Published on February 18, 2020

If you were unable to join Eddy Vataru when he shared practical insights into developing an investment grade strategy that is flexible enough to handle today’s new realities, you can watch the replay here.


Shawn Eubanks (00:05): 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 joining our webinar today titled: A Roadmap for Fixed Income Investing in a Low Rate Environment. 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 our Total Return strategy. Eddy graduated from the California Institute of Technology with a BS in Chemistry and Economics and from the Olin Business School at Washington University in St. Louis with an MBA. Mr. Vataru also holds the Chartered Financial Analyst designation.
Prior to joining Osterweis capital management in 2016, Eddy worked in senior management positions at Incapture and Citadel LLC. Before that he spent over 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 and the 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 the 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 as well, so please type your questions in 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 (01:57): All right. Thanks Shawn. I hope and thanks everyone for joining me this morning. I'd like to make this presentation a little bit, kind of more thought-provoking and less about where I see value in the market and kind of giving our outlook on the market, which I will provide towards the end. But I really want to provide a framework by which you can think about markets and kind of approach it, in some of the same ways we do, or how we think about opportunities in fixed income. Obviously with yields where they are and spreads where they are it's a pretty challenging environment for an investor here to look at this landscape and try to determine where we see value. But I hope that with the benefit of this presentation, you'll be able to kind of ask those questions and think about the markets in a way that hopefully as you deploy capital, and think about markets going forward, will provide some insight that you can use in that analysis.
So just very briefly, the way the slides are going to progress, I'm going to give the current landscape of where we are. Also, how to think about how to attack the fixed income market given this landscape. Then I'm going to provide a quick survey of the fixed income vehicles that you might want to consider based on kind of your risk/reward perspective in fixed income and what you're trying to achieve with your investment in fixed income.
I'll give a short, kind of interesting, sidebar about some of my experiences in addressing the proliferation of quantitative models and how to compare those or think about those and quantitative investing in general versus a more fundamental approach. I've done both and I think there are pluses and minuses of each of that I'm going to address quickly, and finally I'll conclude with the outlook, which again, is I think really a standard requirement of a presentation of this sort. I think we have a very interesting 2020 ahead of us. It's already been quite interesting, but I hope that, with that, and Q&A on the follow that we'll have a productive discussion on all these matters.
So moving forward into the presentation, just to kind of set the landscape for where we've been. Obviously we had the financial crisis in 2008, which led to several rounds of quantitative easing, and I think of this in the context of this tide that's lifted all boats. So basically all assets benefited from this. So even though the purchases by central banks, specifically our own in the U.S., were targeted towards treasuries and agency mortgage securities, the benefits were actually even more greatly felt in other asset classes, including corporate bonds--both investment grade and high yield--equities, et cetera.
So it really was a tremendously favorable credit cycle, it created an unprecedented investment opportunity. That changed, however, and only temporarily a couple of years ago as we have the unwinding of QE. As you can see, the tide is rolled out, and some of these boats have gotten stuck. We had a series of Fed rate hikes that took us to 2.5%. We did have some inflation pressures that started to increase and it did create a much more challenging environment for investors. If you think about 2018 in particular, that was a year where the Agg was able to squeeze out only a one basis point return for the entire year and it took really a heroic fourth quarter treasury rally that to eke out those gains, or that gain of one basis point.
So it really was a challenging environment. I think this is something we need to think about going forward, as we assess the market condition now where interest rates are actually about as low as they've been in several of the last rallies we've had over the last four years. Now we take the story forward to 2019, we had our three eases. We have a dovish stance that has continued and will continue I think through the rest of this year, 1.5% being the lower end of the Fed target rate.
I believe that to be a pretty accommodative stance, given the relative strength of the economy. The Fed has been able to keep this stance because inflation is persistently below their hypothetical 2% target. When you compare yields in the U.S. to those abroad, we have negative yields in Europe, we have negative yields also in Japan, in its last print for example, I'm spotting a 10-year bund yield at minus 39 basis points, which again, if you think about this as a bond investor, you typically don't pay for the privilege to lend money, but such as the case 12 years after our great financial crisis where this continuous quantitative easing program that we've seen globally has created this conundrum that we're in. So as fixed income investors, we've certainly benefited from this. The rally in yields down from our 2007-2008 levels, to today, has been a big driver of the returns in the Agg over the last 10-11 years. If you look at this return series, a portion of that is certainly carry that comes from the yield on the bonds that you own. But a lot of this is also a price appreciation. You'll see that here that the gold line is the yield of the Aggregate Index and the blue line is the duration of the Aggregate Index. Something that's happened really since 2008 is yields have been persistently low and we're again pretty close to our lows. This is through year-end; we're actually much closer to the lows now, with the rally that we had in January.
