Published on June 6, 2023

If you were unable to join the Total Return team for their recent town hall webinar, you can watch a replay to hear the team answer questions about a range of fixed income topics, including the markets, Fed policy, and the economy.

(Source for Bloomberg charts displayed during the replay: Bloomberg)


Shawn Eubanks: Good morning everyone. My name's Shawn Eubanks and I'm the Director of Business Development at Osterweis Capital Management. We'd like to welcome you to our Town Hall for the Osterweis Total Return Fund team. This is a new format for us and we appreciate any feedback that you have after this event. At this time, all of our participants are in a listen only mode, and we'll conduct a question-and-answer session that you can participate in via the online chat or through your computer.

We'll hold all the questions until the end, but first we'll go through some questions that came in ahead of time. Please note that this webinar is being recorded. Today I'll be moderating the Q&A with Eddy Vataru, John Sheehan, and Daniel Oh. Eddy, let's start out by talking about the Fed. Do you have any particular insights coming from the last Fed meeting?

Eddy Vataru: Thanks, Shawn. Thanks everyone for joining. Gosh, when was the last Fed meeting? Feels so long ago. I think the way I would characterize it and kind of where we are at this stage in the cycle is the Fed is either completely done or really close to done hiking rates. Obviously, they're first and foremost still concerned about inflation, although inflation is falling, and I'll talk a little bit more about that in a bit.

But I do think that the quote-unquote "pivot" that people have been waiting for from the Fed, I think has finally hit us in the last meeting. So we're basically at the same level of rates that we were between 2006 and 2008. That's the last of the parallels I'm going to draw to 2008, because things are very different now. The thing that will send us into our next recession is not the thing that sent us into the financial crisis back then, but to the extent that now we're staring at data and some of it looks good and some of it looks a little more mixed, I think the Fed is going to be on hold and try to stay and hold this line as long as they can without easing.

They want the fed fund's target rate to be sufficiently restrictive to dampen inflation or tamp inflation without being overly restrictive to crush the economy. But again, we've had two or three years of incredibly stimulative policy, incredibly easy policy, and I think the Fed is trying to undo some of the steam that's come from that. So we're in a holding period now. Yes, you might see one more hike at the margin if the data is exceedingly positive. This is what folks were starting to look at last week. I think that expectation has changed this week. I think we're on hold and I think the Fed will try to stay on hold as long as they possibly can.

Shawn Eubanks: Thanks, Eddy. Continuing on that thought, what data points are you keeping an eye on?

Eddy Vataru: So on cue, my favorite metric for basically eating popcorn and watching with a courtside seat on what's going on is to track this scoreboard, basically the inflation scoreboard, but more specifically track it using UIG as a metric of inflation, not CPI. And for those that have read our posts and materials and outlooks over the years, you'll know what UIG is. But for those that are new, welcome, and UIG stands for the underlying inflation gauge.

It is a measure of the persistent component of headline inflation. It's published by the Federal Reserve Bank of New York. I've found it quite interesting in tracking all the Fed speak and all the governors and everything that's come out in the last three years, including the entire debate on persistence versus transitory nature of inflation, and the answer was staring us in the face and nobody chose to quote it.

It was right here. It really in our case in blue, and let's call CPI pewter, where inflation was rising and UIG tells us that a significant portion of the headline inflation that was rising in 2021 into 2022 was of a persistent nature. Now, what's interesting is UIG crested around March of 2022 at about 6%, a little over 6%. There are actually two metrics, two measures of UIG. One is a direct comparable to CPI that's called the "prices paid index." The other is a full data set that includes some other market variables that I think are geared to be a little bit more forward-looking measures of inflation.

They both work fine, but the reality is that UIG prices paid is a nice direct comparison to CPI and regardless of which UIG flavor you choose, it's very clear that UIG has fallen over the last 14, 15 months. The other thing I think that's intuitively rewarding about looking at UIG as a measure of inflation is if you notice how stable the line is. And think about it, this is the persistent component of inflation, so there's a lot of inertia. You're talking about persistence, we're talking about something that sticks. It's not something that will move based on how one survey reacted or one part of CPI moved in a given month because of some exception or noise or fraud or whatever the case might be.

You eliminate a lot of the volatility in the underlying CPI series when you look at UIG, which is why this is our favored method of looking at inflation. Similarly, you find that the UIG metric itself does not ... because it has less noise, it also gives us more conviction in deriving conclusions from it. So when it crested at six early last year and has fallen, it has fallen in a manner that is consistent with inflation peaking and falling decisively.

So yes, we might see headline CPI have an owner's equivalent rent bump because of something or some other noise here or there, but I can say that UIG is actually fallen now below 4%. This data is as of March, but it's actually fallen below 4% and at its present velocity we'll probably get to the 2% area if it doesn't change by fall or winter of this year. So I expected the rate of change of UIG to slow, but I expect it to continue to fall and probably get us nicely to that 2%, certainly sub 3% range by the fall and probably even down to 2% by the winter, which I think if you consider the headlines and the fears of inflation right now, I think would come as a surprise to some.

That also will give the Fed perhaps a little more green light to relax on how restrictive their policy is. But that's looking forward 6 to 12 to maybe even 18 months in terms of what the Fed might do from there. But for me, UIG is really the key and it eliminates all the noise from the forecast. It performed really well. Even if you look back at the GFC 2008, 2009, 2010, I think it's a real indicator of what the real inflation is in our system. And yes, it's elevated, yes, it's falling and I think the continued restrictive policy will have us edging back to a more normal 2% number going forward.

Shawn Eubanks: Thanks for that, Eddy. Given that, can you discuss your interest rate and then the yield curve outlook?

