October 10 Webinar Replay - Osterweis Strategic Income Fund Q3 Update

Sean Ryan: Good morning, everyone. My name is Sean Ryan, and I'm our Regional Investment Consultant responsible for covering the Midwest.

As a reminder, we've started rotating the moderator role among our Regional Investment Consultant team, and today I'll be moderating a panel discussion with Carl Kaufman, Brad Kane, Craig Manchuk, and John Sheehan, Carl, Brad, Craig, and John, it's great to be with you today.

Carl, I was hoping we could start with a quick recap of the third quarter, which was the second quarter in a row that markets have fared well. Why do you think investors have been so bullish lately, particularly given all the turmoil in Washington?

Carl Kaufman: Morning, Sean, and thank you, everybody. Nice to have you with us today. Markets did indeed do well again in the third quarter. As you can see from the slide we just put up, most major indicators improved during the period. Treasury yields fell, meaning that prices went up. The S&P 500 rose almost 500 points, which is an 8% increase. High yield and investment grade spreads tightened a bit, and volatility remained low. In other words, it was a strong quarter across the board.

So the obvious question is why did this happen? As we said during our call last quarter, we think the biggest reason is that economic fundamentals are still fairly healthy. In other words, investors have been focusing on economics and fundamentals rather than politics, and the backdrop is still reasonably healthy, despite the trade wars and other static coming from Washington.

But this quarter also, there was a second driver, which was the Fed cut combined with continued record money supply. So there's money supply, you can only buy so many goods, so the money seems to be finding its way into financial assets, and rate cuts are typically good for risk assets, and this quarter was no exception.

Sean Ryan: Thanks, Carl. Before we talk about the Fed, can you talk about some of the specific economic factors that are going well?

Carl Kaufman: Sure. Probably the most important thing last quarter was that corporate earnings mostly came in in or above expectations. This is the second quarter in a row we've had that meaningfully. Earnings matter as much for high yield bonds as they do for equities. So this was important.

Also, inflation seems to have leveled off in the high 2s or 3% depending on which measure you use. It's still higher than the Fed's 2% target. But importantly thus far, tariffs have not yet been as inflationary as expected, although there is a lag and we do have to work through the inventory that all these companies bought earlier in the year at pre-tariff prices.

Also, unemployment remains fairly low. It's in the low fours, despite a little softening in new job creation. So the combination of healthy labor market with manageable inflation led to strong consumer spending in the third quarter. Remember that the consumer is roughly 2/3 of the economy.

Sean Ryan: Thanks, Carl.

Craig, why do you think inflation has not been more of an issue, given that tariff levels are so high with so many of our biggest trading partners?

Craig Manchuk: Morning, Sean. Companies were extremely well-prepared, I think, for the onslaught of the tariff announcements. And as a result, I think a lot of them front-loaded inventory purchases. So we saw that happening very, very early, and there were blips in purchasing activity. And consequently, a lot of the goods and things that people have been buying in the last three and six months really were not impacted by tariffs yet. So as a result, we haven't seen that inflationary pressure filter through. We may see that later, and that's part of the thing that economists have been talking about. They've been suggesting that the ultimate inflationary impact of the tariffs is yet to be seen. So we'll keep an eye on that and see how it evolves as we go through in the next couple quarters.

Sean Ryan: Thanks, Craig. Can we talk about the Fed now? Why did they cut rates, and what do you think it means for the markets and the economy?

Craig Manchuk: Well, the Fed has a dual mandate, and that really has not been discussed too broadly for the last couple of years, because the focus for most of the time has been on quelling inflation. But the other mandate is maintaining a stable employment base.

And the recent softness in jobs numbers has started to create a little bit more attention, at least in the media, on that other part of the dual mandate. Neither one of them is supposed to be more important than the other. It just so happens that inflation was much more heavily covered by the media and was perceived to be a bigger problem early on.

So we just need to make sure that with the stable employment base... Excuse me, if the employment base doesn't remain stable and starts to weaken, I think the Fed is ultimately forced to actually cut to try to support that. But we need to make sure also that it doesn't create further inflationary pressures on the back end because we've seen some signs that financial conditions are actually easing, and that would suggest that we could see a hiccup again and a re-tick in inflationary pressures higher. So something that needs to be monitored pretty closely from here.

Sean Ryan: Thanks, Craig.

