April 9 Webinar Replay - Osterweis Strategic Income Fund Q1 Update

Mark Schug: Okay. Good morning everyone. My name is Mark Schug, and I am our Regional Investment Consultant here in the Northeast. I'm on our webinar today instead of our regular host, Shawn Eubanks, as we will begin rotating the moderator role amongst our growing Business Development team. I'll be moderating a panel discussion with Carl Kaufman, Craig Manchuck, Brad Kane, and John Sheehan. Carl, Craig, Brad, and John, it's great to be with you today.

Carl, ordinarily we start by asking you for your big picture thoughts on the economy, and we'll get to that in a minute. But first, I think we should start by talking about the reciprocal tariffs announced on April 2nd and the ensuing market selloff.

Carl Kaufman: Thank you, Mark, and thank you everyone for joining us today. There's a lot going on in the markets as no doubt you're aware. It is important to talk about the "Liberation Day," but it's tough to do it in isolation. It obviously relates to the larger economy, but I agree we'll get to that a little later.

More importantly, the reciprocal tariffs levied by Trump went further than anyone expected. There are a variety of estimates going into the event, but most people I think were expecting something in the neighborhood of 10% across the board. Turns out the average is much higher than that, and some countries were affected much more than expected with these across-the-board tariffs. It is a blunt tool that he is using where I think the appropriate tool is a scalpel.

In other words, I think we have crossed over into these tariffs being manageable to being harmful to American business and companies. That is the feeling. We'll have to see how soon and how much we get negotiations to walk these down. Clearly, increased costs from the Chinese portion of most companies' supply chain. If it turns out that these companies are now facing materially higher costs on a wider range of supplies, it will either or both hurt their bottom line or it will raise inflation.

On a semi-positive note, I mean, the U.S. dollar has been weak, which does help offset some of that pain. So stay tuned. We have heard a lot of movement, but not a lot of results yet in terms of countries negotiating away some of these tariffs.

Mark Schug: Yeah. So to that point, it has been a week now, which in some ways it was viewed as an opening negotiating position with our trading partners. What sort of deals have we seen that change the landscape, and how do you assess the permanence of the tariffs?

Carl Kaufman: Well, we haven't seen many concrete deals. We did see an offer from a couple of countries to lower their tariffs to zero, most notably Vietnam. So far no response meaningfully from our administration. So I think we're still in the very early phases here, and so we're basically looking at them right now. We have to assume the worst, which I think is what we've gotten, which is these tariffs will be semi-permanent but may not be at the levels originally announced. It's just too early to tell at this point, but I think the more harm he sees he's doing to, I shouldn't say he, the White House sees they are doing to American business and consumers, that may temper their resolve, but we'll have to wait and see.

Mark Schug: Okay. Well then let's come back to your big picture thoughts on the economy. Market sentiment has deteriorated significantly during the quarter, with all the major indices now either in correction or bear market mode. Things have gotten worse since even Liberation Day. The initial optimism surrounding the pro-business agenda seems to be gone, and investors now seem to be turning to fears of a recession. What's your view?

Carl Kaufman: Well, there are definitely legitimate reasons to worry. At the same time, not much has really happened yet because the tariff regime is so new, so we don't really know which companies will figure out effective workarounds and/or how much prices will really go up. We also don't know which companies will decide to invest in domestic manufacturing to avoid tariffs and how long it will take for that to stimulate economic growth.

There are some open questions that do leave a little room for optimism, but the selloff that has occurred in the first quarter and since April 2nd seems to have picked up steam. As we always say, markets dislike uncertainty, and as you can tell by my answers, there's still a lot of uncertainty out there. So it's pretty clear that that was the primary issue in the first quarter and has continued into the second quarter.