Eddy Vataru: Yeah, so one thing that's been interesting is that the yield curve has been massively inverted over the last few months. I can pull up, maybe I can do a quick share here. This is not a normal yield curve shape by any stretch of the imagination. So this is showing the yield curve change over the last month. I can pop in over the last, I can't tell the future. By the way, it'd be an excellent feature if Bloomberg could tell me the future, it would make my job a lot easier.

But if you look, the yield curve has been ... this is the last six months. The curve has inverted further, the green line is current level. So the fact that the curve is this inverted has created a lot of confusion perhaps is the right term among fixed income investors because these periods tend to be fairly transitory. This one's actually lasted for quite some time and it could continue to last for quite some time to the extent that fed funds has really anchored up here above 5%.

We've had a lot of noise around the debt ceiling and other factors that impact T-Bill issuance. So there's certainly, I would say some noise, certainly when you start looking at very, very short term interest rates. And that's not really captured here, but it's something we've had to navigate when looking at T-Bills. Fortunately our mandate is really more focused on longer duration assets one year and out as part of our benchmark. So some of the fireworks we see with very short-term dislocations or changes in fed funds matter a little bit less. I care more about where fed funds is going to be 6 months up, down 12 months down the road, 24, 36, et cetera. How's the economy going to evolve?

And frankly, this inversion in the yield curve I think creates a great opportunity to get more fully invested as we appreciate that the Fed is closer to done or maybe even done with their hiking regime. So in terms of our interest rate outlook and yield curve outlook, I think we could see longer term yields stay relatively unchanged, maybe inch a little bit lower. So 20- and 30-year bonds maybe inch a little bit lower, but what you'll see as the Fed is done and then our eyes turn to the next Fed move being an ease. Whenever that is, that ease might not come for 18 months, may not come for two years, but as long as we have the idea that there is not going to be a hike, I think it's important to use that as a queue to be more fully invested, take on more duration risks. And as we get closer to a Fed ease, that's when you start to see more dramatic curve steepening where the shorter rates will fall and longer rates may fall but maybe fall a little bit less.

I would expect in terms of now this type of yield curve might continue, it does offer some opportunities that I think we're going to spend some time talking about in a bit. But the game plan is 6 months out, 12 months out, 24 months out, this yield curve will steepen, will look more regularly shaped and the Fed will probably be compelled to ease down the road. Again, probably don't want them to do it so soon because if they do it really quickly, that probably is an indicator of a slowing economy that they need to get ahead of. But the reality is I do expect slowing and I do expect the Fed to ease in the next 6 to 12 months most likely.

Shawn Eubanks: Okay. Thank you, Eddy. Maybe Eddy and Daniel, can you talk a little bit about the opportunity to benefit from sector rotation in the investment grade market?

Eddy Vataru: Sure. So why don't I take a couple minutes to talk about how we look at sector rotation or the opportunity in sectors from a clean slate and then Daniel can talk about the opportunity set now. So if we could put up the slide on the matrix slide. Basically we have ... there it is. So I know John wrote a piece I think and called this the Vataru matrix. The reality is this matrix is something I've worked on since I started in the business in the late '90s. It helps me, I'm a visual person, it helps me understand the relationships between the various asset classes and what the similarities and differences are between them.

So in this particular case, what I did was I've had, this is probably version 50 of this slide as it's evolved over the years, but I wanted to isolate the three sectors that matter most in investment grade. So Treasuries, mortgages, and corporates, which are on the left axis. Those comprise over 90% of the Aggregate Index. That's our benchmark. In terms of risk factors, there are several, but I wanted to segregate these between risk factors that are uniquely tied to interest rate exposures and those that are specifically related to the differences between these individual assets that dictate what their spreads are. So let me give an example.

Treasuries, mortgages, and corporates all have significant interest rate risk. Corporates and Treasuries have more because the assets have longer durations, just at the index level, Treasuries and corporates have durations around eight to nine and mortgages are, call it about somewhere between four and six in general. There's some exceptions, but at the index level, mortgage durations are shorter than Treasuries and corporates, so they show up with a lighter shading in this particular case.

Reinvestment risk is an interesting one. Mortgages, they all have pretty modest reinvestment rate risk owing to the fact that if you buy a 30-year Treasury, you're going to get a little bit of coupon every year or semi-annually, then you're going to get the big lump sum at the end. Mortgages have a little more reinvestment risk because they amortize and they have prepayments. So you're getting all your principal paid down every month and you're getting the potential for prepayment. That means you have more money to reinvest on a monthly basis if you're a mortgage investor.

And then all asset classes have exposure to inflation. So we learned that last year. There's really no getting out of the way of that, regardless of which asset class you are in. Now the thing that makes our jobs interesting is trying to understand where the opportunities are between Treasuries, mortgages, and corporates. And the differences there lie on the right side of this chart.

Starting with Treasuries, Treasuries are the risk-free asset. They don't have call risk, they probably don't have default risk, but we can do this again next week and see if that's the case. We have to assume that they don't. Liquidity risk and volatility risk, none of these are really issues that impact Treasuries and they have no spread. So they are the risk-free rate if you think about that at each maturity. Now, we'll move down to corporates because it's a little easier to kind of wrap your arms around that. Corporates are basically a Treasury, a fixed rate bond asset where your primary risk is default risk. So instead of taking on Treasury risk, and again in my head I'm just laughing given the timing of the debt ceiling conversations and this conversation, but trust me, over the longer term and in general, this is really how the markets approach this and continue to approach this.

Corporates, you have to be paid a spread on top of Treasuries because you're taking on the risk that a certain company may not pay. Secondarily and importantly, corporates also have liquidity risk. And you saw this during the pandemic in March of 2020 when corporate spreads widened significantly more than mortgages and severely underperformed Treasuries for a short bit. Also, and that wasn't necessarily related to defaults. There were a couple names that I know, Hertz was a higher profile name that issued a bond and never made a payment. But the reality is that the risk that came to the fore that was addressed by QE4 in March 2020 was largely liquidity risk.

