Published on July 19, 2021

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


Shawn Eubanks: Good morning, everyone. My name is Shawn Eubanks and I'm the Director of Business Development at Osterweis Capital Management. We'd like to welcome you to the second quarter update for the Osterweis Strategic Income Fund. At this time, all participants are in listen-only mode. Later, we will conduct a question and answer session, and you can participate via online chat or through your computer.

We'll hold all questions till the end, but if you would like to get in the queue, please raise your hand or enter your question in the chat. Please note that this webinar is being recorded. I'll be moderating a discussion with Carl Kaufman and Bradley Kane. After our discussion, we'll open up the line for your questions. So let's begin. Carl, can you recap what the markets did in the second quarter and what changed in your view?

Carl Kaufman: Sure. The markets were very uneventful in the second quarter for the most part, almost boring. Interest rates were grinding lower. Equity markets were grinding higher to new highs, but it was very orderly and there was very low volatility. Then June 15th, the FMOC had their meeting and they added more clarity on tapering and rate normalization. And while still pretty far out in the future, the markets had a bout of volatility going into quarter end. Equity markets corrected and the curve flattened pretty dramatically. Everything's in context when I say dramatically. But the short rates moved up and long rates moved down as investors seemed marginally more worried about inflation in the near term and are marginally more worried about an economic slowdown in the long term.

Shawn Eubanks: Great. Following up on that, can you share your views on inflation? Perhaps where you think it's heading and what factors you feel are important to watch?

Carl Kaufman: Sure. It seems to be the question of the day, and anyone with a pulse sees prices going up, but the real important question is what is causing those prices to go up and how sustainable are they? Obviously, we have supply bottlenecks, we have supply shortages. It's different for different components. So commodities certainly had a big run. Building materials, lumber. Part of that was the fact that manufacturers tend to keep very low inventories. So those were sopped up and we had to restart the lumber mills. And once we did that, supply came on and prices came down.

So some will ease quickly. Others will not. Semiconductor shortage, that is causing supply chain issues in a number of things, most notably automobiles. Those are going to be tougher to fix. It's not quite as easy as turning on a lumber mill. So capacity is being added. It's not that there was no demand and they got caught flat-footed. Demand has been very, very strong. April shipments of semiconductors were at all-time records. So you're seeing extremely strong demand.

With energy, that's one that has been under OPEC supply constraints, and so the price of energy has been moving up. And that flows into a lot of things like plastics and materials, et cetera. The other thing to keep an eye on is housing. Owner's equivalent rent is about 30% of the inflation basket. It is very slow moving. And for those of you who don't know, it is a survey-based measure. So the Bureau of Labor assist goes out and surveys a bunch of people every month. They have a very large sample, but they only survey one-sixth of it each month. So it takes six months to get a fully updated, to interview everybody so to speak.

So when they do the interview for the month, those numbers go into the index. The other past five readings stay in there until they are updated. So you can see it's a very slow moving average. So that is moving up and it's moving up slowly. And it also is rather persistent. It's a fairly stable number. But most economists feel that that alone could take inflation to the Fed's target through most of 2022.

The other one to keep an eye on is wages. Clearly wages are rising. Jobs are hard to fill and if they continue to rise, the fear is that it could ignite a wage price spiral as we had in the '70s. I don't think that's going to happen, but worth watching. Used car prices have been a huge driver of the CPI. I think they're over half of the recent moves. I think that will probably ease once semiconductor shortages ease and auto production starts to rise again. So I'm not too worried about that one as a long-term factor. Hopefully that helps.

Shawn Eubanks: Thanks Carl. Turning to Brad, Brad, what do you think about the overall state of the economy and what do you think will happen once this reopening boom subsides?

Brad Kane: Thanks, Shawn. The overall state of the economy seems to be pretty strong. As we saw in the first quarter and now in the second quarter with the reopening continuing, consumers are spending. They're flocking to restaurants. They're flocking to the airports to go on vacation. Places like Hawaii are talking about increasing taxes to prevent all the tourists from coming in. And companies are beginning to spend capital to increase production to try to meet demand. What we heard from, actually most recently from Nancy Lazar at Cornerstone Macro, thinks that you're going to see a big increase in capital spending in the second half, which will continue to spur the economy.