But there's another interesting phenomenon here is that the duration of the index is actually risen at the same time. So if you think about this as an indexed investor in fixed income, you're buying something that's yielding just over 2%, but you also have an interest rate sensitivity as measured by duration of that investment at pretty close to its all-time high, approaching six. So to put that in very basic terms, if interest rates rise 1%, your portfolio will lose. An index portfolio will lose 6% of its principle, on price terms, and you're only earning just over 2% from the privilege of owning that asset.
If you look at this historically, durations have been kind of in the four to six area through time, certainly at the higher end now, but even if you go back to the '90s and 2000s, the yield of the index compensated you or buffeted you from taking a loss if interest rates were to rise, and they've certainly risen at various points over this 30-year period. If you go back to, and I'm not going to go back to '89 when rates are eight or 9%, but if you look even back in the 2000s when rates were closer to four, five, or 6%, if you had a hundred basis point rise during that period, it would take you about a year to earn back what you lost. So basically your portfolio would lose, call it 5% because the duration was five, but your yield was five, so you would break even in a hundred basis point rise and obviously make money in anything less than a hundred basis point rise.
Well since the financial crisis in '08, that math has changed pretty dramatically, where your cushion, your yield, is much lower and the risk you're taking to earn that yield is actually significantly higher. So it's not entirely obvious looking at this chart because of how it's scaled, but the duration of the index in 2008 was about 3.8, and now it's about 5.8. It's over 50% greater interest rate risk, in an index portfolio, that you would otherwise think would be unchanged. There are reasons for this.
The index itself has changed in composition, because companies have been able to term out a lot of their issuance, as taking advantage of low rates, rather than borrowing short they want to lock in low rates for long periods of time, so they're able to issue longer maturity debt, and mortgage borrowers, which are also a big part of the Agg, have been able to lock in lower rates. So analytically, a mortgage that has a lower interest rate is going to have a longer duration than one that has a higher interest rate.
That's for two reasons. One is the coupon is lower, so the math just bears that out. Secondly, the ability to refinance that mortgage is also reduced, which also pushes out or reduces the probability that that loan will be called and therefore that also extends the duration of the assets. So that combination has really made the Agg a significantly riskier index than what we've seen historically and something to keep in mind.
Now drilling in on corporates, this is an interesting story. So as I mentioned, corporations have been able to term out their issuance and take advantage of low rates. So if you look at kind of '08, where the duration of the corporate index was about six, in the last 12 years, the index duration has extended to nearly eight. Again, combination of lower coupon and longer maturity issuance. Now at the same time, the option adjusted spread of the corporate piece of the Aggregate Index is approaching its lows that we saw before the financial crisis and certainly touching those we've seen since in '17. But even if you go back to kind of pre-crisis levels it looks like we're approaching that.
However, the duration profile changing has really created a kind of an interesting dynamic here, so it's really not an apples to apples comparison when you look at 2005 corporate spreads versus looking at 2019 corporate spreads because the duration of the underlying corporate index is dramatically higher now. In other words, you're earning less spread for a what is a materially longer investment, and to illustrate that, we took the corporate credit curve as of 12/31/19 and said, "Okay, what if we took the duration of the index back in 2005 and plotted that as a point?"
The average OAS, or spread, of that part of the index is 85 basis points. Now the duration of the index now is closer to eight, at that point in the curve, the spread of that part of the curve is actually over a hundred. It's a 17 basis point difference between the two. So if you're looking back on this slide, one way to think about this is you should actually to make it apples-to-apples comparison, you should reduce the 2019 spread by 17 basis points, which really takes you below where we were in 2005. So an argument that we're actually, on a risk-adjusted basis, have tighter spreads now than we really ever had. Again, it's because of the composition of the index and the fact that we've had such a protracted period of QE with low coupon issuance that's created this change in the index. So something to keep in mind when looking at investment grade indices and risk metrics around investment grade.
