Published on December 21, 2022

If you were unable to join the Total Return team for their recent webinar, you can watch a replay to hear why they think today’s inflationary headwinds should become tailwinds for fixed income investors, as yields are likely to remain elevated across the bond market.

Transcript

Shawn Eubanks: Good afternoon, everyone. Thanks for joining our webinar today titled, Taking the Long View: Why Inflation Today Could Boost Bonds Tomorrow. I'm Shawn Eubanks, and I lead the Business Development Team at Osterweis Capital Management. Now I'm pleased to introduce Eddy Vataru, Daniel Oh, and John Sheehan, the portfolio managers of the Osterweis Total Return Strategy. They have a great presentation set up for you today, and will explore inflation's impact on fixed income investing in both the current markets and into the future. Eddy, over to you.

Eddy Vataru: Thanks, Shawn, and thanks, everyone, for joining. I'll just give a quick overview about 2022. Obviously I think a lot of us don't want to relive it, but it was a particularly bad year for investors across all asset classes. This was largely driven by the end of QE and part of the reopening, or the end of the emergency measures that the FOMC took, which impacted bonds, which carried through really across the board. Now, it's interesting when you look at 2022, it actually in my memory is the worst performance for fixed income since inception of the Aggregate Index in the mid '70s. So it's really been difficult.

I think one of the things why it's kind of fed through to other asset classes and kind of defied your traditional 60/40-type return profile is that, in my mind at least, and this is probably the last comment I'll make about equities hopefully, for everyone's sake, is a lot of the valuations around some of these other asset classes and instruments, whether it's real estate or other things, really fed from discounting using extremely low interest rates. So when interest rates rose, this really impacted everything. So if we can go to the next slide.

Now, the culprit for this and why the Fed has had to act as it has in 2022 is because of rising inflation, and this is a chart in inflation going back to the '70s to give you some context for what this recent episode looked like compared to the horrible inflation episodes that we saw in the late '70s and early '80s. Now, one thing that was interesting that I read in the last month or so was a study that actually tried to compare this episode to the kind of double hump that you see 30, 40 years ago. And actually, if you compare apples to apples rather than apples to oranges, it's actually much closer than it looks.

One of the issues is that there's a change in the methodology by which inflation was calculated. So the over 14% peak that you see in the early '80s, if you use the current methodology for how inflation is calculated, specifically as it pertains to total home ownership cost, right now we use owner's equivalent rent as a component, but back then it was total home ownership costs, that number actually drops to around 11%, down from 14. So comparing 11 to this recent episode, north of nine, and you really start to get the feeling that as bad as this episode felt, even though the data didn't seem like it was as bad as what things might have felt like 40 years ago, it actually was in many ways. Next slide.

Now, why did inflation spike? If we were giving this presentation a year, year and a half ago, we would be having this discussion around whether or not we were dealing with persistent inflationary drivers or transitory factors related to supply chain disruptions. The answer is, it's both, but the persistent issues in my mind actually were an overhang or a residual effect of overly easy Fed policy during the pandemic. So when we look back on QE1, 2, and 3, one of the things that we didn't see from the chart before was a real spike in inflation. And this is something we've also talked about over the last couple of years, is why is this time different than that period? The answer is that you basically had QE4 dwarf QE1, 2, and 3 in size. Well, in aggregate, QE4 was somewhat larger than those three QEs put together.

It was implemented over a period of 18 to 24 months as opposed to QE1, 2, and 3, which took six years. And just think back to the state of the consumer and the investor in 2020, 2021, into this year, compared to 2009 when QE1 started, and it was a very, very different landscape. We had equities really in the cellar. In 2009, home prices were falling drastically, and you had really something of a collapse in the financial system in 2009. So it stands to reason that an injection of capital and to that kind of environment would really be more of a Band-Aid and allow folks to kind of find their footing and kind of stabilize really some pain in all of our personal balance sheets, if you will, compared to now, which is a response to a global economic shutdown that was relatively short-lived.

Certainly we had a hundred percent shutdown for a month or two and then things reopened somewhat in a haphazard form, but there was nothing structurally wrong with the economy going into the pandemic, and the pandemic wasn't a permanent event that would've flipped us for years and years to come. Certainly there's some leftover, it's not to say the pandemic is gone, but certainly the phase where there were no vaccines and there was no solution and we really were on lockdown, those days are over globally. There are pockets, and obviously it's not a hundred percent. But, QE4 being the size that it was against the backdrop that didn't really require that level of accommodation I think created, in my mind, a big portion of the inflationary bump that we had. We had rates kept at zero for really a long time - an inordinately long time.

If you remember back in 2020, the Fed kind of changed their hurdle for when they were going to increase rates, and their target was full employment, and they adopted this Flexible Average Inflation Targeting at Jackson Hole in 2020, which is to say that they wanted to make up for a period of lost inflation from the prior decade by stoking inflation above 2% so that the longer term mean was around 2%. Now, at the time I thought it was an absurd policy and I think even more so now given what's happened, but it's what we're dealing with and it certainly impacted markets pretty dramatically over the past year.

Now, part of the QE that we've had also featured a rapid expansion of the money supply. Again, it was even more rapid than what we saw in the prior bout of QE and we also had some fiscal stimulus that went along with it, well in excess of what we had during the prior QE period. So in aggregate, you started to see these speculative bubbles come to the fore, whether it was housing, which had double-digit price appreciation year over year, that was unsustainable. That was largely related to low mortgage payments because mortgage rates were at artificially low levels. And then of course crypto, collectibles, and you could argue equities doubling in a year and a half's time. All of these are reflective of speculative bubbles. So really it created an environment that was, in my mind, really created the environment that the bubble had to pop. And I think 2022 was a reflection of that. Now with this, let me turn it over to Daniel to just take this a little bit further.

