April 14 Webinar Replay - Osterweis Strategic Income Fund Q1 Update

Mark Schug: Good morning, everyone. My name is Mark Schug and I'm a Regional Investment Consultant here at Osterweis. Today, I will be moderating a panel discussion with Brad Kane, Craig Manchuck, and John Sheehan. Carl unfortunately cannot be with us as he is undergoing cataract surgery today, but he wanted me to let everyone know that he's looking forward to "seeing you all" next quarter. And as you may have guessed, the pun is intended and written by him. Brad, Craig, and John, it's great to be with you today. Brad, I'd like to start with you and your most recent outlook. The team walked through the major economic and geopolitical events from the first quarter and explored why markets were so resilient despite all the headwinds. I was hoping you could start by summarizing the most consequential events of the quarter, and then we can discuss some of the details afterward.

Brad Kane: Sure. Good morning, Mark. Nice to be with you, and thank you all for joining our call. Seems like a great way to kick off the discussion. The first quarter definitely was not short of market moving events, and it wasn't just the war in Iran, although that certainly continues to have the biggest impact currently. As everyone knows by now, oil price spiked almost immediately after fighting started. The aftershocks are still reverberating throughout the global economy. Oil's come down a little bit the last two days, but again, it's anyone's guess at the moment. And another big storyline in the quarter was about AI and its potential to disrupt the software industry. And this caused equity valuations in software companies to compress pretty rapidly. On a closely related topic was the ongoing trouble in the $1.7 trillion private credit market, which has seen mass redemption requests alongside continued defaults and asset write-downs.

And this is partially related to AI as many private borrowers or software companies. During the quarter, the Supreme Court also overturned Trump's initial tariffs, causing the administration to immediately levy new ones. So this ensures that inflationary pressure is going to remain in place. The U.S. invaded Venezuela to capture President Maduro, which was supposed to increase U.S. access to petroleum reserves but has yet to produce any results. And if that wasn't enough, the Ukraine-Russia conflict marked its 4-year anniversary. The DOJ is still investigating Chair Powell of the Fed. The President threatened regime change in Cuba, mentioned it again this morning. The partial government shutdown at DHS was throughout part of the quarter. And while it seems to have blown over for the moment, the quarter began with renewed threats about annexing Greenland. And so really a lot that happened in one quarter.

Mark Schug: Yeah, that's quite a lot for just three months. I'd like to dig into some of those points a bit more, but can you first talk about how the market responded to so much pressure all at once?

Brad Kane: Sure. I mean, the short answer is the markets held up remarkably well. The most major equity indices were down for the quarter, but only a few percent. I think so far in April, they may have recovered most of that loss. Bonds were mostly flat for the quarter. The Agg was down about five basis points, so essentially zero. And the high yield index was only down about half a percent. So relatively tame considering all the turmoil going on in the news headlines. I would say equity volatility certainly increased since the war started. Back half of March was pretty rough, but given all the potential risks, it could have been a lot worse. And the last two weeks in April, as I said, have seen more volatility with calls for a ceasefire and then breakdown in negotiations. But we're going to continue to monitor the news cycle. But overall, I would say it seems like not much has changed.

Mark Schug: Got it. I'd like to come back to why you think things held up so well a little bit later, but I think it would be useful to start by talking about some of the pressures we touched on a minute ago. John, let's start with the obvious one, the war. Crude oil spiked to about $100 a barrel almost immediately, but it took markets a little while to start selling off in earnest. And even then, it really wasn't that bad. What do you make of the market reaction?

John Sheehan: Sure. Thank you, Mark. I think first, just the sheer volume of headlines. There's a little bit of fatigue around, seems like every subsequent headline gets a smaller and smaller reaction. But specifically to the war, I think the market's initial reaction was that it was going to be relatively short-lived. Both the market and even the Trump administration looked at the experience in Venezuela and thought that Iran would potentially be a similar exercise. As time went on, that became apparent that that was not going to be the case, that this was going to potentially drag on a little longer than expected. Most notably, the closing of the Strait of Hormuz, which has continued to put pressure on oil prices higher. It is important to note that oil's not the only commodity that gets shipped through the strait. Other commodities like helium get shipped through there as well.

