Published on June 16, 2021

If you were unable to join Eddy Vataru’s webinar on Assessing Inflation Risk in a Post-Pandemic Economy, you can watch a replay to hear why he feels the risk of sustained inflation is higher now than at any point in recent memory.

Transcript

Shawn Eubanks: Good afternoon everyone and thank you for joining us today for this very timely webinar on assessing inflation risk in a post pandemic environment. I'm Shawn Eubanks and I'm the Director of Business Development at Osterweis Capital Management. I'm very pleased today to introduce you to Eddy Vataru who's the lead portfolio manager of the Osterweis Total Return Fund. Eddy's been giving this presentation to advisor groups across the country and the presentation has been extremely well received. 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 CFA Designation.

Prior to joining Osterweis Capital in 2016, Mr. Vataru was in senior management positions at Incapture LLC and Citadel LLC. Before that, he spent 11 years at BlackRock, formerly Barclay's Global Investors, where his last position was Managing Director and Head of U.S. Rates and Mortgages. In this role, Eddy worked with the U.S. Treasury Department in implementing its Agency MBS Purchase Program, buying back mortgages for the U.S. government to help stabilize the market from 2008 to 2009. Over the course of his career as a fixed income investor, Eddy has developed expertise and experience in managing passive, active and hedge fund fixed income portfolios. With that, I'll turn it over to Eddy. Thank you, Eddy.

Eddy Vataru: Thanks Shawn and thanks everyone for joining. This is quite topical, obviously. As we follow markets right now, the buzzword is inflation. We're all thrilled about the reopening, and recovery, and expansion, but nothing comes without a price. The question I think that's on many investor's minds right now is the recent uptick in inflation -- is that something that is persistent or transitory? A lot of folks are chalking it up to transitory, but I want to spend some time and walk through a retrospective on what inflation is. How do we measure it? Well, how do we think about it? Then try to draw some conclusions about the episode we're going through now and in particular, drawing some links between this bout of quantitative easing that we've seen for the last year, compared to the prior one from 2009 to 2014 after the financial crisis that is known for not being an event that stoked inflation.

So there's a lot of naysayers out there, and folks have questioned whether this time is any different. I hope in the next hour or so I can share some anecdotes about what we're seeing and what we think about inflation. Hopefully, leave time for some Q&A.

So I think inflation is one of those topics that there's a lot of opinions and there isn't necessarily a gold standard or a right answer. I don't know that I meant that as a pun, but it is something I've joked as a campfire discussion. Probably for a campfire nobody wants to hang out at, but there's a lot of different philosophies about it and a lot of things that people like to think about or how we all individually view inflation. What I'm going to share with you is how the federal government views inflation with regards to data that's published and some potential limitations of that approach. So with no further ado, let me go ahead and share my screen and kick things off. Shawn, can you confirm that you see the screen up there right now?

Shawn Eubanks: I do. Thanks Eddy.

Eddy Vataru: Awesome. So let me give a little bit of a recap on where we've been over the last year in terms of interest rates and spreads in the investment grade market, and then dive right into inflation because I think going forward, the main driver of value and returns in our space is really going to come from this debate around inflation. So if you look over the last year, 10 year Treasury yields have done basically a 180. We had the big flight to quality due to the pandemic. We muddled along around 50 basis points, 60 basis points for most of the summer. Then coming into the fall and winter, we began a little bit of a sell off that accelerated in Q1 of this year, and propelled us back with 10 years back up into the 160-ish range. Right now we're around 155 or so.

So at the lower end of our local range, but still significantly higher than where we were a year ago. In terms of spreads, one thing that's been a hallmark of this QE episode, not too dissimilar from previous ones, is that the government purchases explicitly of mortgage backed securities and to some extent what they bought in corporates. But in general, the overall support for the markets that the Fed has provided, we've seen spreads tighten pretty dramatically. So this is a chart of mortgage spreads above Treasuries. As you can see, we've gone through pre pandemic levels basically last year. All we've done since is gradually tighten further and further. I believe that around the end of April and certainly around the end of May as well, we approach levels that we've really never seen in terms of tightness of margin spread.

So approaching 60 basis points above a five and 10 year interpolated Treasury spread. These are levels that I think we've only seen once before, and that was during the announcement of QE3, which is that open-ended QE that we had 10 years back. So really a pretty heady performance for mortgages. Similar story in corporates where again, we have the massive widening last year. We had what I would consider a two or three step return to normal that was helped by the Fed purchases of corporate bond ETFs and corporate bonds themselves. Then as the market looked forward to reopening trades and we have the first vaccines come through late last year, we've seen steady progress, tighter in corporate spreads.

Again, the index (Bloomberg Barclays U.S. Aggregate Bond Index (Agg)) is [MS1]now tighter than it was pre pandemic. So it really tells the story that the corporate bond market, as well as the mortgage market are both I would say quite healthy. I don't know if you could say too healthy. There's certainly spreads being this tight makes them both look relatively rich to longer-term averages, but it speaks to the effectiveness of the Fed mandate. In terms of stabilizing and helping the markets, it's perhaps a subject of another webinar or campfire discussion. Probably more interesting campfire discussion as to whether it's too much or whether they should keep doing it. Obviously there's the debate around the fiscal stimulus, whether that's needed or what that should look like going forward. All of those ideas I would argue, especially the fiscal stimulus, are the things we look at as potential contributors to inflation.

So that's a piece that is different in this particular episode of QE, compared to what we saw 10 years ago when the majority of the support that was provided by the federal government came in the form of monetary stimulus. That was through the quantitative easing programs themselves. So if you've seen any of my presentations in the past, I always like to flash the screen up there. It's what I call the bond matrix. It basically is a way to visualize the risks in the investment grade bond market. The thing that I want to draw your attention to here, normally when I talk about this and I talk about opportunities in investment grade, I key on these spread related exposures and talk about what makes Treasuries, mortgages and corporates, which comprise 90% plus of the index, different? How do we find value between these three asset classes?