We also saw this, if you think back to Q4 of 2018 where the S&P was down, I think 10 or so percent, corporates underperformed pretty substantially in line with how the equities did. But there wasn't a single name that I recall that defaulted in 2018 or Q4 of 2018. All of the underperformance is attributable to liquidity risk. So when things are going well, corporates do great. When things are going less well and liquidity dries up, corporates tend to struggle. Now you're compensated for that with that spread. So again, when you take on these risks, you're compensated in spread.

I'll conclude with mortgages and turn it over to Daniel to give a survey of where we are now. But agency mortgages, and these are government guaranteed or guaranteed by the agencies that are in conservatorship. So Fannie Mae, Freddie Mac, and then Ginnie Mae being full faith and credit Treasury quality asset, your primary risk is call risk and volatility risk. And what does that mean? Default risk is not a real risk because you have the government backing and the loans that you're buying are securitized by property. So they're actually pretty safe from that risk perspective.

Liquidity, mortgage liquidity is pretty good, especially relative to corporates in times of trouble, not quite as good as Treasuries, but pretty darn good. So they get the light shading. The call risk is the possibility that a homeowner can refinance their loan at any time. So right now that seems pretty remote with mortgage rates near 7%, but certainly two years ago this was a big risk for owning a mortgage, and through time this is the primary risk that you're taking when you buy a mortgage.

One way to think about it to maybe demystify it, or maybe I'll make it a little more confusing, but I like this way of thinking about mortgages, is they're an amortizing Treasury quality asset plus a short option to a homeowner who can refinance at any time. So when I'm looking at mortgages, I'm trying to value that option and what is the likelihood of a borrower to refinance both on account of what is the level of rate that they have versus the current level of rate, but also certain attributes of loans in terms of loan size or loan purpose that drive different behaviors in terms of prepayments also dictate the value of that option. So when I'm doing a deeper dive into actual assets, I'm looking at that.

Volatility is an important risk because if you think about valuing an option, it might ring a bell that volatility of the underlying rate is actually going to drive how valuable that underlying option is. So there is a large residual exposure to interest rate volatility that falls into how we look at the opportunity within MBS. So the nice thing about this chart and something that we think is important, we write about a lot, is the opportunity in fixed income, in investment grade is actually quite robust because the differences between your three pillars of the investment grade market are actually pretty dramatic. Last year didn't really showcase that because inflation trumped everything. But you're starting to see now months where one asset class can outperform another pretty substantially on account of their various exposures to these different risk factors. Maybe here, I'll turn it over to Daniel to kind of walk through where we see value now, where we are now.

Daniel Oh: Hey. Thanks, Eddy. I recently wrote a blog discussing the relative value proposition of mortgages versus corporates. At the time that we wrote the blog, agency mortgages were trading about 25 BPs wider than corporates. This presented an opportunity and it continues to. The average spread between the two sectors over a two-year period actually had agencies trading about eight basis points tighter than corporates. After we wrote the piece, the spread converged to zero as the regional bank crisis came to the forefront. And as of now, the spread has increased to about 40 basis points.

Nominal mortgage spreads continue to trade at historical wides and we continue to see a lot of value here. We're seeing a lot more attention being paid to where they're trading and the value that the sector has over corporates. And we continue to think it's a tremendous value as we continue to see, expect a slowing economy that's going to negatively impact corporates and should benefit agency mortgages. And so if you look at this chart, really if you were to actually go out a little bit further, you would see the historical spread, 138 on corporates versus 171 really, really gives you value and we've been rotating from corporates to mortgages and we continue to do so.

Shawn Eubanks: Great, thank you. I'll kind of throw this out to the whole team. Is there anything else you want to add about the risks and opportunities in the market?

Eddy Vataru: Yeah, I can. Just to follow up on Daniel's point, I mean we've liked mortgages, obviously they've had some headwinds because of the FDIC sales of the Silicon Valley Bank and the Signature Bank portfolios. They're using a template that they used to sell the Treasury portfolio from around 2011, the Treasury portfolio was built as a part of TARP. I actually was involved with creating that portfolio. So I had a front row seat to watching a lot of the bonds that I bought being sold. That sale was extremely orderly. That portfolio grew to over, I think it was well over $200 billion.

So in terms of context, the only thing that's been interesting about the FDIC sales right now is they've probably carried them out at a fairly accelerated pace, I think because they saw that the 2011 effort was so orderly that they could just come to market, and bring it and the market can adapt. It's a slightly different market right now than 2011 and that's part of why spreads have widened a bit. But I'd say overall the bid lists have been well-consumed at somewhat wider levels.

But I also think that this has provided a good backdrop to increase our exposure to the asset class at spreads we haven't seen in years, both compared to corporates but also just outright. I think when I was reading a Bloomberg headline and they have a pretty simplistic way of looking at mortgage spreads and it's an interesting asset class, it's very difficult to kind of say this is a single number that dictates what mortgage spreads are because there are just so many different flavors of mortgages and then different things to compare them against, plus the option value.

But in the crudest sense, the nominal spread of mortgages I think reached something like a 10- or 12-year wide, I think late last week. So again, this is something that we came into this year being significantly underweight. We've been adding steadily throughout the year, continue to really like the story. And I think by virtue of a combination of factors including, A, getting through the FDIC sales, which have started to become well-absorbed; B, getting to the end of the Fed cycle, which means that the curve will probably start to normalize in the coming months, which improves the carry profile of mortgages in particular, especially because mortgage key rate durations, and I'm sorry if I'm going too far off the deep end on this, but because of the cash profile of mortgages, their key rate durations tend to be distributed across a good swath of the yield curve.