Daniel Oh: Thanks, Eddy. As part of the Fed's dual mandate to achieve maximum employment and price stability, the main policy tool they used is a Fed funds target rate. And prior to the pandemic, the Fed was engaged in a tightening program and fed funds hit about two and a half percent, as you can see in this chart. This chart is the upper bound of the fed funds target range. As the economy was hit by the pandemic, the Fed started to cut in July 2019, ending up at 25 basis points, really zero to 25, which was the range in March of 2020. And that was maintained for two years until March of this year. During that period, inflation was dismissed as transitory and full employment seemed to be the primary objective, like Eddy talked about Earlier.

With a surge in inflation, the Fed embarked on the fastest hiking cycle since the 1980s, and the fed funds target range currently stands at four and a quarter to four and a half percent, which includes the 50-basis point hike from yesterday. As of this morning, the market is pricing in a terminal rate of 4.89% with cuts priced in mid-year of 2023. And on that note, we have a poll here. We wanted to see what everyone thought. What do you think will be the peak fed funds target rate during the cycle? And for this we're looking for the lower bound. It looks like 45% say 5%, and coming in next, 42% say above 5%, and after that, below 5% at 12%. So, consistent with a lot that we've been hearing out in the marketplace.

So what is the Fed really trying to do by raising the fed fund's target rate? This rate has two primary effects, which really could be thought as one because they're closely related. Through open market operations, the Fed manages the supply of money and then the fed funds target rate is also very closely tied to short-term lending rates. So with the rise of inflation, the Fed has increased the target rate, thus taking out liquidity from the system and increasing borrowing costs, resulting in less money chasing after assets in tightening financial conditions. With tighter conditions, economic growth slows and we can especially see that in interest-sensitive sectors such as housing and autos. And with the drastic move in mortgage and auto loan rates, we've seen substantial demand destruction. The Fed will continue on this cycle until inflation expectations have come down to reasonable levels by slowing down the economy, thus resulting in falling asset prices. We've seen this take place as Eddy mentioned earlier, in a broad range of asset prices falling including equities, housing, and crypto. Next slide, please.

As many of you know, investment grade fixed income has also been negatively impacted. The performance of the Bloomberg Aggregate Index this year has been the worst in recent memory. As of yesterday, the Index was down about 11%, 10.97% to be exact, year-to-date. But at its worst, the Index was down by 16.82% towards the end of October. Investors were hit as Treasury rates rose across the curve. The Fed was tightening to combat inflation, resulting in higher short-end rates, and investors were also hit on the long end as rates increased to compensate for higher inflation. On top of that, credit spreads widened as demand for risky assets waned, and there was no place to really hide. The usual relationship between Treasury yields and offsetting spreads was broken. And we've seen this previously in periods such as the taper tantrum, but this was much more prolonged and dramatic as the market was readjusting in a world without the zero interest rate policy and ultra-accommodative Fed. Next slide.

The underperformance of the Agg can best be seen through both the level and movement of the index yield. During the pandemic, yields on the Agg hit an all-time historic low on August 4th of 2020, we hit 1.02%, which is the low point of this chart. And as you can see, this marked the end of a multi-decade bull run in bonds. Last year we began to see yields rise and the yields rose from 1.12% to 1.79%, which was a large move on a percentage basis, but on an absolute basis it was minor compared to what happened this year. For this year, yields increased dramatically, hitting a high of 5.21% on October 20th. And remember, we started this year at 1.79%, so that's close to a 3x move. And as some asset managers pointed out, including us, fixed income investors, especially those closely following the index, were put in an extremely precarious position over the past few years, preceding the losses recently experienced. Next slide.

Part of the problem was, investment grade fixed income investors buying index-like products were being exposed to some of the most lopsided risk/return profiles ever seen, with investors being compensated with the lowest yields in history while at the same time being subject to the most interest rate exposure ever experienced. As you can see in this chart, interest rate exposure of the index measure by duration had been increasing. That's the blue line here. While the index yield was falling, the gray line, over multiple decades until the recent spike in rates, as can be seen on the right side of the chart.

Duration on the index got as high as 6.86 years at the beginning of the year, which was a historic high. And some reasons for the index duration increasing so much include corporations were terming out debt at historically low yields. Homeowners were refinancing mortgages at record low rates, thus increasing the analytical duration of mortgage-backed securities. And the U.S. government was issuing Treasury bonds at negative real yields where the nominal yields weren't large enough to compensate for inflation. As a result, bond investors were left with investment with very little yield to cushion against potentially large price movements stemming from the higher duration.

For many investors, including funds like us, a flexible mandate gave us the ability to drastically decrease exposure to an index with this type of risk/return profile. But given the higher rate levels now, the index is comparatively more balanced. The yield on the Agg as of last night was 4.34% and the duration was 6.30 years. Now I'd like to pass it on to John to talk in more detail about yields, spreads, and sector allocation opportunities.

John Sheehan: Thank you, Daniel. As Daniel mentioned, I am going to break down the different sectors within our index. The three main sectors that we have in our investment grade universe are U.S. Treasuries, mortgage-backed securities, and investment grade credit. So here we focus on the yield of the 10-year Treasury. The 10-year is typically the reference point for the investment grade market. A lot of reasons for that. One is that it most closely mirrors the behavior of mortgage rates. That's clearly one of the big levels within the consumer economy that we follow. And then also, it's a pivot point in the curve. Lots of times you'll see longer concerns about inflation impacting the long end of the curve, where in a quantitative tightening environment that we're on now, the front end of the curve will typically be most influenced by Fed activity.

