Published on January 12, 2021

If you were unable to join our quarterly webinar, watch the the replay to hear updates on the Osterweis Strategic Income Fund.


Shawn Eubanks: Good morning, everyone. My name is Shawn Eubanks and I'm the Director of Business Development at Osterweis Capital Management. We'd like to welcome you to our fourth quarter update for the Osterweis Strategic Income Fund.

Let's get started. I'll be moderating a discussion with Carl Kaufman, Bradley Kane, and Craig Manchuck. After our discussion, we'll open up the line for your questions. My first question is for Carl. Carl, the Fed has done a great job supporting the markets through this pandemic, but are you concerned that it could be too much of a good thing? And do you think their purchasing program has caused markets to become untethered from the underlying economic fundamentals?

Carl Kaufman: Thank you, Shawn. That's a $64 trillion question we're asking now. We've always thought the Fed does too much and as a result, distorts market-based prices for financial assets. You can see that today when you look at Greece and Italy, 10-year bonds at mid-60 basis points and the U.S. at 117. Clearly, there's something wrong there. But I don't think it's too much of a good thing given that we've had an unprecedented pandemic and an immediate halt to economic activity around the world. So, this really needed unprecedented action, but there are consequences to that action that we have to be aware of.

Shawn Eubanks: Okay. Well, on a related point, in your latest quarterly outlook, you mentioned that the aggregate money supply increased by a staggering $14 trillion in 2020. What do you think of the implications, particularly with respect to inflation?

Carl Kaufman: Sure. The inflation match has been very tough to light. You can see what's happened in Japan over the last 25 years, or in Europe the last 10 years with monetary stimulus alone. However, there are other factors, which could light a match under inflationary forces namely, number one, there is the money supply, which is about as ample globally as we've ever seen. So that you can think of as the tinder. Two, we've had fiscal stimulus and pent-up demand. So far goods prices have been rising, services, not so much, especially those in the leisure area. But post-vaccine, we could see demand really pick up for those and we would expect airlines, hotels, et cetera to raise prices back to pre-pandemic levels.

Thirdly, we've had supply chain disruptions as a function of the pandemic, increasing both raw and intermediate input costs such as copper and lumber, and you're seeing increases in finished goods prices in a lot of things. So, those are the matches, so to speak. Countervailing forces are also present. We saw some of the best productivity growth we've seen since 2009 in the fourth quarter. We still have aging demographics across the developed economies, they tend to save more, spend less. And then we have math. Owner's equivalent rent is about 40% of CPI, and should act as a dampener as it has in the past, whether rents are rising or falling; they have been falling now, Bureau of Labor Statistics seems to always use that as a dampening agent for inflation.

Shawn Eubanks: Thanks, Carl.

Carl Kaufman: Sorry, I didn't have a more definite answer for you but those are the factors we are looking at.

Shawn Eubanks: Okay. Craig, can you give us your thoughts about the current valuations? We're hearing a lot of talk about the market being priced to perfection. What are you seeing and especially in Sub-Investment Grade?

Craig Manchuck: Good morning. Thanks Shawn. On a historical level, the market can be seen as being tight. Surely, on a spread basis in the ICE BofA index, it's around 380 on a spread basis but when you look at where Treasuries are, the component that relates to spread is still really large and relative to that return. As we also look at and compare it to the rest of the world and the opportunity set out there for fixed income investors, U.S. High Yield looks extremely attractive compared to the rest of the world. The only, really, market sector with higher yields or higher spreads available is in emerging market high yield, and that's just far too risky a place, we think, to venture into and there just so many different country considerations there.

So we feel like there is still ample opportunity available within the U.S. high yield market. And of course I'm voting spread levels within that, there are individual securities where we can find opportunities. So while overall levels may appear tight from an historical perspective, given that the economic backdrop looks like it's very constructive here coming into 2021, which usually portends solid returns for sub-investment grade securities, we think that the markets look relatively attractive and there is opportunity out there for us to continue to put money to work with good rates.

Shawn Eubanks: And turning to the fund specifically, where do you see opportunity in 2021? And are there particular sectors that are looking more attractive?

Craig Manchuck: There are several post-Covid areas here where they have rallied off their lows, but there's still meaningful upside left. If we look at areas like restaurants, restaurant equipment, theaters, retail, travel and leisure, commercial real estate, airlines, aircraft leasing, they've all been significantly impacted by Covid. And while there have been pockets of recovery, there are still companies in there that have yet to really be appreciated for what they've been doing to try to improve their balance sheet and get themselves through to the other side. So we have our eyes on all those sectors, and then we also are looking at other areas that show more meaningful growth. We're looking at sort of infrastructure opportunities, with the new administration coming in, we anticipate there'll be significant infrastructure spend going forward.