So even if you're buying a 30-year mortgage, you really are getting exposure to the two-year point, the three-year point, the five-year point, you're getting a little bit of everything because of that reinvestment component and that prepayment component. The primary focus of a mortgage investment's kind of between the 5- and 10-year area in terms of exposure to that part of the curve. And that's a part of the curve we don't mind owning, especially in this stage of the Fed cycle. So I think that the technical landscape as we get through these sales and we get towards the end of the Fed hiking cycle are very constructive for MBS and we're coming into it with spreads at the widest level seen in over a decade.

For me, that seems like a compelling opportunity because I understand why the spreads are where they are. I know how we got this wide and I'm convinced that because of those factors I described, they should start to tighten in quite nicely. We've already seen 15 basis points of tightening in the last three days. I expect that to continue through the summer into the fall as we get back to something that looks a little bit more normal for mortgage spreads.

So in terms of positioning, yes, I think sector rotation, increased allocation to MBS, probably at the expense of Treasuries and corporate certainly makes sense in this particular market. But maybe Daniel or John have some other thoughts on other areas.

John Sheehan: Yeah, I'd just say in terms of risks that we're focused on from the corporate perspective is leaning to the Fed, they're attempting a very delicate outcome here of controlling inflation without creating a recession. So certainly a Fed policy gets too aggressive in stopping inflation, which they've made many, many statements to the effect that fighting inflation is their primary concern, that you could easily see how corporates would struggle in a recessionary environment. So we're watching that very closely to see if the Fed is able to execute their strategy of controlling inflation without creating a deep recession.

Daniel Oh: From the structured credit space, it's a short asset. So the opportunity there is you're getting a short asset, which is the highest yielding part of the curve, and you're getting some very interesting spread. And so when you look at something like an auto loan deal, you're seeing 175 over the short end of the curve and you're seeing one-year deals priced around 6.5%. That's the opportunity.

I think where it falls apart is we're concerned about the consumer. They seem stretched at points, and we've seen delinquencies increase in areas like autos and you're seeing some of these numbers really increase in unsecured consumer. So that's the risk. In addition to that, the Fed policy tightening, if it remains here, it's going to be a stress point, which it already is to areas such as commercial real estate in the loan space as margins get really squeezed and the economics start falling apart. So those are the concerns in structured credit and the opportunities.

Eddy Vataru: And let me just say one thing just because I've mentioned this a couple times. This is the mortgage spread versus a 5- and 10-year Treasury yield over the last 10 years and the only notable period where spreads were this wide was March, 2020 when Covid hit and shut everything down. So you have to go back to the GFC to find spreads that are wider, and I would argue that we're not in a period right now of complete distress, complete upheaval, any of that. So to have mortgage spreads this wide at this stage in the cycle, especially with some of the more positive tailwinds to come in the months to come, I hate to use a poker term, but there is a part of me wants to kind of go all in on this because it just doesn't speak to the fundamental value of the underlying asset.

And we do have a significant overweight position and I would expect significant tightening. I mean, we certainly have at least another 30, 40 BPs of tightening before I'd even think about reducing, to be honest, in this sector. So I think the timing of this call is great, and we've seen a lot of folks write about the opportunity in mortgages here recently. It's just, they've come under a lot of stress and this just gives you some perspective over a 10-year period. I mean, certainly if you look year-to-date or even over a one-year period, this is year-to-date, this is one-year. I mean, the wide was reached right before Memorial Day. We're still at very compelling levels to add exposure here.

Shawn Eubanks: Great. And kind of going forward, how would you expect the portfolio positioning to evolve if spreads were continue to widen ahead of a recession in the United States?

Eddy Vataru: Let me take it quickly from a Treasury mortgage side and then maybe turn it over to John or Daniel on the securitizing corporate side. Treasuries will obviously do best in a recessionary environment. Mortgages, yes, you have a lot of carry. Yes, you have the Treasury quality asset, but if we have a lot of volatility related to potential, like if the economy starts to crack or the Fed maybe cuts aggressively, like a big crisis-type hard-landing-type situation, then just close your eyes and buy Treasuries. That's the place to be.

In the beginning they probably will actually do okay against Treasuries here just because they're so wide. It's such a compelling cash flow here. But yeah, if we really fall into a pretty deep recession or any kind of recession, Treasuries would just be my knee-jerk reaction to be more fully allocated there and basically reduce corporates to near zero and mortgages substantially lower as well.

John Sheehan: Just to put corporates in perspective, as Daniel mentioned earlier, the spread of the corporate index right now is that 138. The recent tight was at 80 basis points at the end of 2021, and we peaked out about 165 earlier this year. So I'd say certainly we don't expect to get anywhere back to near 80 without the help of quantitative easing again.

The 165 was at the height of Fed tightening concerns in the marketplace. So if we were to head back into a recession, I think we could certainly test the wides that we saw this year, if not more so. I will say that corporates really for the first time in probably the last 10 years took the windfall of some of the Covid policies and really improved their balance sheets. So it was the first meaningful time we saw Corporate America paying down debt, reducing leverage ratios, so the balance sheets are in better shape now than they were certainly coming into the Covid crisis. So we do think they have a little bit of cushion. So it really boils down to the depth of the recession for how we see corporate spreads performing.

Shawn Eubanks: Okay, and when do you think we should start looking to take on more duration?

Eddy Vataru: We've been incrementally adding duration throughout the year. I think again, when the Fed is clearly done and your next question is when are they going to cut? That means it's safe to take duration. Like I've said, we've seen a couple of false starts in the Treasury market. October of last year, January of this year. We were not long duration in either one of those. We actually trailed the benchmark both times and both times the market kind of came back to us.