Brad, a quick follow-up question for you, can you talk about the slowdown in the labor market? Carl just mentioned that the economic fundamentals are healthy, but Craig just said that the Fed is making cuts because they're concerned about job creation. Those seem somewhat contradictory.

Bradley Kane: Yeah, it does seem that way. Well, the last Bureau of Labor Statistics report showed a gain of just 22,000 new jobs nationwide, mostly concentrated in health care and education, and that was much lower than expected, but we have to also balance that with job retention. And so far this year, layoffs have been relatively limited.

Of course, as you'll remember, DOGE eliminated some federal jobs earlier in the year. A bunch of those have been rehired by agencies. So we need to see if the current government shutdown adds significantly to this total, depends on how long it lasts, but it also seems that the private sector has been reluctant to lay people off. The economy is still doing okay, businesses are still doing okay. The pandemic reminded people that layoffs and turnover is extremely inefficient and costly. So we need to see what happens over the next couple of months.

And due to the administration's aggressive immigration policies, Federal Reserve Chairman Jerome Powell recently discussed in a speech that the economy may only need about 50,000 jobs a month to maintain its growth. So if the economy were creating more jobs than that and we didn't have the workers to fill them, that would be inflationary, all things that the Fed has to balance when thinking about where employment is and where labor's going. But so far, labor seems to be in a sort of state of limited equilibrium, and I think the concern, as Craig said, is that it softens from here. So we're going to have to wait and see. And as long as inflation stays under control, I think dropping rates to stimulate job growth might be a good idea. But again, time's going to tell.

Sean Ryan: And Brad, sticking with you, I wanted to ask one last question about the Fed. It appears that Trump has been trying to reshape the Fed's board with his own appointees so that he has more influence over their policies. How significant is this, and what do you think is going to happen?

Bradley Kane: Well, it's pretty significant. An independent Fed is important. Messing with that could really have some bad developments for the economy.

As Craig said, the Fed's got two mandates. They've got to deal with managing inflation and managing full employment, and they, as an independent Fed, don't have to worry about whether or not the decisions they make are popular or whether what the political ramifications are. All they have to focus on, are we meeting the mandates? Is that what we're doing?

If the Fed were politicized, they could potentially be coerced into lowering rates ahead of an election. It could be that they're lowering rates, especially with what President Trump wants. He thinks rates are too high, they could be lowering rates into an economy that doesn't need it, and therefore, it stimulates the economy, and with deficits, increases inflation all of a sudden. So there's a lot of things that can happen if they get political pressure on them.

And what we need to see is something that doesn't happen. So what happened in the '70s was exactly that, the Fed was pushed to lower rates, and in the '70s, and then Volcker had to hike them to 20%. The beauty of that is he didn't have to worry about whether he was popular or not. He did exactly what was needed for the economy, and yet, political pressure might've said to do otherwise. So we're carefully watching. So far so good. The Fed is maintaining independence. We think it's critical.

Sean Ryan: Thanks, Brad.

Switching over to you, John, I have a related question that is partially about the Fed but more about the Treasury market. If the Fed decides to embark on an aggressive easing campaign to stimulate the economy, how confident are you that longer rates will decline along with short rates?

John Sheehan: Thanks, Sean. Quick answer is not very. If you recall last time that the Fed cut, 10-year yields went up by 100 basis points. So it's important to remember that the Fed only controls very short rates, it's an overnight rate, and the market really determines longer rates, supply and demand mechanism. And really, the 10-year note in particular is an indication of the market's long-term inflation views.

We do have increasing U.S. budget deficits, which is going to increase the need for Treasury issuance. So back to that supply and demand dynamic, there's going to obviously be increased supply, and the question is going to be if there's going to be demand there to meet it.

We've seen bouts where the market has expressed concern over the amount of debt that's going to be issued into the marketplace. We had bouts in the past with bond vigilantes expressing concern and trying to impose discipline on the government's fiscal policies. But also, keep in mind we do have inflation just below 3% right now, the 10-year note is in low 4%, so you don't have a tremendous margin above inflation with where yields are right now. So it's important, again, to realize that where 10-year yields are right now are very much in line with historical levels. The period of incredibly low interest rates after the Covid experience was really an anomaly. So we feel that rates have just come back into more normalized range, and we think, looking forward, that we expect the 10-year yield to be range-bound in that 4 to 4.5% range.