In fact, the U.S. Economic Policy Uncertainty Index ... Yes, there is such a thing, which was developed by some professors at Stanford and Northwestern, hit its highest level in 40 years. The shifting landscape has made it tough for businesses to establish long-term plans. We saw one earnings report this morning where the CEO said, "It's impossible for businesses to plan for capital expenditures," which of course makes it tough for investors to plan. So now we have at least a little more clarity on what we're dealing with, but unfortunately, we don't like what we see. As we know, time tends to heal, and I believe this is no different. A year, two, three years from now, we'll all still be here. We'll all still be living our lives, and we will have figured this out.

Mark Schug: Well said. Brad, let me follow up with you on the question about the economy. In your latest outlook, you mention that we're entering a period of "global economic realignment," which is a phrase used by Jim Bianco, one of our favorite market strategists. Can you explain what that means and why it matters?

Brad Kane: Yeah, sure. And welcome, Mark. It's nice to have you on it.

Mark Schug: Thank you.

Brad Kane: The concept of global realignment, it starts with the tariff discussion that we're having, but it's really bigger. I think in the short version, the Trump administration's trying to unwind globalism as much as possible. Think a rejiggering of the supply chain primarily to be U.S.-centric, and at the same time trying to do this we're also trying to achieve multiple other ambitious goals: deregulate the private sector, tighten immigration, turn trade deficits into surpluses, slash government spending, all at the same time. Each is designed to decrease our role in the world different ways, and generally reduce dependence on other nations, but there's unintended consequences, and some of them can be significant.

For example, the new tariff regime might increase inflation even as the economy is slowing down. We're not predicting stagflation, but that's always a risk out there. You are seeing more people talk about it, but the timing of the sequence, that's the most important thing, because if you're doing one step at a time, you may be able to adjust and make changes. If you're trying to do it all at the same time, you're going to have some problems. Since there is always a lag with inflation being the result, we may still be waiting to see what's going to happen.

As Carl mentioned, we heard one CEO today on an earnings call already talk about how hard it is to plan/look going forward. When they're pulling guidance for the year, they're also saying, "We're not sure." When that outlook is cloudy, it's hard for businesses that not just that one company, but anybody who supplies them, anybody who buys from them, very hard to really kind of make plans and figure out where we're going. So we're keeping a very close eye on this because it'll impact our investment decisions over the short- and medium-term.

Mark Schug: Yeah, okay. Yeah, it's a lot to untangle. John, can you talk about what the Fed might be thinking given these simultaneous risks of a slowdown and rising inflation?

John Sheehan: Sure, Mark. It's a great question. I think maybe take a step back, and if you look at the Fed dual mandate of stable prices and maximum employment, the last CPI report, we'll get the next one tomorrow actually, but the last CPI report had year-over-year CPI at 2.8%, so still above the Fed's 2% target. The last employment report, which we had on Friday, came in stronger than expected at 228,000 versus 140,000. So clearly no economic data right now would be pointing towards Fed cuts. Clearly, when you overlay concerns around tariffs, in the Fed's last statement they did express some acknowledgment around uncertainty and concern that import taxes would raise inflation, so it's certainly on their radar screen.

Then another function of the Fed is to ensure proper functioning of financial markets. They did take steps towards that at the last meeting where they reduced the roll-off of the Treasury portfolio from 25 billion to 5 billion a month. That was seen largely to help support the Treasury market during the debt ceiling negotiations.

But I think if you take a bigger picture, the S&P right now year-over-year is down only 2%. It's up, I believe 95% over the last five years. So certainly taking cooler heads, there's no real crisis in risk markets' bigger picture. So I think if you look, the Fed is going to continue to be very much in wait-and-see mode. The market is pricing in for rate cuts. So again, it feels like a situation where the market is ahead of the Fed, but unless we see a significant change to the employment dynamic, I think the Fed is going to continue to interpret the data and take a wait-and-see approach.

Mark Schug: All right, great. Thanks, John. Craig, can you talk a little bit about how all of this volatility has impacted the new issuance market?