So there could be multiple knock-on effects from that fertilizer as well, a big input for the agricultural industry. But at the end of the day, I think that the market realizes that Trump is likely not to employ ground troops. Even if you go back to some of the posture that he took around tariffs, that he talks a big game and he tends to cave pretty quickly. So there's still a good amount of optimism that we will find a resolution. And we did see a pattern in March when the war first started, where every time the administration had tough talk, the markets would sell off. Every time they raised the optimism around a resolution, the markets would rally. Again, those responses seemed to be more and more muted. And it seems like where we sit today, S&P is back pushing towards highs of the year that the market is starting to look past and expecting some sort of resolution in the near term.

Mark Schug: Okay, great. Thanks, John. Craig, another big story from the first quarter was about AI and how startups would deploy AI bots to create cheaper competitors to take market share from established software companies around the world. Can you talk about why this suddenly became a concern and how it affects the high yield market?

Craig Manchuck: Sure. Morning, Mark. The biggest way that it's affecting the high yield market and the borrowing markets in general is a result of the leveraged loan and leveraged buyout transactions that we had from private equity sponsors. There've been a lot of those that have happened in the last few years. They've happened at very high enterprise value to EBITDA multiples. And the public market valuations for a lot of these software companies were also always very high because they were believed to have very substantial moats to defend their businesses and a lot of recurring revenue. As the threat from AI has encroached, what we've seen is a big multiple compression in the public market valuations and a commensurate concern about the same type of multiple compression for the private companies as well. So a lot of these deals were done with very, very high levels of leverage, sometimes seven to ten, maybe even 11 times leverage, which is substantially higher than what the public markets tend to carry.

So any of the private credit guys who have financed those transactions are looking at their portfolios and seeing that they may be underwater, or if not, the equity cushion has gotten very, very thin. The high yield market generally has some software, but not a huge amount of software. We have a de minimis exposure, and so it's not really going to be a major issue for our customers. But what we have seen in the high yield market per se is a lot of the AI companies themselves and the data center companies have come to market, and that's been a big part of the growth in issuance for high yield in the first quarter. So some concern about concentration risk growing in the high yield market among the benchmark investors, we have not been participating in that part of the market, but we're keeping a close eye on it just to monitor and see whether the concentration risk turns into a spot where you could see people starting to balk and pricing will start to widen out substantially.

In the meantime, we just felt that we're not getting paid appropriately in order to take the risk of some of these data center buildouts, because many of these transactions have been project type transactions where there's not current revenue. It's all dependent on future uptake of these AI data centers.

Mark Schug: Got it. Brad, do you want to throw your two cents in there on why AI software is such a problem for private credit?

Brad Kane: Yeah. I mean, as I mentioned before at the beginning, private credit's been going through a little bit of a rough patch with redemptions, defaults, and write-downs. And where we're seeing that for a lot of investors and why they're pulling a lot of the money out is in the business development companies, which are BDCs, and in the non-traded or private credit funds, there's a lot of liquidity restrictions that get put up. So on any given quarter, a fund may only allow you to get 5% of your capital back and you have to keep requesting it each quarter. And a lot of the investments are opaque to the investor. So you put money in, you have a multiple year lockup on your capital, and then you see you don't even know what these companies do because the names of the entity that they're lending to within the fund may not be as clear as, let's say, calling it IBM.