So as you can see here on the graph, we've been in a pretty downward cycle from the financial crisis. A lot of that is a result of Fed activity. So 10-year yields peaked in June of '07, just at about five and a quarter, and we bottomed out in March at the depths of the Covid shutdown concerns at 50 basis points this year. The Fed activity, since then, taking fed funds from zero to 25 basis points to four and a quarter to 4.50 yesterday, we've seen a commensurate move in the 10-year yield. We peaked at about four and a quarter earlier this year, and we've since rallied back down to where we sit here today. Next slide, please.

This is looking at mortgage-backed securities and the spread. So we take the yield of a given mortgage-backed security and we compare it to a like maturity U.S. Treasury. The difference between those two yields is what we refer to as the spread. In this case, this is a spread versus a blend of five and 10-year Treasury yields. So in ordinary times, as both Daniel and Eddy mentioned, spreads represent the risk part of the fixed income market. So it's most akin to the equity that you would see in a 60/40 portfolio. So in typical times, spreads and rates move in opposite directions and produce a dampening effect, where when spreads go tighter, yields tend to go higher and vice versa. When yields go down, spreads tend to go wider. So it's an unusual year that we saw both spreads going wider and yields going higher.

Here we've got mortgage spreads that took us pretty much back to where we were in 2010 as the housing market was healing from the financial crisis. We did have a spike in March of 2020 as well as a result of Covid. But one of the main tools that the Fed has used in their quantitative tightening program has been mortgage-backed securities. So they've been the biggest buyer in the market of mortgage-backed securities, which brought spreads from that spike in March of 2020, down to where we were when it bottomed out in the end of 2021. And as the Fed has backed away and let their mortgage portfolio roll off, we saw a pretty significant widening out to close to 160 basis points similar to other fixed income products, we've seen a decent recovery here in the last couple weeks. Next slide, please.

So, a similar dynamic in corporate spreads. I'd say that corporate spreads have more dramatic moves than mortgages would. With a corporate, you have the concern of default. People are not worried about getting paid back in mortgage-backed securities. It's just a timing function of when you get paid back. Whereas in investment grade corporate, you do have the risk that the corporation is no longer viable when you get to your maturity date. It's pretty rare in the investment grade market, but there have been examples going back to the financial crisis, a big high profile name like Lehman Brothers. Those senior investors in Lehman Brothers paper ended up in default. We did see a similar spike in both the financial crisis and the Covid shutdown.

I think it's important to note that the average of this spread for this time period that we selected here is 153 basis points. We started at the end of last year with the Fed signaling to the market that there were going to be tightening. With the index at about 80 basis points, we widened out to about 165, so we eclipsed that longer term average and we now sit at about 130. So I think when we look forward to opportunities into next year, we're very much focused on the potential for a recession and how that's going to impact corporate balance sheets. So we're going to certainly touch on that further when we talk about sector allocation, but corporates are unique in that you have to worry about default risk. Next slide, please.

So this, we've taken the return of the Bloomberg Aggregate and broken it down into the returns of the three main sectors. I think a lot of people look at the investment grade market and think it is a monolithic entity where all bonds move in the same direction. And I think this is a hallmark of our fund, where we spend a lot of time thinking about the performance of the respective sectors. So if you can look in extreme times of the financial crisis, 2008 Treasuries returned almost 14%. This is because people were seeking out safety and wanted to be in investments that they had no concern about repayment. And at the same time, investment grade corporates returned -5%. So you can see the advantage of being overweight Treasuries in that environment and underweight corporates, which led to a differential and performance of those two sectors of almost 19%.

The next year, 2009, was almost the mirror image where the market got comfortable after the Fed activity that corporates were going to be fine and that corporates actually had sold off too much. So in 2009, corporates returned close to 19%. Treasuries, because people were selling risk-free assets to buy corporates and other riskier assets, had a negative 4% return. So a max differential there of 22%. This year, again, as we've suffered from the drain of liquidity from the Fed, we have all three sectors down. But even still, you can see a pretty significant differential - corporates again were the laggard, that is in part because corporate spreads widened as concerns around liquidity, but also the corporate sector has the longest duration of the three. So they also suffered from interest rates rising. But over the course of this last close to 20 years, the differential between sectors average is about five and a half percent. And we think that an actively managed flexible strategy that can move among these three sectors is a great opportunity to increase alpha and to get very strong risk adjusted returns. Next slide, please.

So this is probably our most favorite and most frequently used slide. This is a slide that Eddy put together when he first joined the industry, and this was a way of him visually laying out the different sectors. So again, Treasuries, agency mortgages and corporates, and then the risk factors that impact those sectors. So on the left side, you have the three risk factors that represent interest rate exposure, interest rates being the most, they impact all three sectors. Again, they impact corporates the most because of the lengthy duration of the corporate sector. They impact agencies the least. The agency sector does have less duration, but there's also a dampening effect in agencies where prepayments tend to slow down in rising interest rates and they tend to accelerate in falling interest rates. So that gives you a good opportunity to have a better profile in perspective of interest rate exposure.

Reinvestment risk, really for Treasuries and corporates, because these are bullet maturities, they tend to have less reinvestment risk where mortgages have the greatest reinvestment risk because you're return to principle at the time when interest rates are the lowest. So when you want to have your bond outstanding longer, your principle is repaid to you at par and vice versa. When you want to get your principle back, mortgages tend to extend as homeowners do not refi their mortgage. And then inflation impacts all sectors pretty much evenly. We've certainly seen that this year, and I think it will be a primary influence on the market next year and beyond.