Craig Manchuck: Yeah, that's an easy one, Mark. Thanks. It shut it down pretty much. Look, high yield originations have basically been shut since this has all started. We haven't really seen anything happen in the month of April. If there has been, it's been a bit under the radar.

First quarter, we had about $80 billion of issuance, which is roughly equal to what we saw in the first quarter last year. I think maybe we had about 86 billion in the first quarter, so maybe it's just down slightly, but not out of the norm. That was up pretty substantially from where we were in the fourth quarter, which was around 60 billion, and that's kind of a seasonally slower period.

But yeah, I would expect that we need some stability again here when markets need to find some footing before anybody comes back to try to issue. I would also think that as spreads widen out some, high yield issuers, if they don't have to come to market, they will wait.

The IG market has been somewhat open. There's been about $10 billion of deals that have come in IG land, and that made sense. When we had the big Treasury rally, we did see a spate of IG issuers hitting the market, but now that Treasuries have backed up again, they've kind of waited and they're sitting on the sidelines. So it's a day-to-day thing. I think the markets will be open, as I said, once we find some stability, but for now we're kind of on pause.

Mark Schug: Got it. Thanks. Brad, can you talk about how the portfolio is positioned, including any adjustments that we've made recently?

Brad Kane: Sure. Well, as we've been saying for a while, we've been leaning into the short end of the curve because it was the best option giving an uncertain outlook, and this was even before all the tariff talk and the actual Liberation Day.

In the last year, we've been taking advantage of the flatter yield curve, staying on the shorter side. There wasn't much incremental yield at the longer end. Still mostly the case, although the last few days, the last week, we're starting to see longer maturities get a little bit yieldier, and they're starting to get more interesting. So we're taking advantage of that and slowly nibbling on some longer-term bonds that we've been waiting for good yields on.

But overall, I think staying shorter helps insulate the portfolio from significant price swings. We've been increasing the investment grade portion of the portfolio, so that helps also boost the quality of the portfolio. That has really helped us plan for and wait for opportunities like we're starting to see now.

To date, I would say the high yield market's still the adult in the room. It has not reacted in the same way as the stock market has, and so we're not seeing the wholesale selloff that equities are seeing. But again, we'll stay on the shorter end and stay in our higher cash balances and wait for the right opportunities to strike.

Mark Schug: Okay. Seems eminently reasonable. Carl, any final thoughts before we open it up to Q&A?

Carl Kaufman: Sure. I mean, just the basics. I think it's essential to stay calm in these types of markets. I also think it's prudent to play defense and choose your spots. I think the market is, if it continues trading the way it has been so far in April, we are going to switch from preferring defense to preferring offense, which is what you're supposed to do. There's a saying on Wall Street that is, you've all heard it a million times, "Buy low, sell high," but I think when we get these market selloffs, people forget that and just want to get back to shore as fast as possible and go to cash.

It's very important to be patient, especially when uncertainty is high and the direction of the economy is unknown, you emphasize defense. But when bargains show up, you're supposed to take advantage of that. As we showed in last quarter's outlook, the year-end outlook, we showed this long-term performance chart comparing high yield to other asset classes, and because this correction is happening early this year, high yield, given its higher coupons, and then the market yields about 8-3/4 % right now, not all bonds, but as an average 8-3/4% right now, you have enough coupon and yield there to catch up over the course of the year.

That's the characteristic that we like in high yield is that it tends to trade down less than equities, but trades up more in up years, in bounce-back years. So it's a great asset class. We're going to continue to play that. We were complaining last quarter because the markets were so boring. We're not complaining anymore. I guess my advice is stay calm, be patient, look for opportunities and carry on. Time does heal all wounds, including this one.

Mark Schug: Okay. Wise words. Thank you. Before we open up for Q&A, here's the fund performance slide, and we will follow with some key portfolio statistics. Then we will begin the Q&A. If you do have a question, either ask it through the chat window or raise your hand, and you can ask the question over audio or by phone. We did have a question come in before the webinar, so I'll throw this out to the team here. It's about high yield ... So can you talk about how high yield bonds have performed this year and maybe provide a little color about the last week in particular?