Now I'm going to take a step and drill deeper into what it is that's driving returns generally within fixed income asset classes and, more specifically, how can you look at fixed income and try to identify what are the risk factors that impact returns across the various asset classes? So within the Agg, treasuries, agency mortgages, and corporates comprise over 90% of the Aggregate Index. So I think these three, are really the three pillars if you will, of the Aggregate Index, and it's important to look at them and compare them against each other.
On the left I've kind of narrowed down the risk factors that are related to interest rate exposure, so you can think of it as Fed policy, inflation, and reinvestment risk. These are all specific bond-specific risk factors that all kind of bucket under interest rate exposure. Where the performance can differ between treasuries, mortgages, and corporates is really more on the spread related exposures, which are on the right. So what are the drivers of corporate bond performance versus mortgage bond performance versus treasuries?
So to start with treasuries, treasuries have the lowest yield and they also have no exposure to any of these four risks, whether it's call risk, default risk, liquidity risk, or volatility risk. Corporate treasuries are immune to all four. If we step down to corporates and think about what's the difference between a corporate bond and a treasury bond, the primary difference is default risk. So to the extent that the economy is plugging along and doing well, default risk is relatively muted and that largely explains why spreads are so tight right now. It does become much more interesting on an issue by issue name, where if you have an acumen as a security selector, you can avoid the issues that have an uptake or increase in default risk.
That's really something that that differentiates performance among corporate bond managers through time is being able to avoid issues that have elevated default risk. But one thing I'll also bring up is in 2018, we had a pretty material under-performance in corporates and it wasn't related to defaults picking up. There are really only one or two names that I can think of that really saw an uptick in default probability. It was really more of a liquidity event that was related to, in my mind, ETF flows, and kind of sector rotation out of corporates, out of risk into less risky assets. So it really drove a material under-performance in corporate bonds at a time when default risks actually hadn't changed. Those were the two primary risks for corporate bonds, defaults and liquidity. Now if you think about agency MBS, it's actually a very different picture. Agency mortgages are originated by Fannie Mae, Freddie Mac, and Ginnie Mae. Ginnie Mae has the full faith and credit of the U.S. treasury. Fannie Mae and Freddie Mac are effectively full faith and credit through the conservatorship. Credit risk on the agency mortgage side is not something that really comes into play in terms of default risk because of that backstop.
So the issues are really talking about here are call risk, and volatility risk, and this is very timely given what happened in 2019 with our big rally, call risk and agency mortgages became, I would say, very pronounced as we hit new rate lows that allowed a lot of borrowers to refinance out of mortgages, primarily ones originated since the last time rates had gotten that low, which was 2016. But you had a very serious uptick in refinance activity, and that activity forced mortgages to underperform, corporates and treasuries last year, in particular in Q3 when rate extremes were reached.
Similarly, volatility is an important aspect of valuing mortgages in a way that's not quite as important for corporates and treasuries. The way to think about this is if interest rates rally and hit a certain level, let's say 2% or 2-1/2%, and the prevailing mortgage rate becomes 3% and is static at 3%, and every borrower who's above 3% will call their mortgage broker, or log on to Quicken, or the tool of their choice and reduce their rate to 3% and it's a onetime refinance and they're done. That's a zero volatility, rates are constant, mortgage rates are constant at 3% scenario.
Now, let's say you have the same scenario where mortgage rates average 3% but bounce between two and 4% while averaging three. Well, those calls are going to come when rates hit 2%, not when they hit 3%, and they're going to keep coming every time rates hit two for anybody who borrowed over a rate above two. That is absolutely at the expense of the mortgage investor who is now forced to a) absorb the call of their original mortgage loan and b) reinvest the capital at a new low rate that's locked in at these absolute low levels.
This is something I've written about, and actually we have on our website, about the impact of interest rates on mortgage supply, and some views around how this actually puts a floor on interest rates in the U.S., but that's a topic for another day, but feel free to check out our website about that. But the important thing to note there is that the drivers of mortgage valuation and corporate valuation are a) very different and b) have very little correlation to each other, and thus a portfolio that includes both agency mortgages and corporates in it actually can deliver a really nice risk-adjusted return over time. Especially if you have some acumen in trying to understand when to time exposure to one asset class or the other, and this slide really demonstrates that, the ability to time and rotate between sectors does create a tremendous amount of opportunity for investing within investment grade. Even in periods where yields seem relatively starved.