And as you see, I just showed you a couple of charts where there's not a lot of volatility in spreads; spreads keep grinding tighter. The main issue or the main, I would say opportunity and risk in this particular market is understanding inflation, because inflation risk really permeates all parts of fixed income. I really feel that given the performance that you might've observed in the Agg, especially for indexed investors in the Agg, Q1 was pretty frustrating despite the fact that spreads did really well. So even though mortgages did well on a relative basis, even though corporates did well on a relative basis compared to Treasuries, they didn't do well enough to protect from outright losses that were realized purely because interest rates rose during that period. So if you have a 50, 80, 90 basis point rise in yields, a 20 basis point tightening in spreads is not enough to counterbalance that. It certainly mitigated some of the loss, but it didn't undo it completely.

So again, this is a good framework for understanding and looking at various forms of risk in the investment grade universe through time. The one that impacts us now the most is inflation. There are two other interest rate exposures here. One is reinvestment risk, which is just the nature of the bonds that you're buying, reinvesting coupon. Again, that's always a risk. That's not entirely relevant in today's discussion. In interest rate risk, and here I mean obviously changes in rates, but also I want to give a nod to Fed policy. The Fed has basically decided to anchor front-end rates at zero until inflation is persistently north of 2% for some period of time to make up for lost inflation; more on that in a minute. Also, to reach maximum employment. So pretty steep hurdle for the Fed to reach before they even think about raising rates. I think historically, the hurdle to raise rates has not been maximum employment and high inflation.

Both of those hurdles seem quite high, but also our telegraph to the market, to really tell the market we're going to go in overdrive, we're going to make this QE work, we might go too far, we're going to keep the pedal to the metal and here we are. So when I think about interest rates, yes, there's a risk in the longer ends of the curve. But in terms of two year, three-year bonds, we just had a three-year option today that came at 32 basis points and it came right up the market. So the market is really taken to this notion that the Fed is committed to anchoring short-term interest rates and trying to stoke inflation through this variety of monetary and fiscal stimulus. So this is realized and we have one metric that we can follow pretty easily in the Treasury market, which is the TIPS market.

So this is the Inflation Protected Treasury (TIPS) [MS2]market, which trades on a real yield basis. That real yield is added to CPI to give you your ultimate return. So basically, this is a way to place your bets on CPI for bond investors. One thing that's interesting is you'll notice that since the trough last year, we're a 10-year break even yield. So this is the market's assessment based on where 10 Year TIPS are trading, as to what the inflation rate implied by the price of that TIP actually is. So a year ago or 15 months ago, we saw levels that were as low as almost 50 basis points. So again, very, very anemic types of inflation projections. I would argue that was never the intended or the market expectation for inflation. It was really a function of all of the volatility in the market, and some of the dislocations that we saw in ETFs[MS3], and some of the very chunky flows and illiquidity that dominated markets back then really drove the severity of that decline.

But the reality is, is in forward expectations of inflation around 1% persistent for about a month or two. As QE took hold, and we got through the first wave of the virus, and things started to look a little bit better, and then we went through subsequent waves later, but you saw an upward trajectory to the market's expectation for inflation. Now there's a very important caveat here, which is the Fed is buying more TIPS than the Treasury is selling. So there is a distortive quality to the nature of this rally. It's not purely a market expectation that inflation is going higher. Certainly the market thinks that, but the magnitude of this increase does not necessarily coincide purely with the market expectation. There's a technical component that's purely related to the fact that the fFed has bought so many TIPS in the last year as a function of the QE program.

So we're sitting in this 230-ish range on 10s right now. We reached a peak that was above 250. TIPS have come under a little bit of pressure lately at around 237 right now, so actually weaker since month end when this was published. But the reality is, is these are still pretty lofty expectations for inflation. Is this the end of the story? By the way, by the end of the story, what this also implies is that because nominal Treasuries are around 155, this means that investors are willing to accept negative real yields by buying TIPS. Because the nominal is 155 and let's say the breakeven is 235, that means that the real yield that the TIP is paying is minus 80 basis points. So basically CPI minus 0.8%.

So as an investor, when you look at markets like this, it does become a little bit tricky to decide to bite the bullet if you think inflation is a concern. Just recognize that it is an investment that I would say looks less compelling from a fundamental standpoint than it might've looked at any time in this history for sure. But just understanding that negative real yields on one hand make the Fed tell the story about all the support they're giving, and they love these negative real yields that companies can borrow at, and individuals can borrow it for mortgages, but it's something that can't last forever. It certainly is, I would say a cause for concern, but something that I think is certainly a function of the outsized nature of the Fed purchases that we've seen so far.

Now I'm going to take a step back and give a retrospective on inflation. Again, I hope that doing this, it certainly helped me when I took a deep look at inflation and understood it a little bit better a couple of months ago, and putting this presentation together, and thinking about it and evolving it. But before I really did this, I think all of us have some notion of what inflation is. Whether we're looking at gas prices, or we go to the supermarket and say, "Wow. That orange juice or that milk is a dollar more than it might've been a year ago." You hear a lot of stories on the news about lumber prices being through the roof and other commodities -- Nevermind oil and gold.

There are other anecdotes too of shortages of semiconductors and whatnot, which I'll get to in a little bit here as we go. But starting back on square one, civilizations have grappled inflation since the beginning of time. The whole concept of inflation was born of the fact that civilizations evolved, urban centers were developed. We went from basically 100% hunter/gatherer, decentralized society to one that had some specialization. So if you look closely when you read about inflation, all the inflation metrics specifically identify this as urban inflation. They always say urban. Well, the reason is because the original concept of inflation was if I'm going to give up my hunter/gathering ways and do something specialized, I'm going to create some product. I still need to eat. I still need to live. I'm going to make some money.

I guess there was barter back then, but beyond that, as currencies evolved, I need to be able to exchange that currency for food. So I make my product, I want to be able to exchange that product for money. That money will then go and buy things I need to live, so inflation is considered an urban phenomenon. The earliest measures of inflation, specifically focused on food, which would be no surprise. We've had bouts of hyperinflation over the millennia. So as old as this concept is of urbanization and these economies, so is hyperinflation. They have various sources of how they began. There've been various efforts to contain them through time. Spoiler alert, none of them work because as we've seen, we've had bouts of price fixing. We've had, if you think about times when coins had precious metal, you dilute the coins, you re-denominate the coins.

