July 15 Webinar Replay - Osterweis Strategic Income Fund Q2 Update

Tyler Voss: Good morning, everyone. My name is Tyler Voss, and I'm a regional investment consultant responsible for covering the Southeast. As a reminder, we've started rotating the moderator call among our regional investment consultant team, and today I have the privilege of moderating the panel discussion with Carl Kaufman, Bradley Kane, and John Sheehan. Carl, Brad, and John, it's great to be with you today.

Carl, I'd like to start by getting your big picture thoughts on the second quarter. It was an eventful period featuring several big storylines that seemed more negative than positive, yet markets seemed to rally consistently for most of the quarter. Why do you think that was?

Carl Kaufman: Good morning, Tyler, and thank you everybody for joining us. It was indeed an action-packed quarter that was bookended by two very big policy changes, for which the economic impact is still pending.

First, on April 2nd to kick off the quarter, Trump announced his reciprocal tariff program, which we spoke about during our last call, even though it technically happened in the second quarter. In fact, regular listeners might remember that during our webinar, the administration announced its 90-day pause, which of course kicked off the rally to new highs in the equity market. Apparently, the markets don't care that much about tariff news. Later, near the end of the quarter, the U.S. executed its targeted military strikes against Iran's nuclear sites, which briefly drove up oil prices, but that didn't stick as tensions fortunately eased pretty quickly. And finally, Congress passed the so-called Big Beautiful Bill just before July 4th, which was signed into law on July 4th, which expands the federal deficit by nearly $3 trillion over the next 10 years.

So, there's a lot to digest in the quarter, none of which is especially good, yet the markets collectively yawned and kept rallying. We've put up a slide with the second quarter returns to underscore that point. I mean, as you can see, Treasury yields, two-year Treasury yield's a little lower. Ten-year Treasury yield's pretty much flat. The S&P up 11%, corporate spreads tightened, investment grade spreads tightened, and the volatility measures VIX for stocks, MOVE for bonds, came down. So we're not seeing much volatility in the market except for that couple of days at the beginning of the quarter.

Tyler Voss: That's interesting, Carl, thank you for sharing. What else do you think is going on?

Carl Kaufman: I'm going to hand it to John to explain. He's been looking at this recently and did some work on it in the outlook. John?

John Sheehan: Thank you, Carl. Yeah, so certainly, the economy has remained very healthy, that's always important for risk markets. But we took a look at two forces that we think could be both driving the health of the economy and financial markets.

So the first that you can see here is the money supply. In the quarter we hit a new all-time high in money supply. It's been growing for 19 consecutive months and it's up 4.5% year-over-year in May. So one way to think about this is that there's more money in the financial system chasing fewer assets. This is in some ways the way that inflation is defined when you're thinking about commodity prices. So it's certainly been a big underpinning of financial markets in the quarter.

The second factor, which is related, is the size of the Fed balance sheet. We spend a lot of time debating over the level of interest rates that is set by the Fed, but probably as big of an impact is the size of their balance sheet. You can see a real spike there. When they first began buying bonds both in Treasuries and mortgages out of the marketplace, this is quantitative easing. And ever since then, they've been trying to shrink the balance sheet but it's been at a much slower pace and it leaves the balance sheet at a significantly elevated level since before they started the quantitative easing.

So the Fed meeting in March on March 19th, the Fed announced that they're going to reduce the amount of the roll-off from 25 billion a month to five billion a month. So this reduction in quantitative tightening is effectively another form of quantitative easing. So this is just adding greater liquidity into the financial markets and certainly something that will be a factor going forward. Trying to filter out the noise of some of the commentary from the White House around the Fed, we think that the size of the balance sheet is as important, maybe more important, than the level of the rate set by the Fed.

Tyler Voss: And Brad-

John Sheehan: Brad, do you want to talk about another factor that we've focused on this quarter?

Bradley Kane: Sure, sure. So this, you could see here, I mean, the growth of defined contribution benefit plans versus defined benefit plans. And what we're looking at here is really what we think is one of the reasons why the markets have been a little bit more one-sided.