Sean Ryan: Thanks, John. And keeping with the same theme, can you talk about what has been happening in the new issuance markets recently, and where are yields and spreads currently?

John Sheehan: Yeah, absolutely. So the new issue market has been robust, particularly this past quarter. We had about 400 billion of supply in the investment grade market, about 120 billion of supply in the high yield market. I think the leveraged loan market had record issuance as well.

The good news is that the demand has been strong as well. So as a result, spreads have been tightening. We are at historical tight spreads in the investment grade market, just a little bit above tights in the high yield market. With that 10-year note at 4%, that is good underpinning for yields. So on a historical basis, yields look a lot more attractive than spreads do.

Once again, we've talked in the past about the increase in quality of the high yield market. So right now about 55% of the high yield market is rated BB, which is the highest rating category for the high yield market. So it's important to keep in mind when we're talking about spreads that we're not necessarily comparing apples to apples because the index is much more high quality than it was, say, 10, 20 years ago. So that alone does warrant tighter spreads.

The good news is we've been able to find attractive opportunities within the high yield market. So we've been able to pick and choose and add some new positions to the portfolio at attractive levels.

Sean Ryan: Great. Thanks, John.

Craig, switching gears here to AI, obviously a topic none of us can avoid, including my 81-year-old mother who refers to AI is A1. It constantly cracks my sister and me up. But anyway, can you talk about AI's role in the fixed income markets? It has been a huge tailwind for equities, particularly the mega caps, but how does it fit into your market?

Craig Manchuk: Well, the large part of the universe is really outside of our investing cohort. Some of the mega caps are financing their deals in the investment grade market with a very low coupon, long maturity debt. So there is some of that that's out there, but it doesn't really fit us. It's not enough yield, and it's extremely interest rate sensitive.

And many of the other companies that are in the ecosystem are new, could be fast-growing but very, very speculative. So a lot of them are either pre-earnings or pre-revenues, excuse me, in the very early days of revenue generation. And that doesn't lend itself to a typical debt issuance. They are issuing convertible debt, and we do see some of these convertible issues, but when we look at them on the surface, the valuations are ridiculous, and that's even an understatement. And the pricing on these is just not that attractive to us. So for the most part, they are outside of our ecosystem.

Sean Ryan: Got it. Thanks, Craig.

Carl, can you provide some perspective on the market's current risk-on approach? Specifically, do you think investors might be getting too complacent?

Carl Kaufman: Well, it seems that certainly might be the case in parts of the equity market where fear of missing out seems to be the overriding emotion.

As we've discussed, despite the solid economic backdrop, there are risks that could complicate our picture here. Inflation could return. We don't really know whether the impact of tariffs has worked its way through the system yet. I would suspect it has not. Although what I see anecdotally is that it's starting to show up. Labor markets could continue to weaken a little bit at the edges. As Brad mentioned, Powell in his speech said that we only need 0 to 50,000 jobs a month, which is a lot lower than people's mindset, given the growth in population that we've had. So it may take some mental adjustment on the part of economists and investors to accept the lower jobs numbers and not fear that the labor market is falling apart.

And, more importantly, the AI bubble could burst. And there are a lot of companies whose stocks and some investment grade fixed income bonds remain very tight because of the speculation that's going on there. So that, combined with an extended government shutdown, could cause some disruption in the market.

But spreads continue to grind a little tighter, although they've loosened a little bit. Equity markets keep making new highs. I mean, we're in red today, but I don't know that that's sustainable. We'll have to wait and see.

The other sign in complacency may be setting in is the rapid growth in the private credit markets. We've talked about this at length in the past. We wrote a white paper talking about the bond markets used to be bifurcated in investment grade and high yield. Now they have four different distinct segments: investment grade, the highest grade; high yield below that; collateralized loans, which is a large part of the purview of private equity LBO deals; and then private credit, which seems to be attracting most of the highly leveraged smaller, lower quality issuers.

Cerulli Associates recently estimated that the private debt market will increase to $3 trillion in the next five or six years, as retail investors start participating in earnest. But as we have discussed previously and we've written about, it's very high-risk, and it is opaque, and I think people need to be careful there.