I think China was one of the first to actually use paper money. So obviously very easy to print paper money and we've also seen various wage and price freezes. What happens when you see wage and price freezes is empty store shelves and black markets. So there can be official prices at which certain items are thought to transact, but we all know that the way those manifest, and we have more recent examples of that in Venezuela or Zimbabwe for example. Fortunately, not in the U.S., but these freezes don't really work and the market trades were a trade. So you'll have empty store shelves and black market's trading all of these items that otherwise would be beholden to these price freezes. But for one of these price freezes, you won't see stores get their shelf stock because the suppliers will know they can get more elsewhere.

We've had many examples in the 20th Century. Certainly after the World Wars we've had examples. In the U.S., the closest thing we had to hyperinflation ... I call it hyperinflation, but the reality is the real definition of hyperinflation is inflation north of 25%. We didn't quite get there in the '70s and '80s. I'd say we got within earshot of it, perhaps at the worst of it. But the reality is, is that was a period of double digit inflation. It started in '72 with price and wage freezes imposed under Nixon, in an effort to bolster the optics of inflation and economy that was robust and help his reelection chances. But then with a turn of bad luck, we had the oil embargo shortly on the follow. That created a significant amount of inflation. We dealt with that ultimately for years to follow.

The one thing that's interesting when I think about inflation is, why don't we consider the period of the late '90s inflationary? The dot com boost, that wasn't inflationary by pretty much any metric. Why wasn't the housing bubble from the 2000s considered inflationary? It's pretty massive price appreciation of homes, but it didn't really filter through in any of the metrics that we follow. So what really happened there and is that true? Is that correct? Probably a good source for another campfire discussion. I'd love to talk about these particular items, but the reality is inflation only measures what I consider things that hurt or things that feel bad. So the price of goods in stores, gas; these are the traditional things that we think about when we think about inflation. When the stock market's on the moon, or when home prices are up double digits year over year like they are right now, nobody looks at those as inflationary impulses.

Those are really just asset bubbles. For that reason, when the Fed looks at or when government statistics look at and calculate CPI, there is no basket for equity prices. There is no basket for home prices. As far as home prices go, the closest you get is owner's equivalent rent, which is basically the rental component or the consumption component if you will of the home equation. Because the idea is that assets themselves are not considered in this basket. Those assets are considered investments. So even though you live in your most valuable asset, in all likelihood the reality is that because they're considered assets, home prices And certainly equities ... We can go down the line if you want to talk about crypto or collectibles or whatnot. None of these are really considered inflationary, although as you probably know, a lot of these are very lofty valuations at this point.

So again, when we talk about inflation, the inflation that "feels good", stock market up, house price up. I guess up if you're looking to sell feels good, but if you're trying to buy, it doesn't. But that support that the market has for general wealth feels good. That's not considered in the basket. What is considered is the stuff that feels bad, the stuff that we consume week to week or month to month is what feels bad. That's what is counted in inflation. Now there's no one size fits all when it comes to inflation, because different wealth deciles are exposed to different consumption baskets. So if you think about individuals with lower wealth, or more of their consumption is focused on food, and sustenance, and probably gas, and being able to get from point A to point B; that basket or those baskets look different than higher wealth deciles where most of your consumption is in the form of durable goods.

So call it appliances, or cars, or other bigger ticket items that are certainly more expensive and more durable, those goods specifically have most of their cost come through in the form of wages. So for lower wealth deciles, typically most of the expense comes through in terms of commodity prices. Orange juice, milk, food like I said, basic goods; those tend to be realized through or you can observe them via commodity prices. For the high wealth deciles, you tend to see wages become a greater component of prices because wages are really the primary driver, ultimately of the more expensive goods that we buy. So we can look back at the last 20, 30, 40 years and say, well, with globalization and whatnot, that's actually ... Of course, certainly the more recent impulsive technology, there's been an incredible amount of deflationary pressure.

A lot of it is related certainly with regards to goods, to cheaper labor. But again, the issue now and some of the dislocation we've seen, and I'm going to walk through this a little bit in regards to wages, is a little bit more transitory and related to some pretty big swings in employment that we've seen because of the pandemic. So I'll talk about that in a bit, but it's important to understand that when we look at CPI, the CPI for me is different than the CPI for any other individual. It all depends on what our consumption basket is. I will say that there's a little bit of a bias that all of us tend to have with regards to the fact that we go and buy gas daily. Not daily. See, it feels like daily, but we go and buy gas weekly or so; for those of us that don't drive electric cars at least.

Certainly, food prices are something we realize fairly constantly. Some of the durables we don't realize because they tend to be more sporadic, even though they're larger, more sporadic purchases. Now one thing that's important to note when you think about commodity prices, is typically the shocks that you see in commodity prices tend to be related to acts of nature. So for example, if you have an oil price spike because of an outage in refining related to refinery outages, related to a hurricane let's say in the gulf or so, or similar for orange juice or whatnot, which can wipe out a crop. You tend to see acts of nature be the primary driver for shocks in commodity prices, certainly the soft commodities that I'm talking about here. That's why the Fed looks more closely at core measures of inflation, whether they use CPI, or the acronym they prefer they look at PCE, which I have on [MS4]this slide as well.

Very similar methodologies, slightly different outputs. PCE is systematically, a couple tenths lower than CPI. But the reality is, is the Fed doesn't want to create policy to counter acts of nature that it can't control. So if you think about it, let's pretend like we had a situation where you had an oil shock and oil prices went through the roof. You probably don't want to have a policy that suddenly tightens. Because that's inflationary, that suddenly tightens policy because there was a transient shock related to a natural disaster that created that outage. So again, the Fed doesn't want to basically react to prices, especially prices it can't control. Because if you think about it, those trends and supply shocks are usually situations where you want to be easier on policy, where you need to rebuild, or you need to provide support in some other way, not tighten the screws and try to get what you think might be an overheating economy. It's not the case.