So historically under a defined benefit plan, companies were incentivized to hire active managers and try to outperform the markets in order to limit future payment liabilities. And this led to a lot more activity, a little bit more volatility in the markets. With the growth of defined contribution plans, this is tended to be managed by individuals and through their corporate 401(k) plan or in their IRAs at home, and they usually use passive funds and ETFs. And so when you treat a portfolio as a set-and-forget and you just reinvest cash automatically, what you're doing is you're never really truly rebalancing from investment market conditions and changes in what's going on. You get what's more investment inertia, and so you just keep buying the same things over and over through your passive funds and your ETFs and they just keep buying the same names. And so as you reinvest every paycheck or every set period, all you're doing is getting a market buy of the same names over and over. And so that's kind of dampened the volatility quite a bit.

And I think this is why when you look at what's going on in Washington, it's not having as much impact on the day. It has impact day-to-day, but over the longer period of time, people just keep sticking with their reinvestment plans.

Tyler Voss: Thank you, Brad. Carl, back to you. Sticking with the big picture, can you talk about what's happening with the Fed?

Carl Kaufman: Sure. Powell seems to be taking a wait and see attitude, which we fully support. The data does not support cuts, the economy's pretty healthy, inflation, you saw the latest number today, it's still 2.8, 2.9% year-on-year depending on how you look at it. Trump, of course, being a real estate guy wants lower rates, not only to stimulate the economy more, but to reduce the cost of the national debt, which is growing due to expenditures but also will continue to grow because of the new budget. Of course, this would be at the short end only because that's what the Fed controls. We don't know how the rest of the yield curve will shake out. And unless the Fed is going to borrow exclusively at the short end, which we think would be a disaster, rate cuts may not have the desired impact that the president wants.

Powell knows his history. He knows that if you cut rates too soon during an inflationary cycle, it can come back with a vengeance, as we saw last year when they were cutting rates and the long end rates moved up. And we don't want to cut too early because we don't want a repeat of the '70s, for sure. And as we alluded to earlier, the underlying economy is still fairly healthy, the jobs number is pretty good, and so there's no real urgency to cut. The tariff policy is I think far from resolved. He seems to use it as a country battering ram, negotiating tool, but we'll have to see whether it's inflationary or not. So, stay tuned.

Tyler Voss: So, what would you predict that Powell is actually going to do?

Carl Kaufman: He's said repeatedly that he's being patient and waiting to get a clear signal before making any big moves. As you know, when the Fed starts cutting, they don't just cut once. So heading into this year, some economists were forecasting up to six cuts by the Fed, so far we've gotten none, and it remains to be seen if we'll get the next one this year. A lot depends on how the trade war plays out, and given that the 90-day pause is nearly over, we have another 30-day pause on top of that to August, which is a couple of weeks away. We'll probably get another extension.

Of course, if the fed funds rate were to come down, it is not clear how much that would impact longer rates. Thirty-year and 20-year, over 5% today. Markets have become a little more concerned about all the borrowing the U.S. government will be doing to pay for the Trump tax cuts and other programs. And for the moment, they're starting to demand higher yields as compensation, and so a Fed cut may not be the right thing to do right now. So, I think Powell knows this. I think we have cover until May of next year.

Tyler Voss: Carl, you touched on two different issues that I'd like to explore a little bit further. John, I'll go to you first. What do you think will happen with the tariff situation, now that the 90-day pause is about to expire?

John Sheehan: Yeah, it's a great question, Tyler. Ultimately, it depends upon the levels that are established. If you think about almost consensus, a lot of talking heads in the market thought that tariffs would be certainly inflationary. As Carl alluded to, we have not seen that show up in CPI numbers yet. So, it's going to be a function of how and if those tariffs are able to be passed through to the consumer. Certain industries will be able to pass along the higher prices, others will not.

It seems like every headline that comes across the market, I think there's one right now about Indonesia, has less and less of an impact on the markets. It could just be that people are getting bored by it or it could be the concept of TACO, which is Trump Always Chickens Out. And I think there's a real question in the marketplace whether these tariffs are ultimately going to stay, and if they do, for how long. It seems that he uses tariffs as a negotiating ploy, and if he can claim victory, he's apt to very quickly take those tariffs off as quickly as he put them on.

So, long-winded answer of saying there's still a tremendous amount of uncertainty around the tariff conversation, but it does feel like the markets are moving less and less on every tariff headline.

Tyler Voss: That's good, John. Thank you. The other question I want to ask is about the recently passed Big Beautiful Bill. Brad, maybe you can take this one. Carl mentioned that the bond market is getting a little uneasy about all the borrowing that the Trump Administration is planning for the next few years. Can you elaborate on that?