It may be some entity within some structure or subsidiary. And with the announcements of some over-lending and private credit, people are getting nervous and you've seen some big write-downs. And so what's happened is people have been asking for a lot of their money back, in fact, over and above the 5% minimums that they're allowed to pull out. And some of it, Jamie Dimon had mentioned a couple months ago when he said, "If you see one cockroach, you know there's going to be more." And I think that has really spurred a lot of people's nervousness. And what does that have to do with AI and software is the real big question. Well, according to the strategist, the credit strategist at UBS, 24% of BDC holdings are in technology and another 30% are in business services. And business services typically means software. So there's a big chunk of capital that's been lent to the software world at pretty high multiples.

And then all of a sudden AI comes in and the risk is that low-priced AI is going to take out a lot of the need for some of these software companies. And so you see a lot of the funds starting to write down or see valuations of software companies come down dramatically, making investors nervous and causing angst. And given that over 50% of BDC exposure is vulnerable industries, it just seems like you're going to see more defaults and more concerns going forward. So the one bright spot I would say, as negative as the headlines and we have been on private credit lately, we don't see it as a systemic risk for the global economy. It is not like subprime mortgages back in 2008. The market's much smaller and the debt is held by much different investors, so the one bright spot.

Mark Schug: Got it. Okay. Well, it does seem like a tricky situation for private credit investors. Let's look at one more headwind that the market absorbed last quarter, and that was tariffs. In February, the Supreme Court ruled that Trump's reciprocal tariffs from Liberation Day were unconstitutional. John, what do you think that means for the economy? Was that good news?

John Sheehan: Sure. I think the easy answer is it's just more uncertainty. On the one hand, it is reassuring that our government's checks and balances are working as they should. Certainly the Trump administration appears that they are going to continue to fight it despite the Supreme Court ruling. So they've imposed new 10% across-the-board tariffs and then subsequently raised to 15%. Those will be challenged as well. In terms of our companies within the portfolio, we've been saying since tariffs were first instituted that our companies have been successful in passing those costs through, so we haven't really seen it impacting the balance sheets or the creditworthiness of our companies, but that is certainly potentially being felt in the form of inflation among consumers. And then the last point, if you look at the fiscal situation of the government, this is something that we've flagged numerous times. If you remember back to the great Big Beautiful Bill, it was really a trade-off between tax cuts and increasing revenue through tariffs.

So if those tax cuts stay in place and we don't have a way to offset the loss of revenue through tariffs, it's just another source of pressure for the fiscal situation and increasing deficits and ultimately increasing debt. So we think it's certainly something worth watching. It's likely to continue to play out in the courts, but the immediate impacts are going to be felt both in terms of inflation and then how long can companies really pass through the higher costs?

Mark Schug: Okay. Yeah, it seems like still a lot to get sorted out there. Craig, John had mentioned Venezuela a bit ago, and I was wondering if we could come back to that. I know we've been talking about market headwinds so far, but Venezuela was supposed to be an economic tailwind, right? Can you talk about how that has played out so far?

Craig Manchuck: Well, I think from a military standpoint, it was successful. They got Maduro out. There's a new administration in place. The biggest issue from an economic standpoint though is convincing U.S. corporates to want to invest in Venezuela. It's been an unstable locale for many, many years. And while they are long a lot of very heavy sour crude, which would be a nice input to add to U.S. refineries, getting it out of the ground is going to require a multi-year investment in infrastructure. So where we are at the moment is trying to convince a bunch of people in the oil industry that you can invest tens or maybe even hundreds of billions of dollars into Venezuela when their recent memory is that that would've been a perilous activity and really irresponsible use of capital in the past. Right now, I think we're probably in a bit of a holding pattern until we get a clearer view on where the current and/or future administration in Venezuela is going to be.

But it's an opportunity out there in the future. It just needs to be hashed out a little bit better before people are going to be pumping billions of dollars in there.

Mark Schug: Interesting. Thanks, Craig. Let's pivot and talk a little bit more about why markets have held up so well in the face of all of these headwinds we've talked about. John, what is your take?