It's really a transient inflationary shock. So a lot of the metrics that we talk about are really related to core measures, and that's why they're ex food and energy. Now as I mentioned, the fFed prefers PCE over CPI. I went through the exercise of looking at the differences between the two. It's a little bit of a mind numbing exercise. There's no particular benefit to understanding one versus the other, except for noticing that the Fed certainly has its eye on PCE. PCE tends to be a couple of tenths below CPI persistently. But again, if we're looking at tenths, we might lose the bigger picture. So just keep that in mind when you're assessing what the Fed's next move might be or what they're thinking. In terms of home prices, like I said, home prices are not included in the basket because homes are considered assets.

We can talk about that separately; I'd be very happy to talk about that item. I do think home price appreciation, and I've certainly seen this with the mortgage crisis from 12 years ago, it's not just the bubble. There is an inflationary component to it. The only part that we actually measure through our data, however, is wealth effects related to monetizing some of these home prices and potential changes in consumer behavior related to it. Similar to equities, when equities appreciate dramatically, the CPI only picks up a very small fraction of changes related to wealth effects from homes or from equities. Now one thing I will talk about a little bit is we can watch the news, and we can follow markets, and think about water consumer prices and where are they now? But the real question is, where are they going?

That's going to answer this question around transitory versus persistent inflation. That's what the Fed cares about. That's what they really are trying to wrap their arms around. I'm going to propose four different measures that I think are worth following with regards to more forward-looking estimates of consumer prices. None of these is perfect, but I think if you look at these and compliment the analysis you might do or just following what inflation is doing, I think it can paint a little bit of a more complete picture around the economy and where things are going. So the first one is producer prices[MS5]. So again, producer prices are inputs ultimately to the goods that we buy, to the extent that producers or that companies are able to pass along their increase in prices to consumers. Then you will see a rise in consumer prices from producer prices.

However, there are times where the consumer may not have strong bid for something and will not pay for something just because the price of it went higher. They might be price sensitive in that regard. In that case, that loss is borne by the company itself and would eat into its profit margins. Either way when you see a spike in producer prices, that impulse has to go somewhere. So it either counts against profit margins and companies that are impacted that can't pass along cost to consumers, or it's borne by consumers. It depends on the item, it depends on the situation, but it is something to follow. Again, this is one index. This is one number versus another number. These numbers individually don't tell a story on an industry basis, on an individual's situation.

It's a one number trying to catch all type of scenario. So you really need to read beyond what that one number is, but understand that when you do see changes in that headline number, it is the aggregate. So we do have producer prices year over year up over 6%. That's a pretty heady number, a pretty substantial number. CPI year over year is around 4%, so there's transmission of some of those producer prices through. The question is, where does the path of that going forward? Do producer prices stay elevated? Do consumers start to pay more? Do those converge? So that's something to keep in mind. I mentioned wages. Again, wages are important for two reasons. One is the contribution to inflation that they provide through increased cost of producing goods, as I mentioned earlier. So if durable goods become more expensive because wages are higher, that can be inflationary. More importantly, if wages are higher, that actually provides for a substantial amount of the consumer base more money to spend.

So if you're making more money, it stands to reason that you'd be in a better position to spend more money. So wages are inflationary really from two different angles. Both are important in this context. So there are two measures that I look at: unit labor cost and average hourly earnings. Again, we can go through some of the biases and measurement issues on these things, but the reality is I think if you take a panel of data and just track it, you can paint an overall picture from really consuming as much of this information as you can and understanding the limitations of individual data sets, but realizing that they contribute to the aggregate and understanding what that is. Durable goods I've already mentioned a couple of times. It's again, an important indicator in my mind. Finally, the Underlying Inflation Gauge. So this is the number that the Federal Reserve Bank of New York publishes.

I've written about this a couple of times, a couple of years ago. It's an interesting gauge. It's been through a couple revisions, at least in the last couple of years, but it seems to have found a little bit of a steady state. They had to update some of the data that I think had gone stale when they introduced the index about 10 or 12 years ago, but they started publishing this in 2017. After a bit of a hiatus, they're publishing it again. I actually think it's a very useful tool. The whole purpose of this tool or this measure is to gauge inflation expectations and predict inflation based on a variety of metrics. So there's a lot of financial market inputs, I guess including that the TIPS market breakeven's might be one of the inputs. But there's an entire panel of inputs that go into this gauge and have been shown to provide, I would say a better estimate of inflation over time than spot estimates of CPI, or PPI, or any of these individual indices that I mentioned.

I'll talk about UIG a little bit later, but it's definitely an interesting gauge to keep an eye on. I can tell you right now after visiting the low to mid ones a few months ago, the underlying inflation gauge is reporting around 2.7% inflation. So again, well north of the 2% target that we've talked about for a bit. So I'm going to take a sidestep here and say, "Okay, this is all great. I've defined all these inflationary metrics and whatnot." What happened 10 years ago when we printed a bunch of money and we didn't have inflation? So the traditional monetary theory, which I walked through a little bit on this slide, is basically that money supply times velocity of money, basically the amount of money you have times how much that is transacted through the economy equals GDP, which is basically the amount of goods you produce times the price of those goods.

That's the relationship I have in the middle of this slide. Now in 2009, '10, '11, '12 when we were doing the previous bouts of QE, the whole point of that or one of the major points of that was to increase the money supply. So the idea was print more money, and you heard this all the time 10 years ago, "The government's printing money, so there's going to be inflation." But there never was. You could certainly take a detour and say, "Well, was there a measurement problem around inflation? Or was there just really no inflation?" Let's just say there was no inflation. The reality is what happened is every dollar that was printed in excess of what we'd seen before, basically reduced the amount of increasing money supply was almost perfectly offset by the decrease in the velocity of money. So basically they were printing a bunch of money, it had bought all these financial assets and it just sat there and nothing happened. That was it.

So again, Traditional Monetary Theory, I don't want to say became out of favor, but it certainly opened a door for Modern Monetary Theory (MMT) to step in as a way of explaining what happened. I think right now we're actually entering a case study of MMT basically stoking inflation through all of the stimulus until we have full employment, and then using taxation as the primary means for putting the brakes on, which we're basically going to experience it seems in the months and years to come. So the question is, was tTraditional Monetary Theory wrong or do we need a new explanation for what happened? I think it's just very easy if you go back and think about where was the consumer in 2009. Where were we collectively in terms of our personal balance sheets? How was our real estate portfolio looking, et cetera? Just collectively in a nationwide aggregate basis.