Let's look at, first at 2016 through 2018, a period marked by, like I said, relatively low returns in fixed income. One thing you'll notice is, if you look at the three columns in the middle give you the returns by asset class, and the column on the right gives you the performance of the best performer versus the worst performer, and even in years where overall yields are relatively low, the ability to rotate between sectors is a huge driver of potential return in a market that may otherwise not give that return to you.
If you were long corporates in '16 and '17 that worked out quite well, but you had, if you rotated out of corporates into treasuries or mortgages in '18 that was the way you were going to be able to preserve those gains. Then obviously in '19, we had a huge outperformance in corporates again, so the ability to rotate is in and of itself quite a strong driver of potential returns that if you're purely indexed, especially if you're an Agg investor, you won't be able to appreciate the potential for outperformance. Again, especially in a low yield market that rotating will give you.
Now, one other interesting thing to note here is if you look at the bottom of the page, the average returns over time. You have mortgage securities at 4.84%, treasuries about the same 4.74 and corporates with 6.21, a much better performer. With corporates, that's easy to understand, you're taking more risks. The standard deviation of returns demonstrates that to you as well, and you're basically being compensated for some incremental rate risks, but certainly incremental spread risk by taking on the default risk of the issuers in that index.
What's interesting though, is if you look at mortgages versus treasuries, the standard deviation of mortgage returns is about 40% lower than that of treasuries, but you actually have a slightly higher overall return. In my mind, this is something that's very important to key on because treasuries are kind of that reflexive flight to quality asset class that specifically serve that kind of function as we've seen really in the first few weeks of this year. But over the long-term an investment in mortgage-backed securities gives you a comparable return with less risk, and I think that's an important thing to key on and think about going forward. Because as a mortgage investor through the worst of times, I can tell you the asset class has a pretty scarred name for anyone who was around in '06, '07, '08, but the reality is if you look at the returns through time, especially on the agency backside, it really creates, in my mind, the best risk, best return per unit of risk.
If you look at the average return divided by standard deviation of return, mortgage-backed securities actually deliver what in my mind are the highest Sharpe Ratio, if you will, return over time. Corporate have the best return, mortgages have the highest quality return, and the fact that these two asset classes have little correlation with each other really makes them a nice kind of cornerstones to an investment grade portfolio.
Now I'm going to take a step back and say, "Okay, we've observed all of these return streams, the differences between the asset classes, how can I approach fixed income, or what are the vehicles that are out there that I can consider for investing in fixed income more broadly," and we'll start with passive, because it's the easiest. It's where I started also, as Shawn mentioned, but it's... Really the part of fixed income that's grown the most rapidly in the last 10, 12 years is passive, and a lot of it is related to the fact you're able to lower fees, but you've had the tailwind of Central Bank policy that's really provided a tremendous backdrop for investing in passive-type strategies.
Now, as I showed you on the slide previously, the risk profile of a passive investment is quite different now than it was over the last few years, and so being able to reproduce this trajectory of returns could become more challenging, given that the actual yield of the underlying assets is so starved. But having said that, there are pros to being a passive investor. Obviously the lower fees, but you also have some efficiencies that ETFs provide from a tax and intraday liquidity standpoint. We all know those, but what's interesting, if you think about the cons to a passive investment, there's no real opportunity for outperforming the index, because, especially for ETF providers, they're beholden, their goal is to achieve exactly an index return so that investors can use them both from the long side and from the short side, so those vehicles are really required to deliver a specific index return.
Separately, there are hidden risks in the benchmark itself. Number one I've mentioned, or actually I'll start with number two; duration is high and yields are low. I've made that point a couple of times, but secondly, if you think about the corporate index and you think about a cap-weighted index, if you think about equities, a cap-weighted index allows larger successful companies to grow their percentage in the index and that's not a bad outcome. You kind of ride the momentum of bigger and successful companies growing and growing, and outperforming, and it actually helps, in my mind, the performance of some of these equity indices.
In fixed income, it's different. The weighting of a fixed income index is related to the size of the issuance of the underlying borrowers. Therefore, the largest and most levered borrowers, which often will carry lower credit ratings for lower end of investment grade for sure, will comprise a larger part of the index, and that might not be something that as an index investor you're comfortable with, especially as we're kind of getting later and later in this growth cycle. So something to think about there.
