free to reach out to us on our 800 line, (800) 700-3316. So look forward to staying in touch and thanks for joining us today, Eddy.

Eddy Vataru: Hey, thank you. Thanks very much.


Eddy Vataru

Chief Investment Officer – Total Return

Eddy Vataru

Chief Investment Officer – Total Return

Prior to joining Osterweis Capital Management in 2016, Eddy Vataru worked in senior management positions at Incapture, LLC and Citadel, LLC. Before that he spent over 11 years at BlackRock (formerly Barclays Global Investors, BGI), where his last position was as Managing Director and Head of U.S. Rates and Mortgages. While in this role, BGI worked with the U.S. Treasury in implementing its Agency MBS Purchase Program, buying mortgages for the U.S. government from 2008-2009.

He is a principal of the firm and the lead Portfolio Manager for the total return fixed income strategy.

Mr. Vataru graduated from California Institute of Technology (B.S. in Chemistry & Economics) and from Olin Business School at Washington University in St. Louis (M.B.A.). Mr. Vataru holds the CFA designation.

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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 Bloomberg Barclays U.S. Aggregate Bond 1 – 3 Year Index is the 1-3 Year segment of the Bloomberg Barclays U.S. Aggregate Bond Index.

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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.

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