We saw a report by Fitch recently as quoted in The Journal that said they're currently estimating the default rate for private credit at 9.5%. That is a very high number that you usually only see in very deep recessions, and we're certainly not in a very deep recession. So what is going to happen in a very deep recession? So the enthusiasm about private credit, maybe because it's a shiny new toy, I don't know, but to us it's sort of a warning sign that the markets may be a little frothy.

Just looking at the economic fundamentals, it seems like the picture is a little more mixed than the market currently acknowledges, but generally hanging in there.

Sean Ryan: Thanks, Carl.

And that was a nice segue into my next question for Brad. Brad, can you talk about your portfolio positioning?

Bradley Kane: Sure. I mean, I might sound a little bit like a broken record, but we've made no major changes lately. In fact, what we said last quarter on this call, I think, still pretty much applies. Plenty of dry powder, the curve's still relatively flat, so we're getting paid in the shorter term securities to wait for better entry points into longer ones.

But in the meantime, as John said, we found some names opportunistically that we're investing in. We still think, given the rally, there are going to be some better entry points in the near to medium future, and so we're waiting for that. And I think just days like today where you start to see some red in the market gives you some opportunities that we're starting to see names start to move a little bit. Hopefully, that gives us some opportunities.

Sean Ryan: Thanks, Brad.

John, I have a follow-up about the current positioning. Can you zoom out a little and talk about your sector allocation, are there certain areas you like versus others you dislike?

John Sheehan: Sure. In general, we prefer to be invested in industries and sectors that are less commoditized and less sensitive to the macro economy. So as we well know, we've avoided energy companies for a while now, particularly businesses related to oil and gas production as they tend to be highly cyclical and correlated to the price of oil. So we prefer to invest in differentiated businesses that are integral to the economy.

One of our favorite sectors is food services, specifically food distributors. They deliver groceries to supermarkets, so they have reasonably predictable costs, fairly stable revenues, and their products are always in demand. We also like the airline industry, including both the lessors and the carriers. It takes a lot of time and energy and expertise to build an aircraft, and the companies in the supply chain are well-situated to continue expanding. However, we focus on users of those planes for which the demand is huge, either to lease or to fly.

Sean Ryan: Thanks, John.

One more question before we open it up to the audience, and I suspect it's one they would've asked anyway, but you briefly mentioned the government shutdown earlier, and I'm wondering if you have any additional thoughts on the topic. How do you see it impacting the economy and your market specifically?

Carl Kaufman: Well, at the moment, it's not a significant economic issue, but obviously, the longer it goes on, the bigger the impact will be. You can see what's happening at some airports, for example, people are working without pay right now, but that'll only last so long.

Also, it's putting a bit of a strain on the labor market, and that could reduce consumer spending. It's also worth noting that the central debate in Congress is about restoring health care subsidies for the Affordable Care Act. And if those are not restored, it will have a negative effect on GDP because consumers will have less discretionary income. So we're keeping an eye on things and hoping for the best.

Sean Ryan: Great. And that was my last question. Before we open it up to the audience, we're sharing the fund performance slide, and we'll follow it up with some key portfolio statistics.

And with that, we'll now begin the Q&A. As noted on the slide, please ask the question through the Q&A window or raise your hand to ask a question over computer audio or by phone. And our first question today is:

What is going on with Tricolor Auto and with First Brands? Is this impacting the high yield market? Is it presenting new risks or opportunities for the fund?

Carl Kaufman: Those were company-specific issues, but of course, whenever you have those, people tend to sell any company that's in that business first and ask questions later. So we have seen weakness in any of the finance companies, asset-backed up issuers, that kind of thing. With First Brands, it looks like that borders on fraud and company-specific. They were multiply hypothecating cars, multiple, multiple, so they had many, many loans on the same car that they were claiming, which wasn't true, of course. So that was company-specific.

And so what you're finding out is that a small number of people who funded their business had very large exposures. UBS is one, and a few others were in very deep. And Prime Brands represented, I was reading, 70% of one fund's exposure in that space. It's insane to have that type of lack of risk controls in those funds. So as those funds clearly will be liquidating, it's creating a little bit of pressure. But these things usually pass in time as companies that are in that group report good earnings.

A number of companies have already come out with statements that this is not what we do, here's what we did. One of companies in our portfolio executed a $400 million securitization last week or this week, actually. So those that do it the right way will continue to have good results, but short sellers haven't had much to do this year, so they pounce on things, and it's creating some opportunities, actually.