The other risk factors on the right side of the page are all spread-related exposures. Again, call risk in mortgages is the primary. We also refer to it as prepayment risk. In corporates, your biggest risk is default. We've talked about that a bit, but the spread that you're paid for owning a corporate versus a U.S. Treasury is largely the probability of default from that given issuer. So the higher the quality of the issuer, the lower the risk of default, the lower the spread, and vice versa. And then lastly, in agency mortgage-backed securities, volatility is the measure of the probability of prepayment. So in times where volatility spikes, mortgages tend to get impacted the most. The way to think about a mortgage-backed security is you have an embedded short option position. So you sold the prepayment ability to the homeowner. So if you're short in option in a higher vol environment, those bonds tend to perform poorly. With that, I will now turn it back to Eddy, and you'll go into probably the topic we're all here for, is a little deeper dive into inflation.

Eddy Vataru: Thanks, John. Actually, if we could back it up two slides just for one quick second. I just think this is fascinating to look at the returns. So it's amazing to me that if you look over time, just look at the mortgage and Treasury returns. They're identical on average over this 20-year period. But I have to plug mortgages because that's kind of where I started and where I've spent most of my career and my focus has been in the mortgage side, is that the standard deviation of returns is a lot lower than in Treasury. So Treasuries tend to be that great knee-jerk kind of flight to quality asset that does best in years like 2008 for example. It's interesting that it didn't do the best this year because again, like John said, inflation is what drove valuations down across the board. It impacted everything. Nothing was unscathed.

But it's also interesting, if you look at this chart, maybe Treasuries might be due for a win here because they haven't been the best performer in any year since 2011. So maybe I'm getting a little ahead of myself. But having said that, it's just fascinating to me that when you look at Treasuries versus mortgages, similar credit quality mortgages with their more dynamic duration profiles actually smooth their returns out over time. They have less negative performance compared to Treasuries, which are a little more binary. They do great in rallies, they do less great in sell-offs. So anyway, I just thought when I saw 4.01 versus 4.01, I had to point that out. And it's no question corporates over time have done best, but you are taking more risk when you own corporates. So you're compensated for that risk over time with an allocation to corporates. So anyway, going back to my slide 15.

So the real question now is about inflation, that's been the primary driver of returns this year. The Fed's taken it upon itself to combat inflation. I did notice, I was peeking at the Q&A, is the Fed more concerned about inflation risk or recession risk? I would say right now they're a hundred percent concerned about inflation risk and they're not concerned about recession risk. I think that will change as the Fed feels more comfortable that it has won the war on inflation. They are not ready to do that yet and they're not even really close to doing that yet, but we'll see what 2023 brings.

Now, here's a chart I wanted to share. One is of the lines of the CPI, the kind of pewter line, and the blue line, the gray blue line is UIG. UIG stands for Underlying Inflation Gauge, it's a gauge we've talked about actually for the last several years. It's provided by the Federal Reserve Bank of New York, and it's intended to measure the persistent component of inflation. So remember earlier I said, is inflation persistent, is it transitory? The answer was, it was a little bit of both. And I think you see that here, it's a little bit of both. The headline CPI number ballooned up to 9%, but the persistent component of inflation peaked at around five. Now, five is significantly higher than the 2% target that the Fed had maintained for years and years and years. So of course we would expect CPI to fall. I think the challenge the Fed is going to have looking forward is, are they going to be able to get back to that 2% number?

Now, talking about UIG a little bit, it's interesting to see, and I bring this up for a very important reason, there's a lot of chop and a lot of noise in the CPI numbers. The markets are hyperreactive right now to every 10th of a point that you see CPI beat or miss as it pertains to the potential for the Fed to react to that. So we've seen a very sharp rally in Treasuries largely because inflation has started to fall. Now, it's true, inflation fall is going in the right direction, and UIG agrees with that. Inflation, per the persistent metric, peaked I believe in March of this year and has fallen since then. The reason I think UIG is a more compelling measure than CPI is because by virtue of measuring the component of inflation that is persistent, if you think intuitively about that, it should be less volatile, it should be less choppy. There should be more momentum in inertia in that number. And you really see this going back for 20 years.

One thing that's interesting when I look back at the housing bubble that was created, UIG actually peaked in 2004 and drifted slightly lower towards the end of that decade before the collapse in '08. Kind of interesting because it's a little bit different than what the housing market was doing. And ultimately, CPI's peak in 2008 did an abrupt reversal right after that. So it was interesting to see that really inflation had actually started to fall a little bit before then. But the more important thing now is, where do we stand now? Where are we going? And when the Fed talked about how inflation was below their 2% target and they wanted to make up for lost inflation in August of 2020, I just look at this chart, and I don't know if laugh is the right word because of the outcome that's been engineered by their policy, but I don't see the period of persistent sub-2% inflation that they're referring to.

I know they use PCE, PCE is three to four-tenths below CPI on average. But they also publish UIG, UIG was persistently at or above 2% in the years preceding 2020 when they made that call. So I'm a little bit cynical, I can't help that I'm a bond market investor. That's part of why I do this I guess. But the reality of the fact is that I believe part of why they targeted a north of 2% inflation rate was to basically run cover for QE and to extend the QE program, which had helped to support the markets earlier that year. The problem was, they ran way, way, way too far with it, and I think that's where we stand now and that's why we had the pain that we did in 2022 and part of what we're facing going into next year.