The reality is in 2009 and '10, we were all licking our wounds. We had equity markets that the S&P was below 700 in 2009. Home prices because of the great debacle in housing, certainly regional disparities occurred there as well. But collectively on average, home prices were down pretty sharply over the subsequent period after 2007 and '08. So collectively again, personal balance sheets were decimated. Values of our homes are down. Stock market was down. We're really licking our wounds in 2009. Where are we today? Because we're using the same forms of stimulus, monetary policy, certainly all the QE that we've seen in terms of the injection of capital by the Fed. On top of that, we're seeing quite a bit more fiscal stimulus now, not only what we've already seen in terms of some of the stimulus payments. But on top of it, the promise of greater and bigger spends going forward, which taxes will fund some of it.

But there's trillions in stimulus coming down the pike it seems. That is, I would argue quite a bit different than what we saw in '09. But it's also quite a bit different because consumers in 2021 are in much better shape than they were in 2009. Again, the wealth component with homes and equities near all time highs, and double digit growth in homes like I said, and home prices, that's quite different than the '09 and '10 experience. We have rates anchored at zero encouraging investment, but also with what I would consider an artificially high hurdle to raise rates. If you remember back in '09, '10, '11, the question was: when would the stimulus stop? Then it didn't stop for a while. We had some false starts and we had some guesses that rates would rise sooner than they ultimately did.

Well now with that in our history, we have a market expectation that rates aren't going to rise for a long time, especially given the hurdle that has been communicated to raise rates. Which again, as I mentioned is full employment. This flexible average inflation targeting metric that basically requires inflation to be above 2% persistently for some period of time to, I think "make up for lost inflation." That frankly, when I look at the data, I don't really see what the loss inflation was, but that's a hurdle that we're looking at. Now we've had rapid expansion of money supply again, and I'll show you on the next page the amount of money supply expansion we've seen in this battle quantitative easing puts the prior one to shame.

It almost looks like it's an order of magnitude greater in terms of size, as you'll see shortly. Like I said, we have significant fiscal stimulus and evidence of bubbles across the board. So very different landscape for this kind of policy versus what we saw 10 to 12 years ago. Now here are the pictures of the Traditional Monetary Theory. I don't want to say I'm touting, but I certainly don't question. I respect it. I think it actually holds plenty of water in this case. If you look at money supply in the top left, these graphs go back to 2008. What we've seen in 2020 makes 2008 and '09 look like a rounding error. Certainly even with the QE that expanded into 2012, '13 and '14, when it ended, we certainly had some increase of money supply over that period.

But what we've seen just in the last year is pretty much equivalent to what we saw over that five or six year period put together. Now again, velocity is important. So money supply times velocity is where you get the total GDP, so we had a decline in velocity. We've had another decline in velocity here, but I would argue that as long as the stimulus goes, if velocity holds steady, that's going to increase GDP. The problem with velocity over the last 10 year period, was it steadily declined basically as money was printed; it wasn't really deployed efficiently. That's where you saw this offset between money supply and velocity. But I would argue that if velocity basically stays put at these somewhat deflated levels, you certainly could see an increase in GDP. The question is, how does that split out between output and prices?

So again, a different way of thinking about the same phenomenon where GDP equals the actual product times the price of that product. If GDP is rising by high single digits or low double digits after this obvious period that we just went through, where we had the big decline and then the big bounce back, if we continue on this sharp, upward trajectory where GDP expands much more rapidly than it did during the prior expansion, some of that is certainly going to be captured in output, but a lot of it is probably going to be captured in price. So we'll see how that plays out. Now as I mentioned, there are a couple of inflation metrics I look at. Here are a couple of examples as well of measures you can use to assess inflation.

It really is beyond the anecdotes that we've seen, there certainly seems to be a lot of inflationary pressure, at least in the short term. So the ISM manufacturing [MS6]reported business prices. One thing that's interesting, although less so for this index, is the surveys always seem to trail the actual readings, which is a little surprising. But I think it speaks to the fact that analysts and folks are looking at and assessing this recovery, and may be a little bit behind the curve in understanding the intensity of the recovery, or what the nature of it is certainly with regards to prices. Now I'm including this seeming counterpoint on the bottom about hourly earnings, which month over month actually fell by about 4%. When you look at that and think about why that is, it really was reflective of the inclusion of jobs that were lost a year ago.

So if you look at this chart, wages rose about 8% when a lot of the lower income jobs fell off, because a lot of those are related to hospitality and were forced out by the reopening or the closing at the time. So now that we're reopening, you have basically the mirror image of that. The thing I would say is this: is that if you take these together and just take the period without that huge spike, and then the huge spike lower, and just look at the period of those six, or eight, or 10 months during the pandemic, it certainly seemed like wages were persistently elevated in this 4% area. This is real hourly earnings, by the way. So inflation adjusted. If we persistently see wages hover around 4% on average and just say that the two spikes counteract each other, plus eight and minus four is around four, is there something more persistent with regards to wage inflation going forward?

Certainly I can point to a lot anecdotally for one. A lot of companies that have stepped up and announced higher minimum pay for employees, some pretty high profile companies as well, if that persists, that's certainly is going to put pressure. I guess what I would say is lift wages generally, lift this average. As I mentioned, wages are really in my mind, the area I want to focus on for understanding if inflation is going to be persistent. A lot of the price stuff, a lot of these transient supply shocks, whether it's semis or lumber or whatnot that are related to supply chain issues, those can come and go. The question is, is our wages going to be sticking? That's really an area I'm focused on. Finally, two more measures. As I mentioned, CPI is up 6.2% year over year.