Craig Manchuk: The broader high yield market is down a little bit this week, not hugely, but it's the first time we've seen, really since April, any pause in the market going up. So I think part of the fact that Tricolor and First Brands have impacted more people and more broadly is making some of the risk managers out there think again about as we come into the end of the year, maybe we should be taking risk down a little bit. So the lower-rated parts of the market and some of the weaker issuers have been hit the hardest. And then specifically, as Carl alluded to, the finance companies, people are starting to ask questions about the ABS market and how that's going to be affected, but that is probably less of an issue.

And I think you'll also see more stories about supply chain finance and vendor finance. That's what happened with First Brands specifically, but other companies are doing it as well as a means of helping them, excuse me, financing their payables more easily or extending the payable cycle for themselves to help their cash flows. So if companies are very reliant on that, then it's potentially a sign that the cash flows of their business aren't going to be that good. So it's something worth watching.

Sean Ryan: Thanks, Craig.

This next one's kind of a two-parter: What's the team's views on the dollar, and what is gold telling us, in your view? Also, if the Fed cuts, would that make gold possibly race even higher?

Carl Kaufman: I'll take the gold one. A lot has been written on the gold rally. You have to keep in mind that what's really happening there is that spot market in gold is not that deep. And we've been seeing central banks, particularly among emerging market countries, shift away from dollar reserves to gold reserves. So they've all been buying at the same time. We know what happens when you have multiple buyers in one name at the same time, it tends to move up in price, so it doesn't take a lot of volume to get that price to move, but that's what's happening right now. And some of the memes that are going around that it's sort of de-dollarization, de-risking, those just don't hold water when you look at the bigger picture.

So if the Fed does lower rates, yeah, the dollar becomes less attractive. That's part of the reason we've had a weak dollar this year. So my views on the dollar are that we've been through cycles like this before, and we'll probably go through cycles like this again where the dollar is weak and everybody starts thinking, "Oh, it'll lose its reserve currency standing." So where do you go? Do you buy Chinese bonds, Chinese Treasuries? Do you buy Japanese Treasuries? Do you buy European Treasuries? They're in a heap of economic trouble.

And the thing to notice is, I'll just tell you, just be aware, when you have an economic bump in the road, keep your eye on which markets the money flows to. 99 times out of 100, they all rush into U.S. Treasuries, because they're seeking safety. So that'll tell you where the real long-term underlying trend is. If you see an economic disaster somewhere and U.S. Treasuries trade down and other countries' Treasuries trade up, maybe there is a shift, but I haven't seen it yet.

Sean Ryan: All right. This one was kind of addressed earlier in the call, but it's concerning cash. They noticed that cash is around 14 or 15% of OSTIX's assets in the third quarter. Somebody want to address the issue of cash and how we utilize cash?

Carl Kaufman: Sure. As a flexible strategy, we have the ability to raise cash in markets that we feel are getting a little overbought, and that's been the case this year. Clearly, it goes on longer than you think sometimes, but that cash consists of maybe 4 or 5% true cash, Treasury, money market-type stuff and commercial paper. And we've also increased our weighting in bonds that mature under one year. We did this in 2019 as well, and we entered 2020 with 35% in short-term and cash. We're currently a little above those levels now, not much, but the same area, and we probably won't get another pandemic, but if we do get a correction, we can deploy that money very quickly.. We are getting yields on that that are not bad. Clearly, they've gone down a little bit, but they're still better than they were in 1920 when they were near zero.

Bradley Kane: And I would just add that even on the yields we're getting on the shorter end are not that far off where you get in the longer end, so you're not giving up that much yield, even as the market has come down a little bit because of the Fed lowering rates and Treasury yields. You're still getting pretty reasonable rates to stay short and wait for real opportunities to move out in duration. You're not getting paid in duration right now, except opportunistically. And that's where we are taking advantage when we see it.

Craig Manchuk: If you're getting long duration right now, it's because people are making a bet on long-term rates. And we don't want to bet on long-term rates going either up or down. We just want to be getting paid appropriately and try to keep the income component as high as possible and the NAV as stable as possible.

Carl Kaufman: There are many new issues that are coming to market now and sort of the higher-quality companies in high yield. I mean, they're getting done in the low 6, high 5% area in some cases, and that's just not enough over the mid-fours that we're getting on cash and short-term corporate debt now.