So it'll be interesting to see how it plays out, but I would definitely keep an eye on UIG. It is reported monthly the same day as CPI, except during Fed blackout periods. So CPI was reported yesterday, or in last couple days, sorry, two days ago. UIG will be reported when the Fed blackout period is over after the meeting they had yesterday. So that being said, when I see that turn in March and that number head lower, my question now is, okay, are we heading back to 2% or are we going to level off at something north of 2%? At which point, the Fed has a decision to make about how far to pursue their restrictive policies and what should be the notion of neutral for the Fed. Now, next slide.

Now, this is the dot plot actually that came out yesterday. So thankfully, we all have uniformity on where we were on yesterday's number. That's kind of nice. But it's interesting to see the divergence of opinions about terminal fed funds after this year. So again, there's a peak north of 5%, skewed slightly above 5% for most in 2023. The market's kind of discounting that. The market is, as Daniel said, I think it's pricing in 4.89. So the market doesn't think the Fed is actually going to go as high as they say they will. And then the eases start, probably some in 2023 and certainly going for... The market's actually pricing in 2023 eases. The Fed is actually looking more towards 2024 and 2025, and you see a pretty big divergence there in terms of their eases.

Now, what's interesting to me is, you look at the longer run, there's actually been a modest change. There's some uniformity around two and a half percent for a longer term target for fed funds. But I did notice a couple of dots above two and a half percent. I think the one that's a three and a quarter is new. That'd be interesting to see how the longer term numbers play out in terms of their expectations because, again, this is the challenge the Fed has, is what is their perception of neutral inflation and how restrictive will they get in this particular period of tightening and how long will they stay there?

I think it's the how long will they stay there that the market is really discounting what the Fed has been saying. So the Fed has basically said, "It's less about how quickly we hike rates now. It's how high do we ultimately go and how long do we stay at that level?" And the market is saying, the economy basically isn't resilient enough to stay at a lofty 5% or north level for all of 2023 in quite the same way that the Fed is targeting. So we are going to have a kind of tug of war between inflation and an economy that's trying to expand against a relatively restrictive monetary policy that's coming from the Fed.

Now, we do have our second poll here, if we could put that up. So how likely do you think a recession will be in the next 12 months? Highly likely over 75%, 50 to 75, 25 to 50, under 25, or no opinion? So again, Fed hiking rates being very restrictive on monetary policy, are they going to basically stoke a recession by really subduing investments and speculation? And the answer is, wow, must have a lot of bond investors in this audience because we're all pretty bearish I guess. Over 50% said likely, and the rest said some probability, hovering around 50% plus or minus 50%. No one said under 25%, which is interesting, and one was no opinion, which I respect.

But yeah, there is a consensus that the Fed is going to drive us to recession by being keenly focused on containing inflation. I actually don't think that they mind that there is that perception in the market either at this stage in time. That's part of the fight against inflation, is to kind of take the starch out of the speculative impulses that have really driven the market over the last two and a half years. So next slide.

So the road ahead, Fed tightening will stop, but yields will probably stay elevated with regards to Fed policy. Now we have seen a recovery in bonds over the last month and a half or two months, which I think some of which has been warranted, some of which is a little bit premature. And I'll get into some of the factors there. Inflation has cooled a little, but structural drivers will probably keep CPI above 2% for some time. When I see UIG get to 2%, then we can talk about CPI getting to 2%. But it just feels like there is still some pent-up drivers, whether it's owner's equivalent rent or some occasional supply chain disruptions that we're continuing to see, although that situation's improved quite a bit. CPI is still above target, and it's going to have a hard time getting back to 2% from here, but this will test the Fed's resolve.

Now, when the Fed stops raising rates, that's typically the green light to be invested in fixed income. And this is why I think the markets are getting a little bit ahead of itself because the market is projecting the Fed to slow down and stop and ultimately ease sooner than the Fed themselves have forecast what their rate is going to be. Basically, this idea, and we've seen this and lived this over the last 15, 20, 25 years with this Fed, that they have not demonstrated the type of resolve to be kind of hawkish, inflation-busting, or in any way to get in the way of risk-taking and have measures that are generally perceived as negative towards risk assets and markets. Whether you want to start with the Greenspan put in all these, that kind of notion, that's persisted, that's a difficult mindset to get over. The mindset being if the economy starts to crack, they're going to start easing because they always do and they're going to do it immediately and that's going to bail everything out.

When you're fighting inflation, that's a different battle than what we've had before. So I tend to take the Fed a little more at its word that it wants to combat inflation. So we don't have the double spike that we had in the late '70s and early '80s. They really have been uniformly hawkish in their testimony and comments over the last few months to really drive home the message that they're going to continue to be vigilant about inflation. And even to prove that point, yesterday's FOMC statement did not change a single word about inflation. It just changed 50 basis points of where the Fed is in terms of their target rate. And they changed two words I believe in their characterization of how the conflict in the Ukraine has contributed to inflation versus what they... I mean, literally, it was a nuanced change just to prove that they weren't cutting and pasting literally what they said six weeks ago.

So again, this to me tells me that the Fed is not stopping here. They might slow down, but even when they slow down, they're going to get to a point where they're going to keep rates at a fairly high level for quite some time and things would have to crack for them to ease. So what does that mean? That means that things that would crack that would make them ease are probably things that involve the economy starting to sputter, probably equities starting to sputter, risk generally sputtering, consumer demand falling, retail sales falling, which we've seen some evidence of. There are some cracks, but overall the economy's still keeping its course. But in that context, if you think about the menu of options and the menu of risks that John presented a couple slides ago, what is the thing that you actually want to own in the context of a slowing economy? Probably Treasuries. This is why I said maybe Treasuries are due.