We'll see if it persists. We're going to have more data on that really shortly, but again, pretty dramatic year over year comparison. It is easy to look year over year and say, "Well, all of this is base effects. After March, April, May of last year, we're recovering now." So you're recovering off a very low base, sure. That narrative works for March, April, May. It starts to work less for June, July, August and so on. So the argument about base effects, the transitory component of inflation being related to base effects starts to wear off probably in the next month or so. So again, keep an eye on this measure. Finally, I've included Michigan's Survey of Inflation Expectations for the next year[MS7].

I think the one thing that's interesting and not a very scientific survey and whatnot, but when the average participant in a survey suddenly tells you, "Yes, I am worried about inflation" and you see the last rating was 4.6%, dramatic spike above what we'd seen previously. When it starts to enter the collective psyche that inflation is a problem, there are some knockoff effects to how that impacts spending behaviors and how that impacts the economy as a whole. So again, I wouldn't call this the most scientifically important component of this question, but it is important to at least know, is inflation in people's minds? How is this going to impact behaviors going forward?

Finally, I have a chart on CPI. So I include this chart for one reason, a couple of reasons. One is to show you that no, I'm not calling for inflation to rise back to the peaks we saw in the early to mid '70s and again in the late '70s, early '80s. That's not what it would take to create a problem, or some uncertainty, or certainly some losses in investments in this day and age. Because interest rates are so much lower now that even a mild surprise to the upside can cause some pretty significant issues with assessing certainly on the fixed income side, values of investments on our side.

The other thing I wanted to include here is, as I mentioned, the Fed had discussed that part of this measure or part of the reason they're adopting this policy is they want to make up for lost inflation. So I look at this chart and you certainly have the down the downstream in 2009. That was, by the way, after a pretty significant spike above 5% in 2008. But again, I look at that period, there was an energy disruption in 2015 that caused some of the fall in energy prices there. But besides that, I look at inflation as being pretty close, sometimes above 2%. I look more closely at this overall chart and I found six different periods over the last 30 years where inflation was north of 3% for over a year at a time.

So I'm not really seeing this chart and feeling like we need to boost inflation because of what's happened over the last two, three, five, 10 years. I don't see that rationale, but it just makes me think that the Fed has imposed that rule to signal to markets that it's really, in some ways targeting for an overshoot, but not so much targeting for an overshoot. What I should say is they're going to keep rates lower than you think they would, for longer than you think they should, to try to create this, at least through the monetary channels they have on the fFed, something that looks like inflation. Well, here it is. But the question is, is this transitory or persistent? I think the punchline I would give in this section is there's an element of it that's certainly transitory. I don't argue that.

But I do think that again, going back to this slide, the state of the consumer, the state of the investor, the state of the economy more generally is significantly stronger now than it was in 2009. Yet, it's getting a whole lot more stimulus now than it got back in 2009 and the early part of the teens. So I do think that the old metrics of Traditional Monetary Theory hold. I do think there was a good explanation for why this didn't work in the prior QE; it's because we're licking our wounds. I do think that by injecting this hyper stimulus now, it could create a pretty dangerous potion for inflation for years to come. So I do have a little bit of a market outlook. Again, I won't spend too much time on this, but I will say that vaccine distribution's out in full force. In fact, they can't even find the arms to jab vaccine in anymore. That's the biggest problem, which that's I think a good problem to have. Although, it would be nice if we had more compliance with vaccine distribution.

The greatest risk has really transitioned from relative spreads and fixed income to absolute rate. I do think if we have significant inflation that looks more persistent than transitory, interest rates have to be higher. There's really no two ways about that. We might spend the next few months talking about how transitory everything is and denying that there is inflation. But if inflation continues to percolate in the way that I think that it will, to me that means that interest rates have to be higher. I do give a nod to folks that look at, as I mentioned, there are deflationary forces that generally have kept inflation low for the last two, three, four decades. I don't argue with those, but what I do believe is that we're going to have inflation now that's higher than what we've seen for most of that period. Given where interest rates are, which are basically near the lows of that period, the two cannot really co-exist. So I do think that inflation will force interest rates higher.

The only caveat, I have this on the bottom of this slide, it's an outside tail possibility. Is if the Fed were to lose control over rates, and again, we don't see that right now, but let's say they did. There are things in the toolbox they could do to actually reign in longer-term rates. So they could do something similar to operation twist, which is QE2 back 10, 11 years ago, which is basically stop buying shorter maturity Treasuries and use that money to buy longer maturity treasuries. I guess you could sell one to buy the other, which is what twisted. But the reality is you could tweak your purchase program so that you took more interest rate risk out of the bond market without spending more money basically. So that could be something that they do if they thought that longer interest rates were just getting uncomfortably high, and they thought inflation would be, I don't want to say more of a problem. But if the market felt that rates would edge higher, again, this may be throwing fuel on the fire by doing a policy of this sort.

I'm not speaking to if it's a good idea to do this, but what I am saying is that is one thing the Fed could do if inflation really were to take root, and if they were concerned about losing the market if you will, or the market's confidence in longer rates, is to do something of this sort, because remember, on the other side of the equation, we have the Treasury issuing bonds. Treasury issuance has really risen pretty dramatically over the last year or so. Forecasts are for Treasury issuance to remain elevated. So again, there's a push pull between the Fed and the Treasury on this, but it is something that I keep in the back of my mind that will prevent interest rates from ballooning dramatically. But again, we'll see how inflation readouts come through.

Now I'll conclude with a couple of slides here to take a step back and think about fixed income investing more generally, and really the conundrum that investors like me have when we're looking at yields in our markets, and thinking about what the relative risk is of investing in fixed income. I realize when I present this slide, in some ways I'm cannibalizing my own product. But at the same time, being aware of this risk and then being able to hedge that risk is really the key. Being able to mitigate this risk is a key, so it's not entirely a negative tail on fixed income. But I will say this is not your father's aggregate index; the aggregate being the primary investment grade index.

This is a play on, you might remember a 1987 ad campaign by Oldsmobile about the Cutlass Supreme, telling you that it wasn't your father's Cutlass Supreme. They were right, because the 1987 Cutlass Supreme probably didn't measure up to anything that Oldsmobile made in the 1960s. I think the same analogy can be made here. If you look at the Aggregate Index 20 years ago or 30 years ago, you had an interest rate sensitivity measured by duration was about four or five. Meaning that if interest rates were to rise by 1% over that period, you would stand to lose four or 5% in terms of price. So this is a relatively stable number. Now duration has increased in recent years because companies have termed out, issued longer maturity bonds. Mortgage rates have fallen, so the mortgage component of this index is suddenly ...