So there could be significant amounts of new capital that are deployed by the government and into the private sector in the infrastructure area and also electronic vehicles. Electric vehicles obviously on the forefront of everybody's mind, so the ancillary companies that provide parts and services into EV companies, and we're not going to make a direct investment in something like Tesla at this point, but a company like American Axle makes axles for gas-powered vehicles also has a unit system to go into electric vehicles. We think that that actually is a great growth path for them. Things like that we think will be attractive here going forward.

Shawn Eubanks: Interesting, thank you, Craig. Carl, now that we finally know which party will control the Senate for the next two years, what impact do you think a Biden administration will have on the economy and interest rates going forward?

Carl Kaufman: Good question. Well, as in the past, Washington doesn't really control the economy but is part of the feedback loop. I think the consensus thinking out there we'll likely get greater fiscal stimulus, but I think you can also expect the roll back on deregulation and corporate red tape that's been cut and abated the last four years, which will somewhat offset that. I'm not really looking to Washington to solve our problems or hurt us in any big way. Economic cycles have a way of marching to the beat of their own drummer and I think in this case it's going to be no different.

Shawn Eubanks: Great. I'd like to turn to Brad for a question that I think that's been on all of our minds. Brad, how do you think the vaccine rollout will affect the economy, particularly the hardest hit sectors like travel and leisure and brick-and-mortar retail.

Bradley Kane: Yeah, that's a great question, Shawn. Thanks. The big question that we have obviously is what's the speed of the rollout. If it goes quickly, you have one answer, if it takes a little longer, you have a second answer. I think what we've seen so far is that it's going to take a little longer into 2021 to really get the vaccine rolled out into enough people and get through enough of these Covid spikes to really begin to reopen a lot of the lockdown economy. There are some states obviously, where restrictions are a lot looser, where we are in the Bay Area in California, we see a lot tighter restrictions. And so it will be somewhat regional on how things are impacted but I think what you're seeing is, you're going to see the local react quicker than you are going to see more foreign travel or regional travel.

When you look at a local brick-and-mortar retail, I think that, for the ones that have been able to stay open, that's held up okay. And I think that as we get more vaccine, you'll see a lot of those stores that are struggling begin to have more customers and be able to operate a little bit better. So I think on the local side you'll see a brick-and-mortar reaction quickly. On the travel and leisure, I think it also will depend on where you are. If you're looking at things that are a little bit more close to home and local, like movie theaters, some local amusement parks, restaurants, bars, all of that leisure and spending will increase a lot quicker, I think, than the destination spending. So the travel to resorts and travel across and around the country and internationally will take longer.

But I think depending on how quickly you see the vaccine roll out here and abroad, it will impact it. I do think, again, people there's a lot of pent-up demand for travel. What we're hearing even from the cruise companies are people are already booking cruises into 2022 because there is just such a big demand of people wanting to get out. So I think as the vaccine really rolls out, you're going to see spikes in performance by some of these companies. But again, I think it's going to start local and then it'll broaden hopefully quickly.

Shawn Eubanks: Thanks, Brad. And Craig, can you talk a little bit about the supply and demand dynamics in the credit market? We know that global yields are quite low and maybe you can talk a little bit about how that may drive prices in 2021.

Craig Manchuck: Supply-demand dynamics are obviously very skewed and there is tremendous amount of demand for anything with yield and as I mentioned earlier, there's just so little yield globally that a lot of money has been coming into the high-yield market, but it's also been going into other ancillary and tertiary markets where they're looking for yield. Like the private credit market money is kind of starting to flow back into the loan market as well. So what will drive prices up in 2021? Well, the world is awash in capital, right? The Fed has pumped a lot of money as have the central banks around the world to support their local economies during this Covid time. The Fed has explicitly stated they will continue to support markets during and through the recovery. So they will not be raising rates for the next couple of years, that provides a very sound foundation and gives people a lot of comfort to put money to work, even at rates where many people feel are not at absolutely high levels.

I do think that there are the recovery names, post-Covid recovery names that are institutionally under-owned, both in equities and fixed income. And I think as we get further along in the vaccination cycle, you will start to see some of those names again begin to pick up some steam. Brad had mentioned cruise names, I think cruise, airlines, the aircraft leasing, movie theaters, restaurants, they're all operating at a significantly reduced capacity and I think we'll start to see people get a better handle on where those industries shake out in 2022 later on this year. And I think that's what people will focus on, start to look past the 2021 numbers again, and really out into 2022 as you start to get a finer pencil and the economy start to open back up. There'll be certain sectors that take longer to recover than others, and I think there are certain areas where there's still an awful lot of under-invested institutionally that money can come back to the market and drive prices higher.