Mortgages are fine. They don't have that same macro exposure to risk that corporates have. The probability of corporate defaults certainly rises when you have the prospect of a recession and a slowdown in the economy. So you probably want to steer somewhat clear of corporates unless valuations warrant being invested there. We typically have owned more mortgages as a substitution for Treasuries in a way that allows us to maintain the same credit quality and a better return per unit of risk when you invest in that asset class in mortgages as we demonstrated a few slides ago.

Next year might be different. I think Treasuries stand to do quite well in a potential slowdown/recession. Corporate spreads may widen, like I mentioned, current coupon mortgages, the stuff that's been originated over the last three to six to nine months at six, six and a half, 7%, that stuff's going to get refinanced at lower rates, and that's really not where you want to own mortgages. You might be fine owning some lower coupon MBS that was originated a couple years ago. But if that's your view, you might as well just own Treasuries and keep it really simple. So I think for the first time in quite some time, Treasuries will be where it's at over this period that we're about to enter.

And even though we've had a pretty rough year for bonds, the future does look promising. Again, we've had a little bit of a recovery already over the last few months or the last six weeks, I should say six to eight weeks. It can continue. But I will say, when I stare at the 10-year south of three and a half percent and the 30-year in the same context, I feel like they've gotten a little bit ahead of themselves. I think the market needs to recalibrate towards where the Fed actually is going to end, which I think is a little bit higher than the market's pricing in right now. And then when the Fed actually does stop hiking and stabilizes, that gives a better entry point for fixed income than say today. Obviously October would've been a great entry point also to be long fixed income and add a lot of duration. We certainly, on our part, added some, but I believe that there will be a better opportunity to be more aggressive in that regard in the months to come. Not so much now.

And again, the thing that's interesting why I like Treasuries in particular is, let's say the Fed does overshoot and they are so keen on fighting inflation that they do trigger a recession. Well, remember 2008, Treasuries are what you're going to want to own. So no reason to get cute about it. Just buying Treasuries, probably longer Treasuries, is really the best way to capture that potential outcome. So it's kind of a nice... Now that we're actually earning a yield in fixed income, as Daniel mentioned, I think the yield in the Agg is 4.34%, if memory serves correct, that is a return, that is fixed income. There is actually income, this is great. You can actually get some price return if we have the downside scenarios where the economy starts to sputter and bonds resume their traditional place in a 60/40 balanced portfolio. 60/40 balanced portfolios don't work as well when you have QE that pushes everything up and now everything down.

When the Fed steps off the gas and allows these two kind of fairly lowly correlated asset classes to kind of work together, equities on one hand and fixed income on the other, pain that equities might feel entering a recession is to the benefit of Treasuries that you might own in the 40% portfolio or model portfolio or bond portfolio on the other side. That relationship looks like it's going to start to work again. And it's nice when you have bonds that have value of their own now. They're worth owning.

Again, maybe I prefer 10 years at 3.75 or 4% and not 3.40. That's a nuance that I have to deal with day to day. But in terms of being invested in fixed income, fixed income as an asset class, now it's found its place again, now it has a place, now it has a yield, it has some value of its own that's not driven by QE shenanigans. And I think that's promising looking forward, for fixed income generally and for strategies like ours in particular, going forward where when you look at the menu of investment options, things start to look more interesting and there is some true fundamental value. So that concludes our prepared comments, and I'll turn it over for Q&A.

Shawn Eubanks: Thank you, Eddy, Daniel, and John. That was great. As a reminder, if you have questions, please add them into the Q&A. Eddy, let's start this off with our first question, which was sent in before the session. The yield curve has obviously been inverted for a few months now. Do you think that necessarily is an indicator of an upcoming recession?

Eddy Vataru: That's a great question because I think the old notion that when 2s, 10s is inverted, that predicts recession, whatever, 87% of the time. I'm just making up a number, but it's a high number, it has some value. I think it's important to think about it not so much in using that metric as a predict... It's not the metric that drives the recession, it's the factors that go into why are fed funds where they are, why are longer rates lower than where fed funds is. What is the landscape that's driving the realized data that goes into that observation? And yes, I do think this is one of those cases where you could have a recession, not because the yield curve's telling me that there's a recession. I think if 10-years were at 5%, I would have the same probability of recession that I would've had if 10-years were at 2%, that doesn't matter.

What matters is the fact that the Fed has adopted a restrictive policy that probably will get increasingly restrictive on purpose, by design to fight inflation. In doing that, they're probably, because there are some lags in how their policy impacts markets and investment and so on, there is a strong possibility that they overshoot, that they raise too high, especially if they're targeting 2%. If they're targeting three or 4% as neutral, they could slow down and not be so obsessed about it. But if you're targeting 2% inflation and you want to fight and get it to that level, you're going to be compelled to hike rates higher than I think most folks would be comfortable with you doing.

And I think that's why we see the massively inverted curve that we have, and it can invert further. Because why invest in short-term instruments that have the possibility of having higher and higher yields when you say, "Okay, we're going to have a recession, let's just kind of get through this one- or two-year rough patch and then I want to own the long end of the yield curve"? And I think that's part of what's happened, is that folks are looking past this kind of owning stuff in the front end of the curve and want to own the long end to get through this patch and then await the recession that's going to be caused. And then you have this massive inversion.

So I think what I would say is, one doesn't cause the other. The reflection of the yield curve is a symptom or a byproduct of the policies then and market levels that got you here. And yes, do I think this inverted curve will ultimately lead us into a recession? Yes, but not because the curve is inverted. The curve is inverted because the Fed is tightening policy to fight inflation. And by tightening that policy, that is what will cause the recession. So like I said, it's not so much at the 10-years at 3.50, it's the fact that the short end is climbing to 5% and probably will go above it that will do that.