Again, if you're invested now, you're buying assets that have a coupon of two or two and a half. Whereas 20 years ago, you were buying something at a coupon of seven. Or even 10 years ago, you were buying stuff at a coupon of four, four and a half. So together, those qualities have really made the interest rate sensitivity of the Aggregate Index significantly more risky. They have more interest rate sensitivity, so when interest rates fall, it feels good. We certainly saw that in 2019 and 2020, when interest rates fell, that benefited fixed income investors. Now Q1 of this year was a different story. Even though the magnitude of the selloff wasn't very severe, the returns in the Agg in Q1 were pretty sobering. The reason is that typically when you invest in fixed income, it's not really an investment in price changes. For the most part when you're buying fixed income, you're buying for dividend, you're buying for income.

What we saw 20 years ago if you look at this chart, is yields were six, seven, eight percent; even higher previously. But even in this century if you will, we still saw yields in the four or five percent range. Even after QE1, two and three, we were still north of 2% or 3%; two and a half percent for a decent chunk of that. Well, now we have the yield of the index below 2%, but we also have the amount of interest rate sensitivity the index at an all-time high north of six. So just to put this in terms of math that I think we can all relate to, let's go back to 2000. The yield of the Agg was let's say 7%. The interest rate sensitivity of the Agg, the duration was about five. So if interest rates were to rise 100 basis points back then, you lose five points or 5% on your investment, but you're earning 7% in terms of yield.

So you're going to earn back that 5% loss over the course of the year and post a full year return of about 2%. That's with interest rates rising 100 basis points in 2000. Now obviously that didn't happen, but I'm just highlighting the composition or the characteristic of the index. Let's just be polite and say it's 2%, even though it's slightly below that. Let's just be nice and say that the duration of the Agg is six, even though it's slightly higher than that. So if rates were to rise 100 basis points today, that means that the Agg would lose six points or 6% in price terms. If you're only earning a 2% yield, it's going to take you three years to earn back the six points that you lost in 100 basis point rise in interest rates.

So the math is very different. The risk /reward profile of owning, especially an indexed version of the Aggregate Index without being an active investor or participating in active strategy, it's pretty stunning. Comparing the risk/reward now versus even 10 years ago and certainly 20 or more years ago, something to keep in mind. That's why I said this is not your father's Aggregate Index, because the index just isn't quite as good as it used to be in terms of risk reward for investors at this point. Again, I'll conclude with this slide just to show you over time, there's certainly some value in rotating between sectors. That's a big part of what we do, but just looking at the return year to date on the bottom for mortgages, Treasuries, and corporate bonds, we're looking at a year to date return that really parallels what we saw during taper tantrum in 2013.

It's actually worse than that, even though we haven't even talked about a taper tantrum this year. That's what the market's worried about is a tantrum. Just the nature of the fact that you're not earning as much yield and there's more interest rate sensitivity in the market than there has been historically, is leading to these out-sized negative returns in the current regime compared to what you saw in 2013. Really, if you look back all the way to 2000, it's a bull market for bonds since 2000. So rates have generally fallen over the period. But again, I want to highlight this because there is rationale for what we do, which is rotating between sectors through time, but understanding that you need to hedge out the interest rate risk in an environment where inflation could be coming to the fore and you're not really being compensated for that in yield. It's something that we actively do. So I realized that I've taken really the full hour here. So I'm going to stop there and open it up for questions if there are any.

Shawn Eubanks: Okay, Eddy. Thank you very much for that; a great discussion. We do have a couple of questions. If the Fed reverses itself and decides it wants to slow inflation, what actions do you think they would take? I'm not sure if you've covered this a little bit in your discussion of operation twist as a potential way that they would fight it. But would they be tapering QE, raising short-term rates or something else? How would that affect the markets, do you think?

Eddy Vataru: It's a great question. The most obvious answer is yes, undoing QE or tapering QE. They've already started to do that because if you look at the corporate bonds that they bought over the last year or so, they've actually announced that they're going to start unwinding that piece. So again, the corporate bond piece, I think was more symbolic and helped the market. But in terms of actual money spent on corporate bonds, it was relatively small, as well as corporate bond ETFs that were part of that program. So they're going to start to unwind that already. So in some effect, that is kind of a taper. But again, it's small potatoes compared to the mortgage and Treasury book. The most obvious answer is reduce the purchases. The market doesn't feel like it would handle that particularly well, given where rates are and given the dovish messaging the Fed has come out with.

Raising rates. Again, given the barrier or the hurdle that the Fed has set for raising rates, they really painted themselves on a corner, I think. I know if I were on the Fed, I'd probably be the crazy guy in the room that nobody agrees with. Then five years later, I was the guy that was right. That was probably how I felt about 12 years ago with the housing debacle. But anyway, that was not something I really wanted to be very right about. It's just I'd seen enough loans with enough bad lending standards to get me there. But I would say this: I think that there's the potential for persistence in inflation. I think keeping the pedal to the metal with rates at zero, and continuing the purchases as they've done will exacerbate, or could contribute certainly to an increase in inflation that maybe they don't see coming. One thing that concerns me is when they asked Powell about the '70s and the '80s, and the potential for hyperinflation or high inflation, I wasn't very impressed by his answer.

I didn't think he really understood the drivers of inflation in the '70s. He just said, Well, we have tools and it's not going to happen again and we have the benefit of knowing what happened before. But he didn't actually tell you what happened before. So anyway, I think what I would say is the number one tool will be to stop throwing fuel on the fire and ultimately raise rates. But I think the hurdle to that, that the Fed has set is pretty high. So we might get taper later this year, sure. But you still have a very accommodative stance with rates at zero.