While that has happened, we have steadily increased our duration in our strategy so that the next time that happens when it's actually definitively the end of the Fed hiking cycle and not some kind of optimistic front running of when the Fed might pivot, then we expect to be paid in full and outperform the benchmark even in an rate-falling market because we like to take that duration risk.

We're right now pretty close to the index here, but I would anticipate as we get even closer to being definitively done with this to increase duration exposure into the summer, the fall, through the end of the year. So we have taken more duration this year than we've taken in the prior six years of our strategy. I think it has made sense to do that in this context, especially after the 2022 being what it was, where we were relatively short. Now's the time to take more risks. So we've been doing it methodically.

I anticipate increasing our duration risk as the year goes on, but again, doing it in a way that is measured and we've spent most of this year slightly shorter than the benchmark, edging towards our benchmark. I'd anticipate as the year goes on, we'll probably extend beyond our benchmark by a little bit to take advantage of rates falling as we stare at a slowing economy and the potential for a recession.

Shawn Eubanks: Thank you, Eddy. John, can you maybe talk a little bit about the risks to the short-term approach of just rolling T-Bills in this environment?

John Sheehan: Sure. It's very understandable coming into this year why people would want to flock to that strategy. Last year the Aggregate was down over 13%, the worst year in the history of the longer-duration index. Combine that with the fact that coming into this year, short term interest rates both in T-Bills and in money market funds were the highest that they've been in 20 years. So seeking that safety is a very understandable motivation, but it does take two main risks into play when you think about the objectives of fixed income investing.

The first is really asset liability matching, so if you're investing to save for a retirement, child's education, et cetera, you tend to have a longer time horizon than a one-month T-Bill would apply. So what that entails is that you need to roll those T-Bills every single month. So if you go back to Eddy's matrix, that brings into play a significant amount of reinvestment risk.

So a T-Bill that is yielding 4%, that's an annualized yield for a one-month security. So the only way you're actually going to realize that 4% is if you successfully buy the one-month T-Bill 12 times at 4% in order to get there. So we think that is certainly something that gets ignored here. And then the other is just keeping pace with inflation. One-month T-Bills yield what they do because the Fed has been raising rates to fight inflation and pretty much every month this year so far inflation has been higher than the yield of the one-month T-Bill. So by doing that you are missing keeping pace with inflation and for many of our clients, maintaining purchasing power is probably the primary objective of their fixed income portfolio.

And then the last point, to Eddy's point about extending duration here, we've looked at the end of the last three hiking cycles and how interest rates have performed over the next year from that point. Fed funds on average, after the end of the last three hiking cycles, ended up over 100 basis points lower, and the 10-year note on average ended 65 basis points lower. So we don't necessarily need to get the exact right month. Again, as Eddy said, there may be one, maybe two more hikes left, but we feel pretty good about the chance that within the 12 months the Fed is certainly going to be done and is going to be more likely to be cutting than hiking in that time period. So you can see that a duration position, once the Fed stops hiking, is going to significantly outperform a T-Bill position.

Eddy Vataru: If I can add one quick thing just to give some perspective, because I love showing charts. This is the cycle at the end of 2006, I could show 2000, I could show 2018. This is all kind of to make John's point. So what this chart's showing is the white line is the fed funds rate through 2006, and I actually like this one because it has the same target rate where we are now five, 5 and a quarter on the high end.

Now the yellow line is the two-year yield, the orange line is the 10-year yield and the blue line is a measure of the shape of the curve. Basically the difference between the two-year yield and the 10-year yield. All of the yields are on the right axis. The spread, the blue line is on the left axis.

So to our point about we don't have to get the timing perfectly right, the Fed... being invested when the Fed is done, let's just look at 2006, which is a pretty well telegraphed exit for Greenspan. If you remember his 17 hikes to five and a quarter and then he left. Being invested, fully invested in fixed income with yields around 5%, 4.5%, 5%. The curve was relatively stable, it bounced around a bit. There were times where the 2-year was above the 10-year and times in reverse. It was fine to be fully invested. Returns certainly compensated you for being fully invested in the first part of this cycle. Then as the pause lasts a little longer and we had a little bit of a selloff where we got back to where we were, but again, you're still earning 4.5% 5% on your asset, so it's not a loss at your respective portfolio level, that was fine.

But what you started to see is the curve start to steepen. When the next move was really definitively going to be an ease. And that wasn't quite as clear over here, but certainly became clear as '07 played on, the 2-year started to rally pretty sharply compared to the 10-year. And this is what John was talking about is that the 10-year rallies some and the 2-year rallies more, and this is also the underpinning of why I don't mind owning MBS, because they tend to outperform in a bull steepening type of environment like this one because of their duration profile.

So as the 2- and 10-year spread started to expand, so 2-year yields fell more than 10-years, then the Fed ultimately eased in late '07 going into '08, and we don't need to replay '08, but again, as I mentioned, this is a slightly different period in terms of what would cause the Fed to ease. We're not going to have the calamity of '08 with bad loans, but we have had some calamity with bad hedging practices at certain banks and whatnot with the banking issues largely related to interest rates, not related to the actual credits themselves.

So there is no concept of bad loans here because performance of loans has been fine. It's the fact that loans are bought at 100 cents on the dollar and are trading at 80 cents on the dollar and when you have a deposit flight, you have to have a mark-to-market event and that's what created the run on the bank and they were done in terms of the cases we had in March. Here, the driver of what's going to cause this to play out is the economy slows down, start to maybe see finally a slowdown in wage growth as the labor market slackens a bit, unemployment rises.