In the first quarter, we saw really strong earnings. I think you're going to continue to see that for the next two quarters. Earning season actually just started. We'll start hearing from some of our companies later this week and next week, but I think for the next couple of quarters, you still have strong earnings after that, so maybe at the end of the year, beginning of next year, I think you begin to see earnings normalize as we cycle through the easy comparables and we get past a lot of the reopening boom.

Then I think the economy goes back into its slow but positive growth rate that it was pre-pandemic. The one caveat to that is, as Carl mentioned, some of the bottlenecks that we've seen develop in computer chips and lumber prices, although coming down, I think those can still cause some hiccups to the reopening and us getting back a normal trajectory. But you're seeing airplanes full, airports are packed. As Carl mentioned, with used car prices, it's hard to get a rental car at the airport because of prices. So I think you're continuing to see the demand there, and it'll be a question of how long that takes to get through before we get to the post-pandemic normal trajectory.

The other thing is there's been a significant mismatch between unemployment, which has dropped significantly, and still the job openings. There's a significant amount of job openings in the country, as seen in the JOLT data. You're starting to see companies really start to use benefits and wage increases, or even some Burger Kings and McDonald's are issuing signing bonuses to people to get them to come back to work or take a job. So I think the unemployment mismatch and stuff will actually help extend the pandemic growth rates, because with higher wages plus more job openings, I think that can stimulate growth further. I hope that that helps.

Shawn Eubanks: Yeah. Thank you, Brad. I mean, given your thoughts on the state of the overall economy, how are you and the team positioning the portfolio, given that you're what you're seeing today and what you expect in the intermediate term, I guess?

Brad Kane: The last quarter or two things have not changed. We've been still holding some of our Covid beneficiaries that we purchased earlier in 2020 as Covid just took off. We're still seeing the benefits to those, things like, as we've talked about in the past, Carnival cruise lines and some of the other more leisure spend as people reopened and want to get back to doing things. We're still heavily weighted to below investment grade in convertibles. I think within below investment grade, we continue to try to upgrade the portfolio, and while our duration has gotten a little bit longer than it has been in the past still, I think it's around two right now, so for us, we're not going out pretty far.

But it's still a relatively short duration as we don't think you're getting paid for a lot of the new issues that come with long maturities and low coupons. With the economic strength, fundamentals are still healthy, as I mentioned. Earnings are strong. We continue to see those benefit below investment grade companies significantly. Where we have some profits, good profits in convertible securities, and we think those stocks have had most of their run, we've been taking some profits, but in others, we continue to watch the stocks perform.

As I mentioned, Carnival's a perfect example of one where we're letting the stocks run and letting the convertibles perform as you see the economy reopen and get better. But as always, our changes to the portfolio are strategic and methodical, which is really nothing new. I think we're continuing to watch to see if we're going to have some inflation here. We're seeing it, but the jury's out of how much of it is temporary and how much of it is a longer-term shift up.

But because of that, we're maintaining the shorter duration. I think that where we've taken some profits, we're letting cash build. As always, cash for us is tactical. If we think that there's going to be better opportunities down the road, we'd rather wait and put that cash to work when we're getting paid the right yield. We know that that that will happen, We do get hiccups in markets, whether it's longer term or shorter term hiccups, we have opportunities to put cash to work. And I think we've been waiting to do that.

Shawn Eubanks: Thanks Brad. Turning to Carl, Carl, what do you think the Fed will be doing in the medium term? What policy changes should we expect?

Carl Kaufman: Well, they're certainly going to be talking more and doing less, as they have been. I think they are starting to talk about talking about taper. We don't know when that's going to happen, but it seems to be a little more frequent now with members of the FOMC in their speaking engagements are bringing it up more. So I'm guessing that they're probably getting close. I would not expect much there till year end. They still firmly believe that inflation is transitory. What I think we need to watch, and they have a history of doing this, is if the markets change their mind and stop believing and start reacting in a way that shows that they don't believe the Fed, they will likely change their strategy on a dime, and quickly do whatever the market seems to be saying they should be doing.