Shawn Eubanks: Thank you, Craig. And I have one more question for Carl and then we'll start our Q&A. Carl, can you just talk a little bit about how you're currently positioning the portfolio?

Carl Kaufman: Sure. We've been trying to improve the quality of the portfolio for a while now. We're doing that while balancing the potential for absolute returns versus risk in the portfolio. We've also been shortening the duration of the portfolio as markets have been moving up and getting a little richer. We have about 25% of the portfolio in cash investment grade, floating rate, and bonds maturing under a year in redeemed bonds, et cetera. So we're in a very liquid position once again to take advantage of any pullbacks.

Shawn Eubanks: Great. Thank you, Carl. Okay. So we'll now we'll begin the Q&A and as noted on the slide, please ask a question through the Q&A chat window, or raise your hand to ask a question over your computer audio or by phone.

I have a question here asking if you're finding any interesting opportunities in real estate, I'm thinking probably commercial real estate or residential.

Carl Kaufman: We have not gone into commercial real estate yet, but we did buy one convertible in a company called Colliers, which services commercial real estate office properties mostly. They take care of all the security guards, they just outsource all the maintenance and management of that building and that convertible has done extremely well. We're looking at that sector.

Shawn Eubanks: Okay. It looks like we have a couple of questions that just came in. What types of yields would you need to say on say a 10-year U.S. Treasury to make it remotely interesting?

Carl Kaufman: You guys want to take a stab at that?

Craig Manchuck: Got to be closer to the 3%, I would think overall, otherwise it's a trade. As an investment, these levels are just kind of paltry.

Carl Kaufman: The latest ten-year auction today was at 1.16. So, that's not enough to make an investment in a 10-year.

Craig Manchuck: The 10-year's down six points, I think it's since July 1st of last year in the backup in rates, that's like 12 years' worth of income that was just given away over the last six months based on that current bond was at that time in July.

Shawn Eubanks: So I have two questions about cash in the portfolio. One is, how low has the cash gotten, I'm guessing in 2020, but then also a question about the cash percentage now in the portfolio compared to the average during last year. So, where are you now relative to the average and to the lowest point in 2020?

Carl Kaufman: Okay. I don't have an exact number for the average. So it's going to be a ballpark, the cash portion of the portfolio is 10% right now, but we look at cash, we have a slightly broader definition, which is cash and near-cash, things that can be easily turned into cash. That started the year, it started the pandemic at 35%, it got down to about 15% and, given the rapid pace of refinancings in our portfolio, that created more cash, so that got up to recently 25%. So that gives you a sort of a range of high to low to now. And I don't have a weighted average for that cash, I'm sorry.

Shawn Eubanks: Okay. Okay. It looks like we don't have any additional questions. Carl, do you have any final comments?

Carl Kaufman: Yes. I just want to point out that my comments on inflation, because that really is a very important topic, and the Fed is very focused on it. I just want to make sure you're clear on our stance. We see the possibility of a spike in inflation, but we do not know the magnitude, durability, or duration of that spike. And the Fed has said that they won't overreact, but as we all know, they have a long and proud tradition of letting inflation get away from them and then chasing it. And we don't know if that is going to be the case this time or whether they will stay disciplined. And we think this will likely be a temporal spike in inflation, but we just don't know how long that spike will last. So it could mean that interest rates do move up more and it will give us some opportunities to layer in some higher-yielding paper while that is happening. So it's an opportunity for us, not a fear. And with that, I thank everybody for calling in and talk to you in a quarter.

Shawn Eubanks: Thank you, Carl. Thank you, Craig. Thank you, Brad.

Carl Kaufman: Thank you, Shawn.

Bradley Kane: Anytime.

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

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

The Bank of America Merrill Lynch U.S. Cash Pay High Yield Index tracks the performance of U.S. dollar denominated below investment grade corporate debt, currently in a coupon paying period, that is publicly issued in the U.S. domestic market.

Fed is short for Federal Reserve.

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.

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

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.

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

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

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.

Performance data current to the most recent month end may be obtained by clicking here.

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

The Fund’s top 10 holdings, credit quality exposure, and sector allocation may be viewed by clicking here.

One cannot invest directly in an index.

Click here to read the prospectus.

The Osterweis Strategic Income Fund may invest 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. The Fund may invest in foreign and emerging market securities, which involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks may increase for emerging markets. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Small- and mid-capitalization companies tend to have limited liquidity and greater price volatility than large-capitalization companies. Higher turnover rates may result in increased transaction costs, which could impact performance. From time to time, the Fund may have concentrated positions in one or more sectors subjecting the Fund to sector emphasis risk. 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-20210112-0112]