Carl Kaufman: Sure, I can take that one. They started off the year with a bang. They were up 2 to 3%, and then since then they've given a little bit back. They're probably down 2 to 3% now on average. So we'll have to see how the year plays out.

But there has been a big swing to the negative side. I think most of the damage is in some of the riskier gamier names, some of the LBO names that we do not participate in. We've seen those really take a hit. We bought a new issue at the end of last quarter in a company that is a very good company. The stock actually traded up on most of the down days, and the bonds are still up a point. So I mean, as Craig likes to say it's a market of bonds, not a bond market, but-

Carl Kaufman: Craig, did you have something to add?

Craig Manchuck: Sure. Yeah, the only place there's a bond market is in the oil and gas area. We're seeing generally that whole sector trading off en masse, and that's just because they're following oil prices. I think we can reiterate again our position as to why we don't invest frequently in the oil and gas sector because they trade with the commodity, and we are not prognosticators or forecasters of what oil prices are going to do. So consequently, we've stayed away, and that's always served us well in times like this in the past, and I think it is again here today.

Mark Schug: We do have some questions rolling in here to the Q&A window, so I'll throw some out to you guys. First one right up your alley, have we become more selective in high yield, and how have we become more selective?

Carl Kaufman: Well, we've always been selective in high yield. As you know, we have many fewer companies than a fund our size normally would have. We probably have 135 portfolio companies in the fund, in the strategy. We are being very, very selective about what we want to buy. We're not taking flyers, we're not changing our deep research approach to high yield. So we're just continuing doing what we've always done, is find the quality companies that are mispriced and subject to either forced selling or ... We haven't seen that yet. We haven't seen big liquidations in high yield and selling in size. Who knows whether we will or not, but we'll have to wait and see. So we just continue doing what we're doing. Always been selective. Good question though.

Craig Manchuck: Yeah, one thing I would just add to that is we've positioned the portfolio, as we talked about, in a lot of shorter maturity, shorter duration bonds where we were clipping decent yields. They've really done their job for us in the last quarter. They provided us the ballast to outperform the broader high yield market on the downside. Now, some of the opportunities we're investigating are more offensive because now we're getting to levels that these yields are attractive to lock in over longer periods of time. So if we find something we like, we're okay going out and extending that duration a little bit provided we're getting paid for, and that's always been our mantra. We don't mind owning longer bonds when we feel we're getting paid appropriately for the risk. That's the credit risk and the interest rate risk. When we get paid 8.5, 9.5, 10%, we feel like we're well compensated generally for some of the risks that are out there. So that's where we're looking, but we're not necessarily jumping in with both feet quite yet.

Mark Schug: Good. Thanks. To the point about ballast, there was a question about the net cash position. Do you want to comment about where we're at roughly with cash right now?

Carl Kaufman: I think at quarter end we view cash as a number of different assets. One is Treasury Money Market funds, commercial paper, and then we've been, more lately the last six to 12 months, we've been focused on bonds that mature under one year. We've been getting much better yields there and much better companies. Total, I think at quarter end, those three total about 35%.

Mark Schug: Okay, great. Thanks. Then I do have a question here about tariffs. Do you expect tariffs to have a significant impact on the credit fundamentals of any current holdings? Are you concerned about potential for higher defaults among current holdings?

Carl Kaufman: I'll take the last part first. No, we're not concerned about any defaults in the portfolio. We pretty much have scrubbed it. We feel very comfortable with the names we have. We do tend not to focus on large multinational companies. Many companies that issue in the high yield market are domestic. We have lot of, we probably have an overweight in the service and financial area, which tend to be domestic and not subject to tariffs because they don't do anything overseas. We have a number of mortgage originators, for example, mortgage servicers. Those are immune to what's going on. Not immune, but they're immune to the tariff part of it. Clearly they will be affected by any economic impact. If the economy is weak, you tend to get some rising defaults. But we're confident in their ability to manage the credit part of that portfolio, but we're in pretty good shape there.