That's kind of how this is going to play out. We've seen some evidence of this with continuing claims rising and a little bit of weakness in the labor market, but it's happened a little more slowly than the Fed's probably happy with. But that's how this playbook in my mind is going to play out. It's not going to be a loan event or so it was in '08, but it may be some other type of asset and if folks are pointing at commercial real estate, I don't know. I think those issues are fairly well-documented, but we'll see.

There'll be some trigger and you'll have some things that are the symptom of the problem and some things that are the actual problem. The actual problem will be a material slowdown in the economy that we'll see in the months to come. So being fully invested at this stage in the cycle, where basically you're somewhere around here, maybe we're here, maybe we're one hike away, this feels okay. And I think if I pulled up '18 or I pulled up 2000, the charts would look very similar in terms of defining this as a good entry point to add duration exposure to your strategy.

Shawn Eubanks: Thanks, Eddy. A question came in about repos in relation to the debt ceiling. Can you talk a little bit about that?

Eddy Vataru: I don't know. I mean, what's going on with the debt ceiling right now is there's just too much uncertainty around how this is going to play out. It feels like they're going to have resolution as things have passed through the House, but nothing is ever as easy as it seems. Although, I will say that the passage through the House happened more easily than I would've expected, but it seems like a strategy of annoying the fringes for the greater good seemed to work there.

So a little less of this kind of polarized behavior you've seen in terms of voting certainly came through yesterday. But we'll see. I mean, this is far from done. I know the Senate is working until they get something signed, sealed, and delivered to the President on Monday, but difficult to forecast. I know that some of the disruption that we've seen has largely weighed on certain Treasury bills maturing on certain dates. Fortunately, we don't traffic in trying to ... we're not running a money market fund and we're not dealing with nailing with absolute precision when a deal this is going to get done.

It doesn't impact us directly other than if a deal doesn't get done, then you would have a risk-off event, probably. Paradoxically, you'd actually have Treasuries probably rally a little bit. Mortgages should do okay. Corporates should probably underperform. Again, if a deal doesn't get done. It'd be a big volatility event. I mean Treasuries, again, this is strange, but it's the flight to quality asset and ultimately you think that the Fed, you will get paid, but it would just be kind of ... I hate even talking about it to be honest, because it is kind of a ridiculous scenario, but the issue starts to come where contractors are not paid or you have a real economic impact of delayed payments and things closing and stuff like that that have a more profound impact than are you going to get paid. That's not in doubt, it's just a matter of when.

But for the real economy, it may not be in a position to wait for a payment that you were expecting to get tomorrow or next week or next or so. But again, it feels like we're on a trajectory to get this resolved, but we'll find out next week if it actually is.

John Sheehan: And the repo and T-Bill markets have largely normalized. So there was a period when the T-Bill that was maturing the day after the "X-date" was trading 150 basis points higher than the day before. The T-Bill market is smooth, upward sloping, normal as you'd expect, which implies that the market is expecting the deal to go through.

Shawn Eubanks: Thanks. John, can you talk a little bit about undervalued credits in the IG corporate bond space?

John Sheehan: Sure, absolutely. I think it's pretty safe to say that the most significant event in the credit markets this year was the failure of a couple of the big banks, Silicon Valley Bank, et cetera. We think this has created a good opportunity in the globally systematically important banks. These are the largest banks that are going to be the beneficiaries of what's happened in some of the super-regional banks going under.

So the deposits that left some of those banks found their way into the biggest banks, which allowed those big banks to pay near zero for those incremental new deposits. If you consider the fact that they're originating new mortgages at 6.5%, 7%, you can see that they're going to earn a very, very healthy spread on those new deposits coming in. This is certainly evidenced by even their last earnings reports, which showed improving net interest margins across the board and that all didn't even reflect some of the new deposits that came in, which occurred in the second quarter.

So within the globally systematically important banks, one in particular that we like a lot is Morgan Stanley. This is a bank that has really transformed their business going back since 2010. 2010, about 72% of their revenues came from their institutional securities business. So think investment banking, sales and trading, higher volatility businesses that require mandate after mandate and the remainder came from their global wealth and investment management business.

This past year in 2022, they shifted that mix to 48% coming from institutional securities business and 52% coming from global and investment wealth management with plans to continue to grow the wealth and investment management. So this makes the credit much more stable, creates a recurring income of fee-based business as opposed to relying on the markets. So we think that that's a name that's going to continue to do well here.

Shawn Eubanks: Thanks John. And Daniel, maybe can you talk a little bit about what you're seeing in the securitized market?

Daniel Oh: Yep. In terms of securitized products, we continue to think that auto ABS is attractive, especially deals done in 2020 and early 2021. These deals were based on a borrower that was flush with cash from stimulus and public transportation wasn't viable due to Covid and robust values in their cars, so increased values of their cars.

Recently, one of the deals that we owned just got upgraded actually yesterday and S&P talked about the original assumption of net cum losses lifetime was 20.5% for a deal that we owned, and they revised at 9% lower to 11.5%. So really outperforming the initial assumption that the losses were going to be much higher.

What we saw in 2022 was a lot of these auto deals did not perform well. So we have not looked at 2022 paper, as underwriting guidelines were loose. Underwriters did not tighten up their credit box fast enough, and so you had borrowers that had higher exposure in terms of the principal amount of their loan in addition to higher terms and higher interest rates. So really exposed the investors to a lot of risk.

In 2023, we're looking at some auto again, given that underwriters have really tightened their underwriting standards. In addition to that, the rating agencies have adjusted their loss assumptions higher. So you're getting a more robust structure, and we're seeing short deals like I talked about previously, one year deals, 5 to 10 times over subscribe. And you're seeing deals are pricing around 6% to 6.5%.