Bradley Kane: Sure. Well, as Carl said, we're looking at three trillion in deficits over the next ten years, added thanks to the bill, and I think the Treasury market is telling you they are concerned about that. As Carl said, today, 20- and 30-year Treasuries are over 5%. 10-year has been hovering in the mid-fours for quite a while now, and we haven't even started actually funding the extension of the old tax cuts and added the new tax cuts in, a lot of that doesn't kick in until second half of next year. So you're going to see, spending right now is just to... The borrowing now is to replenish the Fed's ability after they raised the Treasury limits, and then we're going to have to do some future funding for these deficits that are going to kick in.

And so when you do that, you have to issue more paper. The way to induce people to buy your paper is to increase the yield you're offering. And so, you've got foreign banks have been cutting back, and so they may not be a reliable buyer. You saw that they're talking about possibly changing the rules and relaxing the capital rules on banks to allow them to buy more Treasuries versus what they're holding right now. The Fed has lowered the quantitative tightening they're doing by reinvesting more of the Treasuries that are running off.

So they're all trying to find ways to add to the buyer base, but the problem is, we are going to be issuing a significant amount of paper and to do that, rates have to go up. And what ends up suffering from that is corporations who are looking to finance are probably going to have to either raise their capital rates that they're going to pay to compensate for the risk over a government Treasury, or they're going to get crowded out from borrowing. And so we haven't seen that yet, but that's something we're keeping an eye on as we see rates have not really come down, at least on the Treasury side.

Tyler Voss: Thank you, Brad, that's good. Sticking with the market just a little bit longer, John, can you talk a little bit about the new issuance in the second quarter?

John Sheehan: Sure, absolutely. So in the second quarter, not surprisingly after Liberation Day and the brief volatility we saw in the market, corporate issuers don't like issuing into that uncertain environment. So, April was a very, very light month for issuance, but they still need to do their refinancings. So when they got the "coast is clear" sign, May was a very, very active month. We did see a good number of opportunities, both in terms of portfolio companies and other companies in the marketplace, and we are now sitting at about the five-year anniversary from the low in interest rates, if you think about where interest rates were in 2020 around Covid. So a lot of the very low coupon bonds within the high yield market are now being refinanced into substantially higher coupons. So that's an opportunity that we're taking to put some yield back into our portfolio.

Tyler Voss: Great. Well, last question for me, it's a great segue. Carl, can you talk about the current portfolio positioning?

Carl Kaufman: Sure. I'm sure everybody's on the edge of their seat. We've not really made any major changes, as you might expect. We are still in a somewhat defensive posture, although as John mentioned, we did add some names during the refinancings at attractive yields. We'd like to do more of that if only they would bring us more of those. But despite the extended rally, we still feel we're getting reasonably paid on our cash and we'll wait for right entry points. It may be one name at a time as they come, or it might be the market does trade off if there's some event that happens to capture its imagination and kick off a risk-off move in the market. But as the old saying goes, "When the market's greedy, be afraid. When the market's afraid be greedy." So we'll just wait, or as I like to say, buy low, sell high.

Tyler Voss: That's great. Well, thank you Carl.

Before we open up the floor for Q&A, I'd like to just discuss a new white paper that the team has recently published that talks about how the credit quality of the high yield market has been steadily improving since the global financial crisis, and how new markets are now funding the riskiest credits. I encourage everyone to take a look, I think it may change your perspective actually on the high yield market. Also, we're sharing the fund performance slide and we'll follow it with some key portfolio statistics as well.

What I'd like to do now is just to open up the floor for Q&A, and as noted on the slide, please ask a question through the Q&A window, or you're more than welcome to raise your hand to ask a question over computer audio or by phone. Carl, what I'd like to do is to start with a question that I have as we're waiting for the Q&A to populate. In past calls over the last year or two, you've emphasized how important spread duration is for our portfolio positioning and how we're looking at the markets. Could you talk just a little bit about that as we're waiting for the Q&A to populate?

Carl Kaufman: Sure. There are two durations, as you know, just for those of you who forgot your definitions. Duration is a portfolio sensitivity to changes in interest rates, and spread duration is a portfolio's sensitivity to changes in spreads. So, both of those can impact a non-Treasury portfolio.