John Sheehan: Yeah, I think the quickest answer is that the economy remains in good shape. It's resilient whether you look at inflation data, again, earnings of companies. I think that we still have a tremendous amount of liquidity in the financial system. Much of this is coming from fiscal and monetary policies coming out of Covid, and that is still in the system. So we still have more cash chasing fewer assets. There's still a good amount of CapEx in the marketplace. We've talked a lot about the tremendous CapEx from the hyperscalers. So it's a resilient economy, and we have not really seen many signs of that changing. I think coming into the year, there was lots of questions around valuations. The resetting that we had in the market helped around valuations, so did earnings. But in general, the economy is in strong shape. As much as people are looking for the next catalyst for the economy to suffer, we haven't seen it materialize yet, so we're still pretty constructive on the economy.

Mark Schug: Great. So to summarize, fair to say the market is dealing with a lot of concurrent potentially serious headwinds, but the underlying economy is strong enough to provide some ballast to keep risk assets at a reasonable level.

John Sheehan: I think that's a very good summary. Yeah.

Mark Schug: Okay, great. I have one last question for Craig. Can you talk about how the fund is positioned given all the various headwinds?

Craig Manchuck: We're positioned defensively as we usually are when you get into situations like this where we have lots of moving parts, lots of volatility. There's not a lot of clarity about how any of these things are necessarily going to be resolved. But as we look out at the landscape, the high yield market we think still represents a really attractive market given the yields we're getting relative to the quality. If you go above high yield and you look at IG, spreads are incredibly tight. The quality of the IG market, as we've talked about for years, has actually deteriorated a lot because more companies have gone from A all the way down to just the triple B or triple B minus level, whereas high yield has moved up market and gotten better in quality. So in aggregate, the pool in which we're fishing and looking for investment ideas is a better quality pool, we think, with better yield per unit of risk than in IG.

And similarly, leveraged loans and private credit, they're both financing much riskier ventures and doing it with much more leverage and far fewer protections than in the past. So we think we're fishing in the right pond. Having said that, given the macro backdrop and all the moving parts out there, we're still very defensively positioned. We have a lot of dry powder. We were able to put some money to work in the recent weakness that was precipitated by the onset of the fighting in Iran. Not as much as we would like to. Again, markets have recovered pretty rapidly in the last couple of weeks, but we're still out there searching and when we find something interesting, we've got the dry power to put money to work.

Mark Schug: Got it. Great. Well, thanks guys. We covered a lot of ground here. This is great. Anything want to add? Anything before we open up the questions?

Brad Kane: I'd say not really. I mean, as Craig and John and I have said, the environment's challenging right now and we're just trying to do what we always do, which is look for the most attractive areas of the market, invest where we think we're getting paid for the risk we're taking. As Craig said, we're not seeing tons of stuff that seems like we're supposed to jump in at these levels, and we're getting paid to wait.

Mark Schug: Sage. Sage advice. Okay, that's great. Thank you. That was really it for me. Before we open it up to the audience, we're sharing you some performance information and some current portfolio statistics and let's check in the Q&A here. First question, what is OSTIX's highest concentration risk in the portfolio and what percentage is it?

Brad Kane: I could take that. I think right now the highest percentage exposure is in what would be considered consumer cyclicals, so things like auto and auto parts, airlines. For us, it's about 11.5% of the portfolio right now, but what I would stress is to look at where we are on the maturity and duration spectrum in addition to that. So while we may have a high exposure, let's say in consumer cyclicals because we have a few airline positions, some of those are maturing or coming up in very short amount of time. So when you look at the overall portfolio, you're going to look at industry or you're going to look at sector, but then when you look at the duration, and our duration on the portfolio is about 1.3, which is extremely low compared to the indices and where we have been at the heights of taking on risk.

I mean, the overall yield to maturity, the average years to maturity, as you see on the screen is 2.4 years. So we're still taking very, while we are exposed in sectors, we're taking much more calculated shorter term volatility risk than what you might see in a normal fund out there.

Mark Schug: Great. Next question that came in, do you think there are any broader implications of the Iran conflicts economically, politically, et cetera?