So I would keep that in the back of your mind. So far, the market has acted exactly the way they expected and we got a huge spike in inflation today, as you saw, and the markets did the same thing they did the last time. You got a little more flattening. We had a 30-year auction today that went very well. The equity markets are showing a little weakness. That's exactly how they would like things to be. Now, if bonds had corrected three, four points on that inflation spike, and the equity markets were down 2, 3%, that would get their attention and may change their thinking if that persisted. So I'd keep an eye on the markets more than on what the Fed is talking about, because they've been saying the same thing for quite a while.

Shawn Eubanks: Interesting. Brad, can you take a second and just remind the audience why non-investment grade bonds may be a good option in a potentially rising interest rate environment going forward?

Brad Kane: Yeah. Typically, rising rate environment is a sign the economy has been growing, and obviously the Fed is looking to control potential inflation and calm the temper of growth. But in that scenario, non-investment grade companies and their bonds benefit in two ways. First, growing economies were a healthy backdrop for profits and expansion. And that allows below investment companies to continue to grow. A lot of them are higher growth, smaller businesses. We see corporate leverage declining, interest coverage increasing, which all leads to, typically leads to, higher bond prices.

Second, below investment grade typically have higher coupons than investment grade companies. They typically have shorter durations. So there is more cushion to absorb the rise and the risk-free rate, and there's more spread as we always talk about that compensates you, as rates are beginning to rise. Investment grade is priced much tighter spread, so they have typically much closer coupons to where Treasuries are. And so they don't have the same type of cushion to absorb that quick or sustainable rate rise.

And remember, a lot of investment grade companies typically issue 20, 30, sometimes 40-year bonds, which have very long durations, and duration historically, or it actually is a way to look at the price sensitivity of a bond. So the longer the duration, the much more price sensitive a bond will be. So if you see rates begin to rise, those yields have to expand. And as yields expand on investment grade with long durations, that means prices go down, and they can go down pretty significantly. Below investment grade in a rising rate environment seems to be a much more cushioned environment to invest in.

Shawn Eubanks: Thank you, Brad. So we'll now begin the Q and A, and as noted on the slide, please ask a question through the Q and A window, or raise your hand to ask a question over computer audio or by phone. We do have one question from the audience already. Let's see, we've heard a lot of talk about employers having trouble hiring workers because unemployment benefits increased during the pandemic. Can you talk about the long-term implications for business and the economy based on this?

Carl Kaufman: Sure. I mean, clearly we have nine million unemployed and we have nine million job openings. So there's clearly a mismatch there somewhere. I think it's been speculated that some of it is caused by the generous benefits that they're getting. And as you know today, people start getting $300 a month checks for each child they have, if you're a below a certain income level. So that's going to just extend that discussion. I don't think that's the entire story, however. I think a lot of people that were in jobs like fast food and places where you're near a lot of people, they just felt that the risk/reward of going back with a pandemic to that type of work, they weren't comfortable doing it. Plus they were getting the benefits. I think a number of people have actually taken the shelter-in-place time to gain new skills.

So what we're seeing is there's a number that we look at, which is the voluntary departure, the people quitting their jobs. So the quit rate is at a cyclical high. It's almost near an all-time high, which means that people have confidence in their ability to land a better paying job. So that is part of the picture as well, is you've got a lot of these people who are just leaving their jobs for higher paying jobs. So it's making it very tough for employers to find qualified people at wages that they were used to paying.

So it's going to take a while for them to adjust to paying more, whether it's a warehouse worker that might've been earning $10 an hour, a company may have to pay $15 an hour. It's going to take time for that to happen. I think longer term people will eventually find a seat and will be productive. And speaking of productivity, we are seeing really good productivity increases at companies. So that also supports the ability to pay higher wages. So I think it will happen, and I think people will get paid more. I think the wealth gap will close eventually. It won't even out, but it will certainly pull back a little bit. I think overall that's healthy.

Shawn Eubanks: Thanks, Carl. On a go-forward basis, post-reopening, are there any secular trends or particular sectors that you're looking to allocate to, or are you at this point just waiting for the reopening to play out before allocating mindshare beyond the near term?