Moving on to active management, so you have the benefits of being able to take advantage of security selection. The sector rotation slide that I showed you is something that an active manager can certainly take advantage of, and in interest rate management, in terms of managing duration and interest rate exposure, both outright and at various points on the curve to express views on the Fed or the future direction of interest rates. These are things that an active manager can do, and can certainly deliver outperformance against the benchmark. However, there are increased risks with active managers. You have reduced portfolio liquidity, especially as you move further and further away from index security, so securities that are in your index, whether they're high yield or more esoteric. There are alternative asset classes like emerging markets, perhaps some FX types of investments in foreign bonds that also carry increased risks, especially in these markets. The potential use of leverage, this is common in active funds, that some active funds do employ at least a modicum of leverage to amplify returns.
Again, the fourth point, which I think is not a point anyone else would make, but you are tied to a benchmark that itself is a long duration and a low yield. And I know I've made this point several times, but I think it bears repeating, the benchmark itself is riskier than you otherwise would think it would be if you assumed it was static over time. Finally, active funds have higher fees to compensate for this outperformance and the expertise that you're paying for to get this outperformance. You certainly pay higher fees.
Now, I'm going to introduce two other types of mandates that kind of are parallel to this active versus passive approach in the sense that neither one of them is beholden to that benchmark, so that the idea here is that you're using the same assets but you're not doing it in quite the same way that an index or active manager might do.
Starting with an unlevered short duration or hedged portfolio, it's an active portfolio, but your target duration and target positions are not, the Agg, or any fixed income benchmark per se. It could be a cash type benchmark, or you might have rules around sector allocation, but you're not trying to mimic something that has the profile of the Agg. So you do have the benefits of active managers in terms of security selection, sector rotation, and interest rate management, but this is a strategy that because you're hedging most of your duration risk out, you're really focused more on minimizing drawdowns and trying to prevent losses rather than participate in outside gains when you have events like we had early this year, or late, or during last year when treasuries rallied. You're giving up some of those gains and some of these protracted treasury rallies to prevent losses when markets turn the other way.
Having just listed one of the cons there, that you may lag in rallies, the other con of investing in this type of strategy, is that if you are benchmarked, the performance of the strategy is going to be less predictable. If you're using fixed income specifically as ballast against equities, the correlation of a seven-to-10-year treasury benchmark against equities is pretty crystal clear. It's a negative correlation and something that folks will use to protect against downdrafts in equities. However, the return stream of that treasury portfolio, as I showed on a previous slide, is probably not the best you can do in fixed income, and its primary purpose really is, in my mind, as ballast against equities. These strategies do better over more protracted investment cycles, but do not provide that ballast against drawdowns from your equity portfolio if you have a flight to quality, for example.
Finally, you have the levered version of the same, which is really basically a hedge fund. You own a series of assets, you amplify the returns using leverage and notice that my pros and cons are symmetrical. If you have acumen and you're good at this, great, but fees are higher. Obviously, it is benchmark neutral by definition of being a hedge fund, but there are obviously a lot of structural risks with being invested in hedge funds and it certainly, if you enter a period like '08, obviously there were issues then, but even if you look at last year when the repo market headlines started hitting in September and there were some issues around short-term funding, these constructs can certainly be exposed to types of risks that you otherwise wouldn't think of as a long-term, long only investor. Now, I have created a similar table to the one I created before, that highlights this, and this will be available on replay. So I'm not going to go through all 28 points on the grid, and expect that it will be an instant recall for you, but I think the main point here is that I've listed the funds on the left by what I believe are the levels of risks associated with each. Absolute return funds that are focused on minimizing drawdown, these hedge strategies, are actually less risky than passive strategies because they don't have this adherence to the index. I've put passive and active in the middle, active being more risky than passive, and I put hedge funds at the bottom. So the darker shadings corresponds to higher sensitivities and higher risk, and the lighter shadings correspond to less. If you focus on the right where you have target return and target risk, just notice, and again it should follow your intuition that passive and active managers, active takes more risks than passive, has a higher risk target, and a higher target return.
But I think the absolute return piece is interesting here because as I mentioned, your target risk is actually to de-risk some of the riskier components of the index itself, and focus more on minimizing drawdowns and generating a comparable return with a better risk/return profile.