When if inflation is staring you in the face in the mid single digits, having a fed funds rate of zero doesn't make a lot of sense either. So it'll be interesting to see if they're forced to act. It's not something the market would take very well. The bond market wouldn't take it well. I think by association, the equity market wouldn't take it very well either. I don't want to create a ton of fear here, but what I do want to do is highlight that there are risks in the market right now that the Fed has dismissed, that I think are there. It will take time to see how these manifest in the coming months.

Shawn Eubanks: Thanks for that. I have a great question from Katie. It looks like there's some significant tightening of fiscal policy on the horizon via increased taxes. Do you think it's possible that if taxes do increase across the board, it may serve as a coolant for the economy and inflation, and thus allow the fFed to keep rates lower longer? In other words, could tax hikes serve the same purpose as a rate increase, just less explicitly?

Eddy Vataru: Absolutely. I made the case that, that's the ultimate MMT case study that we're about to experience. The size of the tax increase, and how and who it impacts, and how it's done certainly will impact this trajectory of inflation and rate. So it'll be interesting to see how it plays out. The first pass seemed, in my mind, the one that was announced by the White House a week or so ago seemed pretty punitive. I don't know that it will pass in that form, but I also don't have a crystal ball and I'm not plugged into DC, so I can't tell you what's ultimately going to be agreed upon. But I am closely following some of the infrastructure discussion and will be following the tax discussion because yes, increased taxes will certainly have an impact in terms of putting the brakes on some of this hyper investment and some of the behavior we've seen in markets.

Shawn Eubanks: Well, thank you for that Eddy, and thanks to everyone for joining us today.


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

Fund holdings and sector allocations are subject to change and should not be considered a recommendation to buy or sell any security.

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.

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.

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.

The Bloomberg Barclays U.S. Corporate Investment Grade Index consists of publicly issued, fixed rate, dollar-denominated and non-convertible U.S. corporate bonds that are SEC-registered, have at least one year to final maturity regardless of call features, have at least $250 million par amount outstanding, and are rated investment-grade by at least two of the following ratings agencies: Moody’s, S&P, Fitch.

The Bloomberg Barclays U.S. Treasuries Index consists of public obligations of the U.S. Treasury with a remaining maturity of one year or more.

The Bloomberg Barclays U.S. Mortgage Backed Securities Index consists of the mortgage-backed pass-through securities of Ginnie Mae, Fannie Mae, and Freddie Mac. It is formed by grouping the universe of over 600,000 individual fixed rate MBS pools into approximately 3,500 generic aggregates that are defined according to agency, program, issue year, and coupon and then applying maturity and liquidity criteria, resulting in about 600 generic aggregates in the index.

These indices do not incur expenses and are not available for investment. These indices reflect the reinvestment of dividends and/or interest. Historical fixed income index data is provided for informational purposes only, not as an indication of future Fund performance. Source: Bloomberg Barclays Indices. It is not possible to invest directly in an index.

Absolute return strategies are not intended to outperform stocks and bonds during strong market rallies and may underperform during strong positive market performance.

Federal Reserve United States Money Supply (M2) – The money supply measures the total amount of money in circulation in a country or group of countries in a monetary union.

The Bloomberg Barclays U.S. Treasuries Index consists of public obligations of the U.S. Treasury with a remaining maturity of one year or more.

US GDP Price Deflator – The GDP (gross domestic product) deflator (aka implicit price deflator) is calculated by taking nominal GDP divided by real GDP multiplied by 100.

Bloomberg Velocity of Money M2 Money Supply – The average number of times a unit of money (as measured, for instance, by a monetary aggregate) turns over during a specified period of time. The income velocity of circulation is typically calculated as the ratio of a monetary aggregate to nominal GDP.

US Real GDP – Gross domestic product (GDP) measures the final market value of all goods and services produced within a country. It is the most frequently used indicator of economic activity. The GDP by expenditure approach measures total final expenditures (at purchasers’ prices), including exports less imports. This concept is adjusted for inflation.

ISM Manufacturing Report on Business Prices Index NSAPMI Surveys track sentiment among purchasing managers at manufacturing, construction and/or services firms. An overall sentiment index is generally calculated from the results of queries on production, orders, inventories, employment, prices, etc.

US Real Average Hourly Earnings – Wages compiled by the Bureau of Labor Statistics’ Current Employment Statistics (CES) survey, adjusted for inflation.

US PPI Final Demand – Producer prices (output) are a measure of the change in the price of goods as they leave their place of production (i.e. prices received by domestic producers for their outputs either on the domestic or foreign market).

UMich Expected Change in Prices During the Next Year: Median – Consumer confidence tracks sentiment among households or consumers. The results are based on surveys conducted among a random sample of households.

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.

These indices do not incur expenses and are not available for investment. These indices reflect the reinvestment of dividends and/or interest. Historical fixed income index data is provided for informational purposes only, not as an indication of future Fund performance. Source: Bloomberg Barclays Indices.

The 10-year breakeven inflation rate represents a measure of expected inflation derived from 10-Year Treasury Constant Maturity Securities and 10-Year Treasury Inflation-Indexed Constant Maturity Securities. The latest value implies what market participants expect inflation to be in the next 10 years, on average.

Standard Deviation is a measure of dispersion that represents the degree to which an investment’s returns vary around a mean. The greater the Standard Deviation, the more volatile an investment’s returns were during the period measured. This statistic is calculated using the population standard deviation formula: Standard Deviation = Square root of [(Sum of squared deviations from mean)/(Number of returns in the period measured)] If the return periodicity is less than one year, the standard deviation is multiplied by the square root of the number of periods in one year in order to arrive at an annualized measure.

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

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.

Active, passive, levered and absolute return strategies can have various investment objectives. Levered strategies may use aggressive strategies such as leverage. Levered and absolute return strategies may have performance based fees as well as investment management fees. Active, levered and absolute return strategies tend to have higher fees than passive strategies. Investing in any of these strategies involve risk and are subject to potential loss of capital. The tax treatment of returns also differs given differential tax treatment of income versus capital gains.

GFC refers to Global Financial Crisis.

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period.

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

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

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Index performance is not illustrative of fund performance. Please call (866) 236-0050 for fund performance.

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.

The yield to worst (YTW) is the lowest potential yield that can be received on a bond, assuming there is no default.

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

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