Clearly, spreads have come down, but overall yields, although they've come down a little bit, have not come down as much as spreads, and that's because when you look five years ago when rates were near zero, spreads were wider, and since rates have come up, spreads have narrowed. We find that while we are aware of where both our interest rate duration and our spread duration are, they're not as critical. We keep them low, I mean, I think our interest duration is, as you can see, it's 1.39, our spread duration I think is around the same. But we're much more concerned with absolute yield, and that's what we really look at when we look at securities to add to the portfolio. Clearly, if yields on Treasuries go a lot higher, we're going to have to start looking there, because the risk-reward becomes more favorable but right now, it really does favor the non-investment grade corporate part of the market.

Tyler Voss: Okay, that's great. We have another question from Kyle that asks, "You mentioned that yield plays a role in the securities you add to the portfolio. How does the yield dynamic factor into securities you remove from the portfolio?"

Carl Kaufman: Well, if you stand on your head when the yield gets too low, we take them out. We don't tend to sell very often. When we do sell, it's either because, and our turnover's roughly I think about 30%, and about half of that is involuntary, that's over a long period of time. So, 15% voluntary turnover. And typically, you'll find that when we are selling, it's either because a credit has gotten too high quality. In other words, we will buy some names that are growing companies, and as they grow, they get upgraded by the rating agencies. And as they get upgraded, their spreads come in and they're no longer attractive to us.

Perfect example of that over the years have been, we have funded a number of sort of younger aircraft leasing companies. Their goal is to increase size of their portfolio, become investment grade, and move on. And that's when we typically move on too, when we're getting say, 100 basis points over a five-year bond, that's not enough for us. So, we'll sell and let the investment grade guys take over. So it really has to do with not getting enough yield in the portfolio, either, typically it's relative to what the market offers in names that we're looking at, rather than versus what that particular credit should be trading.

Tyler Voss: That's good.

Carl Kaufman: If that answers the question.

Tyler Voss: Another question came in asking, "At what level of 10-year Treasury yield would we consider it attractive and whether or not we might nibble at it?"

Carl Kaufman: I've been around long enough, I remember 15.75% yields, that would be attractive. I don't think we need to get there again, but I think if you get towards the 6-7% range, that's pretty attractive, that's money doubling in ten years, and that's a pretty risk-free way to go. We wouldn't clearly put the whole portfolio in at that level, but we would certainly consider adding a good portion of it at that level. But it also depends on where everything else is trading, if you're getting 12% on high quality non-investment grade names, it'll probably be a barbell of both. But it's hard to say because situations change. But all things being equal, which they never are, that's about the range we're thinking.

Tyler Voss: Certainly. We have another question that came in just a minute ago asking if the team would ever consider non-U.S. high yield corporates or governments.

Carl Kaufman: Well, we probably wouldn't consider governments, because they probably don't yield enough. I mean, I was looking at Iraqi paper, which is one that I look at every now and then, and it's yielding about 6%. Is that the kind of risk you want in the portfolio? I don't think so. So everything's going to key off of that. Safer countries are going to yield less.

In terms of international companies, we do own some international companies. Generally, they are either domiciled overseas for tax reasons. You'll find that cruise companies, like the big cruising companies or the aircraft lessors are domiciled offshore for tax reasons. Also, we own some great companies that happen to have a lot of business in the U.S. and globally.

Bradley Kane: Yeah, I would just say, all of our debt is dollar-denominated.

Carl Kaufman: I was going to add that. Thank you.

Tyler Voss: Another question that's just come in is, with longer-term U.S. Treasuries fluctuating, are the bond vigilantes concerned about our future economy or increasing U.S. debt, or are there other reasons?

Carl Kaufman: I think, well, we haven't seen too much volatility. I mean, volatility these days has to be redefined. I mean, you move up 25 basis points and it's like the end of the world all of a sudden. I remember times when bond yields would change by over a percent in a day. That doesn't happen anymore, but I think they're more concerned about the debt right now than the economy. If they were concerned about the economy, rates would be coming down.

Tyler Voss: Well, if there are no further questions, Carl, I'd like to just turn it back over to you and ask if you have any concluding remarks for our attendees.

Carl Kaufman: I think that this is a period where the market seems to be waiting for something but not quite sure what it's waiting for. Either clarity on the economy, clarity on tariffs, clarity on fiscal policy and its effect on the economy. But I think overall, the economy is in pretty good shape. I mean, jobs are still low, labor's still holding up okay, wages are holding up okay. You see headlines every now and then of layoffs in the tech field, but when you see 4,000 getting laid off, it sounds like a big headline, but when you look at the monthly job numbers in the 200, 250,000, it's still small. So, don't get too carried away with the headlines and just steady as she goes, and we'll see you in three months.