So as promised, I do have a small sidebar to kind of reminisce a little bit about a past life where I was more of a quantitative investor and think about how we've seen a proliferation of strategies that again, they fall across all of these investment vehicle types. Although I'd probably say hedge funds probably use these more than kind of your standard long only manager and certainly more than your index manager, but it's interesting to know and I just wanted to leave you with a couple of interesting tidbits. Is that there's been a lot of kind of adaptive technology dedicated towards taking all this proliferation of data and processing it in a way that gives investors an edge against other investors, or against the index frankly. Owing to the availability of the data and being able to process this data in a way that 10, 15, 20 years ago would have been a dream of mine.
The benefit of this type of approach is when you have a rules-based approach to processing data and developing trading models, you can eliminate emotional biases from the investment process, and that's particularly attractive if you think about markets moving on tweets or on updates on current lore. I mean, today's topical issue would be the Coronavirus. Every single piece of news that impacts markets hits very quickly, and actually, later this year you'll have the presidential election and some of the volatility around that as well. Having a rules-based approach eliminates some of the biases, but there are certainly some issues as well, and I think we're seeing some of that right now with the Coronavirus is that we're mapping the Coronavirus to previous experiences of these viral outbreaks like SARS in 2002 and 2003, which was a period that was marked by a very substantial treasury rally.
The treasury rally in my mind had very little to do with SARS and had a lot more to do with kind of the overall economy and some of the issues that were going on through that kind of mini rut we had an '02 and '03 that weren't related to SARS. However, quant models will look at that and say, "Well, this is what happened back then, so that history will repeat itself," and I think explains a lot of this knee-jerk reaction we've seen in markets so far this year. It's not to say that the Coronavirus couldn't become a bigger impact, and we'll see that in data that comes out specifically in China over the next few months, but I think the jury is out on what actually, how this will actually play out, if we'll have a cure and we'll be able to stem the tide of it.
That component of looking at using models to predict the future based on the past is really a fundamental flaw in the underlying model, because if you think about 2008 as an example, the Great Recession that we had, that really largely stemmed from a debacle on the mortgage side and really mortgage lending excesses. There were no models that predicted that outcome. There certainly were a lot of fundamental analysts and folks that looked at things and said that this can't persist. How does this continue? But there was no model, no matter how adaptive it could have been, because this was not in their history or in your back test, they could have predicted '08, per se. So I think it's important to think about the positives of being a quantitative investor or thinking about quantitative approaches, but recognizing the number one weakness is that quant models don't have the benefit of predicting the future. Even with the ideas that are built around machine learning and some of the more adaptive ideas, they still do not include the ability to actually take with your eyes and ears and process what is happening and constructing your own true fundamental viewpoint on where things are going to go.
And I think the 2008 crisis was a very good example of that. And I think going forward, now that we're very seemingly mid- to late-cycle on this economic expansion, thinking about do I really want to defer the investment process or the decision to something that's using X amount of history to come up with our overall allocations or my overall portfolio solution. Something to think about. As promised, I'll give you a brief outlook and again, this is as of the end of Jan 31. And I've specifically not included a strong mention of Coronavirus, but I think in the short term, most of the market moves that we're going to see are really related to news headlines around that. Fundamentally, the economy still remains quite strong. We'll see if China, how much China is impacted by this and what actions their central bank will take to protect the economy and how long some of the quarantine issues play out.
So obviously there's an asterisk on all of this, but absent that, a massive proliferation of the Coronavirus, I do think that most of the bullet points here hold. We do see low inflation persisting, but again, there is the potential for higher wages in this tight labor market to see inflation kind of crop back into the picture in a way that the market is ... at least in a way that the market is not anticipating. We do have unemployment and underemployment at generational lows. We don't really see an elevated risk for a recession at this time, but market volatility could certainly pick up later this year, depending on the complexion of the U.S. presidential election. And we've seen that so far, where at any time where a more progressive Democratic candidate picks up steam or is more likely to win the Democratic nomination, that has actually spooked markets a little bit because of the fear that policies that might come from one of them being elected could materially impact the economic prospects that we've seen or benefited from over the last few years.