Sean Ryan: This is a somewhat related question: Do you feel like you are getting compensated for taking the credit risk you're taking at this time with credit spreads being so narrow?

Carl Kaufman: Yes, because the yields are higher. Nobody's ever been able to pay a bill in spread. You have to pay it in yield. So back in when the market, pre-Covid, was financing deals at 4 and 5% coupons, with the peak of that being an issue that Ball Corp did a 2 and 7/8, you weren't getting paid in yield, and spreads were higher then than they are now because rates were zero. So spreads are lower today, but yields are 300 basis points higher. So yes, we think we're getting paid today.

Craig Manchuk: And just adding to that, if you notice our positioning, again, we've got more ballast at the front end of the portfolio because of that. If we don't find things that we like at the longer end and it is taking us a little bit longer.

Sean Ryan: I think I can combine these two questions. Can you please discuss specific sectors and names you were invested in, and have you invested in fixed income securities in the brokerage industry?

Carl Kaufman: I'll take the first one, no. I'll let my partners take the second part.

Bradley Kane: Well, let me clarify, Carl, we don't have any now, but at one point, we were the largest bondholder to Oppenheimer and Company.

Craig Manchuk: And some short Goldman Sachs paper and JP Morgan paper, but very short, not long-maturity stuff.

Bradley Kane: On the other side, I'll give you an example of something that's opportunistic that we did recently. We've talked about this name in the past because we've owned it for a very long time, Unisys, which is a technology company, very tied in with their customers. They do all the security for Amazon Web Services, also for a Google Web. They had a bond coming up for maturity and wanted to refinance it. The only rub is since they've been around for since actually the late-1800s, in one form or another, they have some legacy pension liabilities, all manageable, all small, but the high yield market, the minute they see pension, they freak out, and they don't want to look at it.

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Bradley Kane: So we know the name well, we understand the pension issues, we understand what they're doing. This last deal both refinanced old debt and funded some of the liability, which is, as I said, pretty manageable to term it out and get rid of it and shrink the liability more.

So you have a company that's taking care of the liability, but it's got the word pension in it, and the market said, "We're going to charge it 10 and 5/8." Well that's well above where a lot of seven and eight-year bonds were coming in the sixes. So we're comfortable with it. It's got very low leverage, even including pension liabilities, generates tons of free cash flow, and we know management well. So for us, it was a no-brainer, and that's the kind of thing we were doing. Otherwise, we were just rolling a lot of short paper, waiting for opportunities like that to pop up.

Carl Kaufman: And we bought that bond at par this year, and it's trading at 106 now. So the market is waking up to the fact that maybe they missed it.

Craig Manchuk: Yeah. Another area that we have fairly significant investments in, John had mentioned earlier about aircraft lessors, airlines, but we have decent investments in the auto dealers and the auto supply companies.

The auto supply companies went through difficult periods several years ago, and most, if not all of them, have been really vigilant about paying down debt. So the credit profiles have been steadily improving over time, and they've all done a good job of transitioning from traditionally serving internal combustion engine manufacturing over to finding ways to get their parts into EVs as well.

So they have maintained critical stature in terms of supply into the auto ecosystem, but the dealerships in particular are extremely resilient in downturns, and we found that over time. And that's largely because a lot of their revenues come in the form of service.

The only caveat there is that they can't even get enough techs to come in and keep the service base as full as they'd like to. Demand exceeds their ability to service all their customers. So the service component in the dealer models is doing very, very well, even when the spread that they earn on both new and used vehicle sales compresses, they continue to be good cash flow machines. So we like that industry as well.

Sean Ryan: Great. Carl referenced risks in private credit, and with so much money flowing into the sector, how is that impacting your ability to find good pricing in your space?

Carl Kaufman: It hasn't really changed all that much. I mean, the quality of the market is certainly higher, and we have always been fundamentally focused on understanding the risks that we take and buying companies that we like, and if there's... And so we've seen less crap come to market in our market. It's going to the private credit space. So it just makes our life a little bit easier, I guess. Don't have to sift through as much risky paper.

Craig Manchuk: Yeah. Private credit is a very broad sector, and I think there's generally a misunderstanding of what it is, but it encompasses infrastructure, it encompasses all kinds of different specialty finance. We see a lot of private credit money going now to finance credit card receivables. So instead of credit card companies or buy-now-pay-later lenders going to the asset-backed markets, they engage in what are called forward flow agreements with private credit funds who are willing to take multiple billions of dollars from them that they originate and put it onto their own balance sheet. So a lot of private credit can be taking risks there.