Mark Schug: Okay, thanks. Then another question that we've all talked about a lot lately. What do you make of the private markets or private credit reaction to all of this?

Carl Kaufman: We'll let Craig answer that.

Craig Manchuck: We haven't even begun to see the impact of these changes on private credit. Because of the more opaque nature of private credit, I think it will take longer for them to manifest themselves in the portfolio characteristics and statistics.

Typically, the private credit companies are weaker companies, not all, but some of them are weaker and more highly levered. That's why they go that route. So I would think you could see a potential uptick in restructuring or equitization of some of those names in the portfolio.

On the flip side, for them going forward, they're probably going to be able to extract more rate and more covenants from some of their borrowers or their future borrowers. So there's a bit of a double-edged sword. I don't expect private credit will collapse, but our comment for a long time has been that the incremental returns that you're going to be getting and seeing in private credit don't necessarily compensate you for the illiquidity and the additional credit risk by owning something that has so much more leverage on it.

Carl Kaufman: To add to that, we saw a couple of articles recently talking about the illiquidity premium that these private funds offer is starting to shrink, and as you have seen, these purveyors of private credit are now looking for your 401(k) money. I don't know whether they've run out of sophisticated money, but they want to make sure that you don't miss this ground floor opportunity, so be aware.

Mark Schug: Yeah. A somewhat related question, are we seeing a trend toward better covenants?

Carl Kaufman: Well, since there hasn't been much in the new issue market in the last couple of weeks, I'd say we haven't seen any change, but we started to see a little bit of that earlier this year with some of the more, what's the word I'm looking for? Gamey issuers. They did get sort of held up with some covenant change requests that they granted. So I'd say at the margin, yes, but not meaningfully.

Brad Kane: But I would add that that's the covenants of something we've always focused on. There's a lot of times when we really like a business, like a company, but they bring a deal and because of the market demand, they can get away with no covenants and we have to say, "Okay, we'll just watch from the sidelines," and we'll ... So I would say as I would echo what Carl and Craig said about covenants generally in the market, but for us it's always been a focus. So that's still something that we're always looking for, and we're always making sure we're protecting ourselves.

Craig Manchuck: I think it would take a much more protracted decline before we start to see covenants coming back in a meaningful way in the high yield universe. Part of the problem is the leverage loan world, and the leverage loan world is largely dominated by the CLO managers. They have essentially rolled over and they don't really require any covenants of anybody right now because they have a bucket that they need to fill up, and it's become a very competitive market for them. So if we don't see covenants kind of creeping back into leveraged loans, it's hard to expect them to come back in high yield bonds en masse. Situationally though, we'll push where we can and try to get what we can out of issuers when we see any sort of sign of weakness on their part.

Mark Schug: Well said. Okay, here's a question about Treasury liquidity. Liquidity is dried up to some extent in Treasuries. Can it get worse, and will the Fed come to the rescue if things get really bad?

Carl Kaufman: John, why don't you take that one?

John Sheehan: Sure. In the last day or two, we have seen signs of illiquidity appearing in the Treasury market, I'd say most notably in the swap market and then also if you look at the discounts at some of the ETFs relative to the cash bond prices. We referenced the Fed's move around slowing the roll-off. That was an effort to support the Treasury market. That is a crucial market for the functioning of the economy. I do think if we saw real signs of stress of liquidity in there, that the Fed would definitely support the market.

Mark Schug: Okay, great. Thank you.

Carl Kaufman: There was a question about high yield spreads.

Mark Schug: As when do we step in to buy?