Finally, in terms of our own portfolios, we are generally defensive on rates because when I look at the seven year treasury yield at 1.51 or the 10 year treasury at 1.59, I think sure, investing in these securities might make sense as trades, as protection against some material headline risk, but again, they're not investments at that point, they're trades. So as trades, they might make sense, but as longer term investors, I look at the opportunity set and think I don't really want to own treasuries at these rate levels. I'd rather be parked in cash where I can earn a similar rate level, allow all of this to kind of play out, and not lock in to a 10 year return of 1.59. I really think of these as investments not trades. So we tend to avoid seeing long duration in this particular market, while respecting that in the short term, it could be pretty bumpy given the profile of news headlines.
Secondly, despite the fact that spreads are pretty tight, we maintain our slight overweight. Frankly, like I said, the drivers of the economy are still quite strong, absent this virus news that we've had lately. I don't see any material reason for that to change, again, outside of a change in the prospects around that one event. But I think overall, the economy's doing quite well. The global landscape I think has improved from where we were last year. You've seen some normalization in European yields, although again, they're still quite negative, but not as negative as they were. And then within the U.S., I do think that corporates, while they still offer some value here, mortgages are probably a little bit of a better investment relative to corporates given their under-performance last year. And in my mind, the unlikeliness that a protracted rally would make mortgages much cheaper, I just don't see treasuries rallying towards the zero bound at this point.
I think Fed policy is relatively accommodative at 1.5%. I think domestic data show that the economy remains relatively strong and I just feel that if rates were to fall substantially from here, it would require quite a large exogenous event to get us to that point. I just don't see anything in our current landscape that that warrants or would suggest that rates would go much lower. So with that I will turn it over to Q&A.
Shawn Eubanks (41:53): Thank you, Eddy. We would love to get your questions if you can type them in the chat. So please go ahead and do that, we'd love to answer whatever we can.
Eddy, while we're waiting, you mentioned that sector rotation can be a big source of returns, even when yields are low in the market overall. How do you and your team go about determining your sector weightings in your strategy?
Eddy Vataru (42:26): Sure. Well, we use that ... qualitatively, I would say we use the chart that I showed a little bit earlier that demonstrated the various risk factors across the asset classes. And we really try to come up with our assessment of what the risks are at current rate levels, at current spread levels, looking at data, et cetera, which of those risks are properly priced, which are rich, which are cheap, and it's an iterative process. So it's really an ongoing, almost daily process where we're assessing data, assessing spreads, and then trying to understand is this a market where we're comfortable taking default risk or liquidity risk at the spread levels that corporates offer, are we more comfortable taking the call and volatility risk by owning an agency mortgage, or are we in a market where both are too tight and we'd rather just own treasuries.
Like I said, it's difficult to maintain a treasury exposure over a long period of time or to justify that, because it just does not offer the same return per unit of risk that say a mortgage investment does for the same credit quality. But at the same time, there's certainly a place for a treasury investment if valuations in mortgages and corporates get really stretched. They're pretty stretched, but there's still, in my mind, some value in both asset classes. So we really assess the opportunity set in the assets that we're able to purchase in corporate land versus the mortgage assets that I buy, and mapping them to that kind of framework.
Shawn Eubanks (44:13): Thank you. Still waiting for any questions that you may have. In your mind, Eddy, what would you say are the most likely factors that would cause the Fed to change its current stance on interest rates in 2020, kind of in either direction?
Eddy Vataru (44:30): Well, I think the hurdle is pretty high in both directions. So we've had three eases in '19, that if you look purely at data, you might have questioned why we even had the eases. I didn't think that our starting point was particularly restrictive, but I think the Fed felt that the combination of uncertainty around trade policy with the fact that inflation was so low that they kind of had some cover that they could drop rates without really fearing creating an inflation spike. It allowed them to kind of address some of the risks or fears that the market had by basically implementing these rate cuts. Now, absent the uncertainty around the trade scenario last year, I don't know that we would had those rate cuts, but they did serve a purpose in at least dis-inverting the yield curve last year and restoring some confidence in markets. I mean, you see how equities have performed over the last year, year and a half. I mean it's really been a tremendous market for risk.
Going forward, I think it's difficult to justify cutting rates again, unless you have an exogenous event that none of us want. In terms of hiking rates, because inflation is so muted, there really is no reason to hike rates from here either. I think the Fed has been pretty clear that they not only would like to see inflation get to 2%, but they've talked about having it get persistently over 2% or remain above using 2% as a symmetric target, not as a ceiling on where inflation should be. So I think that would allow them, even if inflation were to tick to 2.5% tomorrow and stay there for three months, I still don't think that triggers a hike at all. I think that's, in some ways, a desired outcome and reflective of a strong economy, but they'd want to see that persist. And if it manifested as higher and uncontrollable inflation, then they would start to hike.