Carl Kaufman: That's a very good question. Very thoughtful. I think that our view is that people don't change in the long term. They typically change in the near term due to circumstances. So I think that over weighting sectors that you believe people may gravitate more to or less to, I think is tricky. A perfect example would be our people saw an article recently about fast food chains, that people are just not going to them anymore. I think that once we reopen, people will come back to those. In some areas they've been very busy and others they haven't.

So over-allocating to one sector or two sectors based on expected changes in human behavior is really tough. I think that, as I've pointed out in the past, people lead their lives pretty much the way they have. People generally don't make large changes in their behavior. You may make a tweak here or a tweak there, but I don't think it's enough to really change positioning for the long-term. I hope that answers the question.

Shawn Eubanks: Thank you. Can you spend some time and discuss the evolution of the portfolio a little bit more and where you are? Are you de-risking and can you still find opportunities with many high yield bonds at all-time lows in terms of yield?

Carl Kaufman: Sure. We find opportunities. Now, I will say that the opportunities don't pay as much as they did five years ago, but then again that's the market. So you have to play within what the market gives you and you have to parse risk and opportunity within that framework. Given that, the high yield market yields about 4% right now. So when you're dealing with a market that yields 4%, what is a good value? A high quality company with a five-year bond that yield say 5% is actually attractive. If you think that rates aren't going to rise for a couple of years, in two years you'll have a three-year bond with a five coupon, which will be fairly low risk. So you have to think in terms of a couple of steps ahead, and what you think is the most likely complexion of the market a couple of years out in order to do that.

So we're not getting the really obvious plays, but you have to take your value where you find it. But there are still some very strong companies out there that are issuing paper that are at yields that are above the average for the market. I'm not unwilling to buy a slightly longer piece of paper if it has an above market yield, because I don't think yields are going to move up dramatically in the future. They may move up to more normal levels like we had pre-pandemic. I think 1.5% short-term rates, while it seems pretty juicy today, is not all that high.

I think you have to just get yourself into a mindset that you have to accept the slightly lower yield on the portfolio. Otherwise, you're stretching for quality, or maybe you're buying some sponsored deal that has the cards stacked against you, or you're buying really long-term paper to get that yield. And you really want to have a portfolio that can balance value, in other words, buying attractive yields, but also be able to protect in a correction. That's really the important thing that we're always mindful of is the ability for the portfolio to withstand a correction and deploy cash at irrational levels during that correction.

Brad Kane: The other thing I would just add to that is that some of the companies that some of the better quality companies that we like that are coming with lower coupons than we would like to see and longer maturities that we're not playing, it doesn't take a lot of hiccup in the market for those, because of their durations, to drop a couple of points and then start to yield into the levels where we think it would make sense to add it back. So even though we may not find a lot of the new issue that are coming that interesting, they get interesting to us once we start to see the yields move a little more. So we're always keeping an eye on what's coming and trying to pick the best names and keep them in the back of our head, as those are names that we want to add when the markets move our way.

Shawn Eubanks: Great. Thank you. Can you provide some color around the current convertibles position and equity allocation in the portfolio, particularly as it relates to the historical allocations and the average? Is it high or low relatively? At what point do you become more uncomfortable with equity market beta in the portfolio?

Carl Kaufman: The convertible part of the portfolio has been coming down a little bit. We do have about 8.5% in convertible, 8.9% in convertibles right now. Not all of that is equity beta. We do have some busted. I'd say about a 6.5 is equity sensitive at this point. So that is a little higher than normal, but it's not a big enough part of the portfolio to really cause us to be nervous, but it is a source of alpha in the portfolio.

So as you can see, it's not a huge part of the portfolio. The equity part of the portfolio consists primarily of two issues that we purposefully took through bankruptcy, one of which is one of our larger positions. It just happens to be a private company at this point, so we can't really sell it at this point, but it's been doing very, very well and has taken its debt down to below one times leverage. We also own bonds in that company, so we're pretty happy with that.

Shawn Eubanks: So I do have a question just about yields in general and spread duration on the portfolio today. Could you talk a little bit about that?

Carl Kaufman: Sure. I want you to keep in mind, so we have stated yields on the portfolio. So the yield to maturity is roughly four-and-a-quarter. And the yield to worst is 3.07, but I want to put a big asterisk there, because our convertible portfolio has negative yields to maturity and even more negative yields to theoretical worst the way they're calculated.