Shawn Eubanks: Thank you. One other question: Do you think that the markets are currently in sync with Fed policy? Or are investors having a hard time figuring out the Powell Fed today?

Eddy Vataru: It's funny because you always have a knee-jerk reaction around Fed meetings. A lot of that reflects positioning, there's some noise, there's some head scratching going on. When you look at market reactions, you go, "Why did the market do that when the Fed said this?" I think when you look at the markets today, today's markets actually make a ton of sense to me. Because what the Fed has said is, they're committed to fighting inflation, period. They're going to continue to hike rates and keep them in restrictive level for some time. So equities feel like they got the message today, maybe not yesterday.

Fixed income is a little bit interesting because you saw an initial sell-off and then a rally and then today you've had a little bit more of a rally. But again, most of it is on the long end. So again, investors are avoiding the front end where the Fed is going to keep hiking and hiking and hiking, and trying to find the "safety" by being out the curve a little bit because you will have this idea of a recession and a slowdown, and you want to have more duration and you want to be invested out the curve. It does make sense.

So I think the markets today actually behaved rationally. We'll see how this continues into the yearend. I think what's going to be most interesting to follow are metrics for inflation, specifically not just the headline ones like CPI or the ones I follow like UIG, but wages. Wages hold a big key. Rents hold the key. Some of these sub-components of inflation are important. If the labor market remains tight and wages continue to accelerate at five, five and a half percent yearly increases, that is supportive of inflation well north of 2%. Pre-pandemic, wages rose about two to 3% per year. Now we're at five to five and a half. Now granted against CPI, it looks like negative real wages, so we're going to be in a recession. But again, until I actually see nominal wages come back to kind of their longer term averages, if there's a five, five and half percent embedded gain in wages going forward, that is supportive of inflation north of 2% persistently, and the Fed will need to rethink what its notion of neutral is.

This is why it's really key for the Fed to really stay restrictive for this period and just see what happens on that front. If the labor market remains tight, and again, there's a ton of factors. We've had a lot of folks leave the workforce. You've had a lot of other drivers for why wages have increased. But the tightness of the labor market's ultimately going to reflect how far the Fed goes and really how long the Fed stays where it is. So that's what I'll really be watching. I think any news that suggests that wages remain strong will be negative for bonds because, again, that's positive for TIPSs, I guess, for inflation protected bonds and really means that the Fed has to stay higher for longer. If wages start to crack, you have unemployment rates start to tick higher and claims start to tick higher, then your probability for recession starts to increase, but then the Fed will be seen as turning the corner and maybe can become a little more accommodative ultimately.

So to me, inflation metrics are going to be front and center, and all the data around jobs is going to drive what the Fed does from here, in my opinion. There are other areas like housing, which has weakened obviously. That will continue to weaken as long as mortgage rates are higher. That's okay because we had such massive price appreciation over the last two years, and as we saw from two decades ago, or a decade and a half ago, home prices going up in unsustainable fashions cannot happen forever. And I feel that the move we've had over the last two years is driven by mortgage rates being artificially low. So there is a natural correction. I don't think the Fed cares about that. They're not going to change course because of that. So it really comes down to getting the job market to basically not be as tight as it is and to see some decline potentially in nominal wage growth that, again, since the pandemic has really risen by about two to two and a half percent over its longer term averages.

Shawn Eubanks: And also a thought on high yield, is that something that people should be looking at in their portfolios today given the market environment? What would convince you that high yield would be a good entry point?

Eddy Vataru: I mean I did make the point that, I mean, high yield has actually done really well this year, relatively speaking, because its duration profile is a bit different than investment grade. It has more yield, has more cushion, and you haven't seen the defaults in issues in high yield. But that being said, the landscape, if the Fed is architecting a recession or at least elements of a recession to be able to fight inflation, that most directly impacts corporates. And high yield, in my mind, reflects the riskier quadrant of the corporate market. So it probably would be, for me, the least favored place to be.

In thinking and talking to Carl over the last few months as well, it probably would be one of his least favorite places to be. And I know it's something when he's looked at markets like '08, he's invested in Treasuries in the past as well in markets like that. I don't think we're going to have an '08 type repeat. I do think we're going to have a slowdown. So it's going to be a little more nuanced and I think Treasuries will be the best thing to own and corporates will probably be not the best thing to own. And high yield will probably be the worst of that group in my mind. They'll be the most vulnerable asset to a true slowdown where you may start to see an uptick in defaults or the credit worthiness of the underlying borrowers.

John Sheehan: Yeah, Eddy, I'll just add that, right now, I think the current yield of the high yield market is about 7% and the current dollar price in the high yield market is about 90. So for short maturity high yield bonds, you're going to earn that 7% in current carry, but you're going to get that pull to par of 10 points from 90 to par. So, a lot of high yield issuers as well as investment grade issuers pushed out their maturity upcoming to take advantage of lower rates. So there's much fewer maturities coming. Companies tend not to default without a pending maturity. So I think in the near term, as long as you're picking the right credits, short duration, high yield should do well because you have two ways of winning, both in the current yield and the pull to par. And when higher defaults start hitting, it's probably far enough out in the future that those shorter maturity bonds are going to have already matured.

Eddy Vataru: Yeah. And we know Carl tends to invest in the shorter side, so I'm sure he'll navigate that well. But I would say a typical kind of indexed high yield investment might struggle with some of the more termed-out exposures in that.