But I don't see that happening either. So we're kind of at this very comfortable 1.5% points that is difficult to see us getting off of for certainly for the balance of the year, and we'll see how things evolve as the year goes on.
Shawn Eubanks (46:48): Great. Thank you. We did have a question that came in about the Fed taking any action, but I think you've kind of answered that question. They're kind of in a pause at this point and the bar to make a move in either direction would be pretty high. I do have a question here. If you're building a traditional 60/40 portfolio and you want to design fixed income to be primarily safety ballast in the case of stock declines, how would you allocate that fixed income portfolio in that scenario?
Eddy Vataru (47:19): Right. So I think it's an interesting question. The question becomes a function of if your sole purpose of being in that 60/40 split, if all you're trying to get out of the 40 is protection against your 60, then your considerations will be more related to correlation against equities rather than the return on the asset itself. So I know something that's kind of a popular approach is to use treasuries and use specifically seven- to 10-year treasuries to achieve that outcome. Seven- to 10-years have a little bit of yield, I suppose, compared to shorter durations over time. But also they have enough interest rate sensitivity that when you do have an event, they do provide some return when equities are otherwise challenged. So I would probably say if the purpose of constructing a portfolio is specifically against an equity allocation, then that's kind of the first place you would look.
Now, I do think as I've kind of made a point in this presentation, that treasuries, as a long-term investment, are not a compelling vehicle. So I would kind of favor an approach that has more of a longer term look at the overall return profile, rather than a day-to-day or month-to-month return. How did my equities do, did my bonds save me, I think it's more important to kind of look at each individually and say, "Okay, well within my equity exposure, I want to own these types of funds or these types of assets. But then within fixed income I want to own something that has the best return per unit of risk," and I don't necessarily ... my view, taking a longer term view, is that it doesn't necessarily need to line up specifically as equity ballast against a drawdown in equities tomorrow or next week or next month.
I think a 60/40 portfolio is meant to outperform over time, and to do that, I think the fixed income fees should be looked at in isolation. And I do favor more hedge-type strategies, at least today, given where markets are and given where interest rates are. But again, I think it really depends on your risk profile and what you're specifically trying to achieve in terms of how frequently are you measuring your returns and how are you looking at the purpose of your fixed income portfolio. My take would be to take a longer term view and buy a fixed income strategy that fits your risk/reward better, that can deliver a better return over time. But again, I think different folks have different ways of approaching how they look at fixed income as equity ballast.
Shawn Eubanks (50:24): Great. Thank you, Eddy. Would you say that given where we are in the interest rate cycle and just the dynamics of the more core Baclays Agg oriented-type exposures, that maybe taking a portion of that core exposure and allocating it to more defensive hedge strategies might be an idea worth considering as kind of a non-correlated piece to that core exposure but still have investment grade quality assets?
Eddy Vataru (50:59): Sure. I mean, I might be a little bit biased in this space because it's ... in creating a fund that I manage, it's trying to take the best of all worlds and apply them in one strategy. And that strategy is really more of a hedged investment grade strategy. But I mean, like I said, when Fed funds are 1.5% and don't look to be moving, it's difficult to justify buying five year treasuries 10 basis points lower than that. Unless you're specifically making a trade on something related to fear or some exogenous event, there's no fundamental value there.
I do think hedge strategies here make a lot of sense. But again, I'm kind of speaking my own book there because I think we're at a point in the cycle where we really have gotten towards the end of the whole Central Bank intervention cycle. And unless you think that Central Bank intervention will persist for all eternity, interest rates are simply too low. I do think inflation will pick up a little bit. And even just a muted rise in inflation will certainly change how we think about and how we value fixed income. I mean 30-year yields at barely north of 2% in the U.S. seems like a very, very, very low return for an incredible amount of interest rate risk.
So that risk/return profile to me doesn't look very attractive.
Shawn Eubanks (52:31): Thank you. Eddy, we don't have any additional questions at this point, so thank you very much for your time and for this educational conversation.
Eddy Vataru (52:41): All right. Thank you.

Fed is short for Federal Reserve.

The Sharpe Ratio represents the added value over the risk-free rate per unit of volatility risk.

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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.

Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [43948]