Shawn Eubanks: Okay. Okay. Well, Carl, any closing comments before we-

Carl Kaufman: I just want to thank you all for attending. This environment is not optimal for grabbing yield, but the total returns are still pretty good. I think the backdrop is very constructive, as Brad talked about, for at least the next couple of quarters and possibly beyond that. And we don't see any huge expected headwinds out there for the market for years to come. So I don't think we're going to have a recession or something like that, that occurs naturally in maybe a Black Swan event that we can't predict. But by the very nature, we can't predict it. But that's all I have to say. We'll just keep doing what we do.

Shawn Eubanks: Thank you, Carl, and thank you, Brad, and thanks for everyone for joining us today.

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

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

Fed is short for Federal Reserve.

The Federal Open Market Committee (FOMC) is the branch of the Federal Reserve System (FRS) that determines the direction of monetary policy specifically by directing open market operations (OMO).

The job openings and labor turnover survey (JOLTS) is a survey done by the United States Bureau of Labor Statistics (BLS) within the Department of Labor to help measure job vacancies.

Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.

Duration measures the sensitivity of a fixed income security’s price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.

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

A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.

The yield to worst (YTW) is the lowest potential yield that can be received on a bond, assuming there is no default.

Treasuries (including bonds, notes, and bills) are securities sold by the federal government to consumers and investors to fund its operations. They are all backed by “the full faith and credit of the United States government“ and thus are considered free of default risk.

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

Coupon is the interest rate stated on a bond when it’s issued. The coupon is typically paid semiannually.

Yield to maturity is the rate of return anticipated on a bond if it is held until the maturity date.

Treasury Inflation-Protected Security (TIPS) are a type of Treasury security issued by the U.S. government that is indexed to inflation in order to protect investors from a decline in the purchasing power of their money. As inflation rises, TIPS adjust in price to maintain its real value.

Spread is the difference in yield between a risk-free asset such as a U.S. Treasury bond and another security with the same maturity but of lesser quality.

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

Investment grade and non-investment grade (high yield) categories are determined by credit ratings from Standard and Poor’s and Moody’s, which are private independent rating services that assign grades to bonds to represent their credit quality. The issues are evaluated based on such factors as the bond issuer’s financial strength, or its ability to pay a bond’s principal and interest in a timely fashion. Standard and Poor’s ratings are expressed as letters ranging from ‘AAA’, which is the highest grade, to ‘D’, which is the lowest grade. Moody’s ratings are expressed as letters and numbers ranging from ‘Aaa’, which is the highest grade, to ‘C’, which is the lowest grade. A Standard and Poor’s rating of BBB- or higher is considered investment grade. A Moody’s rating of Baa3 or higher is considered investment grade. A Standard and Poor’s rating below BBB- is considered non-investment grade. A Moody’s rating below Baa3 is considered non-investment grade. If an issue is rated by both agencies, the higher rating is used to determine the sector. Fund breakdown by credit ratings are based on Standard and Poor’s ratings. Not Rated Securities consists of securities not rated by either agency, including common stocks, if any.

Alpha is a measure of the difference between the portfolio’s actual return versus its expected performance, given its level of risk as measured by Beta. It is a measure of the historical movement of a portfolio’s performance not explained by movements of the market. It is also referred to as a portfolio’s non-systematic return.

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

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

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

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

One cannot invest directly in an index.

Click here to read the prospectus.

The Osterweis Strategic Income Fund may invest in debt securities that are un-rated or rated below investment grade. Lower-rated securities may present an increased possibility of default, price volatility or illiquidity compared to higher-rated securities. The Fund may invest in foreign and emerging market securities, which involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks may increase for emerging markets. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Small- and mid-capitalization companies tend to have limited liquidity and greater price volatility than large-capitalization companies. Higher turnover rates may result in increased transaction costs, which could impact performance. From time to time, the Fund may have concentrated positions in one or more sectors subjecting the Fund to sector emphasis risk. The Fund may invest in municipal securities which are subject to the risk of default.

Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [OSTE-20210713-0278]