Away from that, we also continue to deals backed by real assets. One of the areas we really like is aircraft ABS. John and I on the corporate side look at corporates of manufacturers like Boeing lessors, aircraft lessors, in addition to that, airlines. And what we're hearing is the airlines are saying that travel is robust. Boeing is continuing to have an issue with manufacturing airplanes on time. So what you're seeing is they continue to have supply chain issues. The latest being issues with the tail assembly, the vertical tail assembly is slowing down the 737 MAX production again, and air lessors cannot get their hands on aircraft.

So we like deals that are backed by NextGen aircraft, and unfortunately one of our deals actually had to repo a jet recently. And just to give you an idea the value of these aircraft, they repoed an air aircraft 737 MAX on April 25th and they already have letters of interest as of March 15th. So they're turning around that airplane very quickly. A lot of value given the supply chain issues and the demand on the other side. These are the kinds of ABS deals we like to look at where there are multiple positive factors. If one goes bad, there's other factors to support the deal.

Shawn Eubanks: Thank you. Let's take a look at some of the questions coming in during our discussion. And as noted on the slide, please ask a question through the Q&A window or raise your hand if you want to ask a question over your computer audio or by phone. So let's see. Okay, we have one question on Charles Schwab bonds. Any thoughts on that?

John Sheehan: Yeah, I'd echo some of the comments that we said about Morgan Stanley. Charles Schwab has a massive deposit base. They do not engage in some of the riskier businesses that the other banks do in terms of market activities. And this really comes down to prudent management and the bank's ability to match their assets and liabilities. The banks that got in trouble took very short duration deposits and invested in long duration mortgages and Treasuries, which created massive losses. I think Charles Schwab has displayed very strong management, and we don't own it, but I feel pretty good about Charles Schwab's ability to properly manage their asset liability mix.

Shawn Eubanks: Okay. And do you see a recession coming sooner rather than later and when and how might that affect the markets?

Eddy Vataru: Let me take that one. So that's a great question and I think before answering it, let me provide some thought around just the investment landscape in general because something that we've heard a lot about in the last few years is, Is 60/40 investing dead? Especially with the results of last year where stocks were down and bonds were down. The thing that kills 60/40 investing is not what year it is, it's what the central banks are doing. So I would argue that 60/40 investing was hurt in 2020 when the Fed provided all this hyper stimulus.

Anytime the Fed, you have a large non-economic buyer in markets that distorts markets, that's where the traditional correlations of 60/40 investing stocks and bonds falls apart. So 2020 was actually where 60/40 broke, but no one identified that because stocks are up and bonds are up, so everything feels good, it's fine. That's not the way it works. So 2022 was a reversal of that and now we're on more of a level footing. So I would argue that 60/40 is alive and well, and an appropriate way to look at markets that are balanced.

Once the Fed or other central banks get involved and distort markets, then you can start to ask about if that type of approach makes sense. But having said that, when you start to see behaviors that are a little more normal, where stocks start to suffer, but bonds make up the difference, I think that's what you'll start to see as we edge towards the potential for a recession in the coming months. And I struggle to put ... I'm not going to put a date on it, say it's going to happen in Q3 or Q4. The definition of a recession matters less than how severe will it be and how long will it last?

But right now we're not there yet. I do think we have very restrictive rate policy that will create the opportunity for a slowdown. How we navigate through the slowdown remains to be seen. But one thing I did want to highlight, and I'm going to share my screen here is there is a little bit of confusion I think around how the media or how folks interpret the future trajectory of interest rates.

This is a lot to digest in a short time, but basically the market right now, this is a projection of hikes and cuts over the coming few Fed meetings, and I think it's inappropriate to look at this and say, "Well the market is pricing in an ease by December of 2023, a full ease or pretty close to that." What this is actually telling us is it is a point measure of a distribution of outcomes.

So I could say one thing I do know is that this will not happen as it is shown. So we are not going to have a hike in July and then we're going to start easing in September and November and easing 25 basis points out into 2024. That is not going to happen. What I think will happen is the Fed will either pause or maybe hike one more time. I think they're going to pause, keep rates where they are. So forget about that first bump that you see, the first three bumps of the next Fed meetings, and then the Fed is not going to ease until they have to.

So all these eases that you see are not really eases with ... That ease in January of 2024 is not a 100% probability of 1.75 rate cuts. In my mind, the way I look at that is it's probably like a 20% chance of a 100 basis point rate cut. You have to think about things a little more probabilistically rather than absolute. Like the hikes that we've had have been in 50 and 75 basis point increments, which is actually slightly unusual, but we had to for inflation reasons. Cuts are almost never in 25 basis point increments. Maybe you had a few cuts in 2018, '19 that were 25 and then we cut to zero. I mean, usually is not something the Fed does a ton of fine-tuning around.

Frankly, I think the Fed's neutral in terms of rates probably 200 BPs lower than where we are now in terms of fed funds. I just don't see this kind of elegant 25 basis point cutting here and there to get us to our end goal. I feel like the Fed wants to pause here, wait until inflation is definitively defeated, hope that there isn't too much damage to the economy, and then start to ease.

So I think the steps will not be 25 BP increments, and I think we're going to see a Fed on hold for a while. And then as data comes in that looks like the economy's starting to slow, then the Fed will take action then. But we're entering a period that is incredibly data-dependent, more so than we've been really in years. Data didn't really matter in 2020 or 2021 when we were in the middle of QE, but it really matters now. And the fact that we're in a more balanced period where the Fed is rolling off some of the QE that they bought, we're not in a period of stimulus as we had been, a 60/40 approach to investing for a larger portfolio. We focus on the fixed income part obviously, but it makes sense for us to take duration, behave like a bond fund, and try to outperform and behave like bonds, because I think bonds are going to start behaving as they should, given that we have yields that are 3.5%, 4%, 4.5%, 5% or even higher.