Craig Manchuck: I would say yes, there has to be. One thing in particular I think that we are somewhat concerned about and companies should be concerned about is during Covid, we ran into big supply chain issues, and the supply chain issues were caused by people having a single source of supply that was shut down. So many looked to bolster their supply chains post-Covid and added some duplicative supply chains in case we ran into another situation like that. That could be filtering through here in the case of Iran. Globally, shipping is now going to be a little bit different and problematic, particularly if you have other countries decide they want to start acting as toll operators and collecting tolls every time somebody comes by in a ship, which is essentially what Iran wants to do by holding the world hostage to allowing boats in and out of the Strait of Hormuz.

So I think you're going to see another spate of concern about various supply chains being disrupted globally as a result of concerns that shipping on the open seas is not as free and easy as it's been for the last 50 years, largely as a result of the United States.

Brad Kane: The one thing I would also add to that is it takes for on average, I think the number's 45 days to move product from, let's say, the Strait of Hormuz around to some of the destinations they're getting to. So you haven't yet really seen the shortages that Craig's talking about that could happen because there has been some inventory and it takes a while for whatever ships are getting places. So now that we've had a longer Iran conflict than I think people thought we would, you might start to see those hiccups in the global supply chain.

Craig Manchuck: And I think that if you're looking at oil prices today, I'm not sure that the oil prices today necessarily reflect some of the risk. So one of the things to look at with regards to Iran right now is it takes about 13 days or so for them to fill up their pipeline, basically getting the oil from their wells through the pipeline out to Kharg Island where it then fills up a ship. If we're stopping them from doing that, within 13 days or so, they're going to have to shut down their productive capacity for oil because they're just going to be full and it's not going to have anywhere to go. They don't have storage for it. If they shut it down, once you shut it down, you can't just flip a switch and turn it back on. It could be anywhere from 30 to as many as 60 days for them to actually turn that back on.

So every day the clock is ticking, we're getting closer and closer and closer to a shutdown that will extend longer of all that oil coming out and finding its way out into the global market for an extended period of time. And a lot of people are talking about the summer driving season here in the U.S. That's fine, but that doesn't encompass the entire world. So there's an awful lot of angst and concern, I think, out there about where oil prices could actually go and get squeezed to in the short run. And that could be a big problem, could be a problem for airlines, could be a problem for other companies that aren't currently able to pass through those costs, but it could be a real problem for the consumer as well.

Mark Schug: Yeah. And Craig, do you want to just talk about how we're approaching convertibles at the moment? I know we've built up a pretty good size busted allocation that's come down a little bit. Anything we're seeing there?

Craig Manchuck: Most of it has been in the busted world. We've found a number of opportunities there where issuer's stocks have fallen, bonds have fallen in their very, very low equity sensitivity, which is the time when most of the hedge funds want to peel out of them. But a lot of these companies still have cash that they raised on their balance sheet. So we continue to find places where we can buy converts with more cash than debt. So a balance sheet that actually looks better than much of what we see in the high yield world. And we're finding those in fairly short tenors from anywhere from a month to call it 15 months and at reasonable yield. So that's been a good spot for us. The new issue market and convertibles, not so much because the companies that have been coming to market of late have just been too new, not earning any money, some ridiculous valuations.

A company that just came to market yesterday after the stock popped 40% in a day that has seen some positive results of pancreatic cancer treatment, but you just can't chase after some of these high flyers because that stock could be down another 20% the next day. So we've avoided the primary market for convertibles. We're just waiting to see if our types of companies will come back to market or not.

Mark Schug: Fair enough. Well, I don't see any other questions in the queue. Gentlemen, any parting words you'd like to leave us with?

Brad Kane: No, we continue to invest the way we've always invested and we appreciate everyone's trust in us.

Mark Schug: Great. Thank you all, gentlemen. Thank you all for joining, and please reach out if we can be a resource in any way. Thanks so much.