They're also doing investment grade deals with the likes of Meta and companies like that where they're able to expediently commit to multi-billion-dollar financings. And in some cases, that's what these bigger companies want as well.

So where it would impact us is really more in the middle to upper-middle market part of the market. And BDCs (business development companies) have been around for a long time. They themselves are private credit shops. So it's a part of the market that has been there.

What we've seen more often though are companies that finance in private credit really want to graduate up to either the levered loan market or to the high yield bond market, because that suggests that they become more credit worthy over time and the financing is much more economical for them. So we do see waves of former private credit borrowers coming to our market to finance themselves as they sort of mature out of a stressier credit profile.

John Sheehan: And one of the first uses of private credit was to finance sponsor-backed transactions, so leveraged buyouts, M&As, et cetera, that are driven by the private equity firms. So we've talked a lot about our avoidance of those type of names. So instead of them coming into the high yield market where they would've 10, 15 years ago, many of those transactions are now financing in the private credit world. So it's really a sector that we wouldn't buy even if they were in the high yield market. So it's not something that we're really missing out on.

Sean Ryan: I think we've kind of addressed this as well, but regarding AI in particular, is there a lot of speculation in the structured finance build-out of data centers?

Carl Kaufman: Yes. Craig mentioned Meta has accessed the private credit market for $20, $30 billion of commitments to build out data centers. I mean, those are big numbers, and you can see they're choosing not to finance it out of free cash flow, they're doing it with debt. But that's a source of deal financing for the private credit guys, the big one. This is sort of the Apollo-level financing. The little funds can't do that.

But yeah, I mean, there's a lot of companies that are starting up, that either are building data centers to rent or build that they will come type companies that are financing in the convertible market, for example, or in the private credit market.

Craig Manchuk: As an example, just yesterday, a company called Iren--you can look this up yourself. The symbol is I-R-E-N--came to market with a convertible. The stock has been a double in the last two months, I think. And they came to market with a convert, which would mean you'd have to take some equity risk to buy it.

Company has only $500 million in revenues, but already has an $18 billion market cap. So the valuation seems way out of line. And what they do, they build data centers. That's it. So it makes it really, really difficult, unless you just want to close your eyes and roll the dice, which is not something we do. It seems that there's a lot of speculation in the data center part of the AI world, and it just makes it very hard to invest into that space.

Bradley Kane: Yes. And a fair amount of IREN's data center is used for Bitcoin mining. So it's not even really economically constructive uses. But I would also just say that the size of these deals, the data centers, are a lot larger than the high yield market would even want to finance. You would not see a high yield financing for a $10 billion or $20 billion bond deal. And some of these data centers are so big that that's what they need. So they're going to go to the Apollos of the world for that. So it's not taking away from an investment that we would make in the high yield market, because it's not something that would probably come toward the high market in the first place.

John Sheehan: Yeah. A lot of these data centers are being financed in the securitization market, so it's a big growth area of the asset-backed securities market. We do not rely on financial engineering for risk that we take, so we look through to the underlying loan or the underlying company. But yes, that is certainly a big area of growth and yet to be seen how those asset-backed structures are going to hold up down the road.

Sean Ryan: And this looks like finally our very last question: Do you trade any regulatory capital securities?

John Sheehan: I'm guessing that's trust preferreds, subordinated preferreds issued by banks and insurance companies.

Carl Kaufman: Insurance companies?

John Sheehan: I believe so. No, we do not. Those are oftentimes seen in high yield portfolios. There are a number of managers who will buy them to the call, even though they're perpetual securities. That seems to be a trade where you're picking up nickels in front of the bulldozer for us, so we do not own any of those. Keep in mind, they are one level above equity, so you have bond upside and equity downside. That's not the type of risk/reward we're looking for.

Carl Kaufman: But they generally have attractive coupons and very long duration profiles. Many of them are perpetual.

Sean Ryan: Carl, I think that was our last question.

Carl Kaufman: Great. Good questions, everybody.

Well, thank you very much for calling in. If you think of any other questions, get them to us, and we'll do our best to answer them.

Thank you very much, and we'll see you next year.