John Sheehan: Sure. The three handle nine-year bond that was printed, that's probably trading at 75 cents on the dollar. I think that's probably something you want to avoid.

Eddy Vataru: Yep.

Shawn Eubanks: And if the yield curve does normalize at some point, why would it make sense to own the longer end of the curve if the only way to achieve a rising curve is for the short end to drop or the long end to rise, I guess? So why extend in that environment?

Eddy Vataru: No, understood, it's a very good question. So really, and this is why I am not super eager to extend right now. It comes down to level. The reason you want to own long bonds instead of short bonds is, if the curve steepens but you rally, if it's a bull steepener, you want to get that return that comes from the duration that you own in the long bonds. So I'll give you an example. Let's say current one-year yields are 5% and 30-year yields are three and a half percent. But let's say the curve normalizes to the new notion of normal and say the front end goes to 1% and the long end goes to 3%. So let's just say one-year bonds go from 5% to 1%, down 400 basis points, and 30-year bonds go from three and a half percent to three. Your return on the one-year bond at 5% is basically... Well, actually I think I just constructed an example that is, they're equal. But you will get 5% yield from that asset.

Plus, you'll get about four points in price appreciation, and your bond matures in a year, and then you're staring at... Reinvesting becomes a big problem for owning shorter bonds in that environment. If you own a three and a half percent bond that rallies 50 basis points, the duration of a 30-year bond is about 20. So you're going to get 0.5 points, 0.5% times 20, about 10% return on your asset, and you still own something that yields 3%. So you don't have the reinvestment risk that comes with that. Now, I gave you a very dramatic steepening that is 350 basis points of steepening from the short end to the long end. A more normalized curve wouldn't steepen nearly that much. Let's say the front end rallies by 200 basis points, then your return on the front end does not match what you would earn on the long end.

It really comes down to whether or not the level is right on the curve. And then secondarily, the shape of the curve. When you buy short, because you're really attracted to that four and a half, 5% carrot that you see right now, you have to understand that in a year's time when that matures, what are your options for reinvesting? And you might be staring at a 10-year that's a two and a half percent or 2% or so on. If you're invested in the long end, and like I said, I agree three and a half percent's a little too low for my liking, but 3.75, 4% much more interesting. And you do get the potential for price appreciation into a Fed that will likely... Once you have conviction that the Fed's next move is to ease, once we know that they're done and they've peaked in terms of where they're setting their fed funds target rate, which we're not there yet, but once we have conviction that they're there, it makes sense to really place most of your cards, I believe, really in the longer end.

You get more benefit from a total return perspective, adding the duration to the portfolio. And historically, we've seen yields peak right when the Fed is done hiking. They're not done yet. So I think that the positive here is in the months to come. And I do think that a lot of what we've seen over the last few weeks has been front running that event because we've gotten through the worst of inflation. But there's still some questions to be answered and the Fed still has some work to do. I think the opportunity now is okay. I think it will get better, but it's certainly a lot better than it's been over the last two and a half to three years. There's no question.

So again, I'm giving you an answer as an active investor that finds some nuance in current levels and is trying to, I don't want to say thread a needle, but trying to identify value where we see the value. Three fifty on 10-years and 30-years could be better, could be worse. Owning the short end obviously has value, but it's only a good investment for a year. With our strategy, we've actually maintained a decent amount of investments in commercial paper to give us the flexibility that in a month's time or in two months' time, when those roll off or mature, maybe we want to buy something then rather than lock in for a year and then find that our opportunities in a year's time may have evaporated. I do think the opportunities will get better than they are today. I don't think they may get as good as they were six weeks ago. But I do think overall, being invested in fixed income, 2022 was a bad year for fixed income. The future looks a lot brighter with interest rates being significantly higher and actually earning an income wherever you are on the curve.

Shawn Eubanks: That's great. Thank you, Eddy, Daniel, John. That was our last question. Any final comments? I felt like you wrapped it up pretty nicely there, Eddy.

Eddy Vataru: Yeah, no, I look forward to next year. I think the real challenge is going to come down to, when do we declare victory on inflation? We've gotten through the worst of it. That is clear. I reiterate that UIG is a great indicator for removing the noise from CPI. Don't get too wrapped up in CPI being a 10th of a percent better than you thought it was going to be. This is going to be played out over many, many months. This isn't the end. You might have noise both ways. But UIG definitely tells us that inflation is falling. The next hurdle, or the next challenge for the Fed is, is it going to get to 2% or are they going to have to move the goalposts a little bit? That remains to be seen, but it certainly is a much better landscape and picture for the Fed's fighting against inflation than they had six months ago. That's for sure.

Shawn Eubanks: Thank you and thanks, everyone-

Eddy Vataru: And that's good for us.

Shawn Eubanks: Yeah.

Eddy Vataru: That's great for fixed income investors.

Shawn Eubanks: Thank you and thanks, everyone, for joining us today. If you do have any follow-up questions, feel free to email us at institutionalservices@osterweis.com. We look forward to staying in touch and being a resource. Thank you.


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.

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.

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

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.

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

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.

Alpha is a measure of the difference between the portfolio’s actual return versus its expected performance, given its level of risk as measured by Beta. It is a measure of the historical movement of a portfolio’s performance not explained by movements of the market. It is also referred to as a portfolio’s non-systematic return.

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.

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.

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.

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.

Par is the face value, or value at which a bond will be redeemed at maturity.

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

The Bloomberg U.S. Aggregate Bond Index is widely regarded as the standard for measuring U.S. investment grade bond market performance.

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.

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-20221215-0715]