You're getting paid to be in bonds in a way that you weren't paid in 2020 or 2021. So for my money and through all the slides that I've shown over the course of today, I think that being invested in fixed income makes sense. If there is a recession, you certainly want to be in fixed income to offset potential losses in other risk assets, equities potentially included. And within fixed income, having an allocation to things that do not have specific default risk makes a lot of sense. So owning more Treasuries than we generally have, owning more MBS than we generally have that are government guaranteed, makes a lot of sense.

Shawn Eubanks: Thank you, Eddy. That was a good closing remarks. Any other remarks from the team? Okay, well thank you everyone for participating today. We would love to have your feedback on the format and the content. Thank you for joining us.


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.

Daniel Oh

Vice President & Portfolio Manager

Daniel Oh

Vice President & Portfolio Manager

Prior to joining Osterweis Capital Management in 2018, Daniel Oh spent over eight years as a Director at Estabrook Capital Management in New York City and was the lead Portfolio Manager of the Estabrook Investment Grade Fixed Income Fund. Before that he was at Merrill Lynch & Co. as an Associate in Prime/Alt-A-Non-Agency Mortgage Trading. Prior to that, he held positions at Seneca Financial Group and Morgan Stanley.

Mr. Oh’s professional history includes experience in investment grade corporate credit, non-agency and whole loan mortgages, structured credit, and distressed investments.

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

Mr. Oh graduated from Columbia University (B.A. in Economics/Political Science) and from the Stephen M. Ross School of Business at the University of Michigan (M.B.A.).

John Sheehan

Vice President & Portfolio Manager

John Sheehan

Vice President & Portfolio Manager

Prior to joining Osterweis Capital Management in 2018, John Sheehan spent more than 20 years working at Citigroup, first as Managing Director responsible for Investment Grade Syndicate in New York City, where he advised issuers on accessing funding in the corporate bond market. Later at Citigroup, he was Managing Director in charge of West Coast Investment Grade Sales in San Francisco, where he covered several of the largest U.S. investment grade credit investors.

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

Mr. Sheehan graduated from Georgetown University (B.A. in Economics). Mr. Sheehan holds the CFA designation.

Invest With Us

Total Return Fund Quarter-End Performance (as of 9/30/23)

  1 MO QTD YTD 1 YR 3 YR 5 YR 7 YR 10 YR INCEP
OSTRX -2.39% -2.86% -0.52% 0.57% -2.27% 0.57% - - 1.37%
Bloomberg U.S. Aggregate Bond Index -2.54 -3.23 -1.21 0.64 -5.21 0.10 - - 0.35
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Gross expense ratio as of 3/31/23: 0.68%

30 Day SEC Yield as of 9/30/23: 3.77%

Performance data quoted represent past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the Fund may be higher or lower than the performance quoted. Performance data current to the most recent month end may be obtained by calling shareholder services toll free at (866) 236-0050.

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

Where applicable, charts illustrating the performance of a hypothetical $10,000 investment made at a Fund’s inception assume the reinvestment of dividends and capital gains, but do not reflect the effect of any applicable sales charge or redemption fees. Such charts do not imply any future performance.

The Bloomberg U.S. Aggregate Bond Index (Agg) is an unmanaged index that is widely regarded as the standard for measuring U.S. investment grade bond market performance. This index does not incur expenses and is not available for investment. The index includes reinvestment of dividends and/or interest income.

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

An investment cannot be made directly in an index.

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

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

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

As of 3/31/2023, Osterweis did not hold Charles Schwab, Silicon Valley Bank, Signature Bank, or Hertz in the Total Return strategy.

Opinions expressed are subject to change, are not intended to be a forecast of future events, a guarantee of future results, nor investment advice.

QE, or quantitative easing, is a monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.

Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.

The Underlying Inflation Gauge (UIG) captures sustained movements in inflation from information contained in a broad set of price, real activity, and financial data.

Investment grade bonds are those with high and medium credit quality as determined by ratings agencies.

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

A yield curve is a graph that plots bond yields vs. maturities, at a set point in time, assuming the bonds have equal credit quality. In the U.S., the yield curve generally refers to that of Treasuries.

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

Duration measures the sensitivity of a fixed income security’s price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.

A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages. Agency MBS securities are issued by quasi-government entities and carry an implied guarantee by the federal government.

Spread is the difference in yield between a risk-free asset such as a U.S. Treasury bond and another security with the same maturity but of lesser quality. Option-Adjusted Spread is a spread calculation for securities with embedded options and takes into account that expected cash flows will fluctuate as interest rates change.

A corporate bond is a debt security issued by a corporation and sold to investors. The backing for the bond is usually the payment ability of the company, which typically depends on money to be earned from future operations. In some cases, the company’s physical assets may be used as collateral for bonds.

Coupon is the interest rate paid by a bond. The coupon is typically paid semiannually.

The Troubled Asset Relief Program (TARP) was an initiative created and run by the U.S. Treasury to stabilize the country’s financial system, restore economic growth, and mitigate foreclosures in the wake of the 2008 financial crisis. TARP sought to achieve these targets by purchasing troubled companies’ assets and stock.

GFC refers to Global Financial Crisis.

Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g., depreciation) and interest expense to pretax income.

Carry refers to the cashflows received during the holding period of a fixed income security.

MBS = Mortgage Backed Securities/ CMOs = Collateralized Mortgage Obligations/ CMBS = Commercial Mortgage Backed Securities/ CRT = Credit Risk Transfer/ CLO = Collateralized Loan Obligation

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

Nothing contained on this communication constitutes tax, legal, or investment advice. Investors must consult their tax advisor or legal counsel for advice and information concerning their particular situation.

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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. [OSTE-20230601-0888]