Carl Kaufman: Yeah, high yield spreads did widen a bit. Part of that was because Treasuries rallied so hard. Now that Treasuries are pulling back, spreads are narrowing a little bit. As you know, we don't really look at spreads as the indicator to buy because we're not a hedge fund that is shorting Treasuries versus buying high yield or the opposite when spreads narrow or widen. We are looking for absolute yield.

So we look at a bond, in 2018 it might've yielded 5% but had a 400 basis point spread. That's a 5% yield back then. Today, a 400 basis point spread would get you to somewhere in the mid-eights, which is where the high yield market is. So we're looking at the absolute yield rather than the spread. Now if riskless yield goes up to a spot, say 5, 6%, it doesn't really matter. That's good enough to sort of buy some riskless paper, but that's on an absolute basis, not in a relative spread basis. Hope that answers the question.

Mark Schug: Yes, thank you. Let's see. A lot of chatter about the risk of foreign investors selling U.S. bonds in retaliation to tariffs, mainly China. How does this situation affect Treasury auctions going forward?

Carl Kaufman: Well, we'll see. There's a 10-year auction today, so we'll see how that's going on right now as a matter of fact. China's down to about 900 billion of Treasuries. They're down from 3 trillion a while back when things were a little less frosty. If they are in fact the ones selling their Treasury position out, it doesn't give them much leverage going forward. But the market is deep enough to absorb that I think. There might be some temporary dislocations here and there. John, do you have anything to add to that?

John Sheehan: Yeah, I would just add most foreign entities who buy Treasuries do it as a mechanism to help manage their own currency. They don't do it because they're our friends or because they like us. They do it because it helps their exports remain cheap. So I think there is concern that the trade war becomes a capital war. I think those fears are overblown and that people are going to continue to operate in their own best interest, and there's a lot of reasons why it makes sense for China to own Treasuries.

Mark Schug: A question about do we see a path forward for this tariff situation that will result in a net positive, or do you prefer the prior status quo?

Carl Kaufman: Yeah, they go away. Clearly, tariffs are bad for employers, so to the extent that they get reduced or go away, that's positive. I don't know at this point whether it's a case of "I'm in so deep, I'm just going to stick with it no matter what the outcome." But they're already starting to get some pushback in Congress. I think there are still some checks and balances that can happen to ameliorate the situation, but we'll see.

Mark Schug: Okay. There is a question about whether our mandate allows for high yield Munis. Do you want to just address that real quick?

Carl Kaufman: Well, Munis is not an area which we have deep expertise in, so probably we're going to stay away. There's enough opportunity in the markets we do have expertise in.

Mark Schug: Carl, anything else, or anybody else want to give us any closing thoughts before we wrap it up?

Carl Kaufman: Well, I think there was a question on probability of defaults as well. I mean, Goldman Sachs came out with a very precise 79% probability this morning. I think our numbers range from 78.5 to 79.5. Who knows? We probably will be in a technical recession after this quarter, after the revisions come out for the first quarter. We won't know that until closer to the end of the year, whether we were in it or not. I think we'll have to wait and see. There's definitely a probability of a recession, and as most of you saw came across the tape, that Donald Trump just raised the tariffs on China to 125%, but delayed them for 90 days.

Brad Kane: No, he delayed the 90 days for every other country.

Carl Kaufman: For all but China, yeah. So clearly we know who he's got in his sights. It is China, and that is our biggest trading partner so why not? I think that this will get resolved somehow, hopefully peacefully. They're in a world of hurt as well right now, so they don't have the capacity to eat those tariffs. But at the very minimum, I would expect a lot more devaluation of their currency.

Mark Schug: Okay. Well, I guess that wraps it up unless we have any other closing comments.

Carl Kaufman: Well, I would say keep your seatbelt on. It's going to be a wild ride as you can see by today's action. We're looking for opportunities to buy. Remember, buy low, sell high. That's the mantra, and we'll talk to you all in a quarter or sooner. Thank you, Mark.

Mark Schug: Thank you all very much.

Brad Kane: Thanks, Mark.