October 11 Webinar Replay - Osterweis Strategic Income Fund Q3 Update

Shawn Eubanks: Good morning, everyone. And gentlemen, it's great to be with you today. Carl, as usual, I'd like to start things off by asking you about your big-picture thoughts on the economy. The question of a soft landing continues to loom over the markets, and I'm sure the audience would love to hear your take on that.

Carl Kaufman: Of course, and good morning to everyone. Thank you for joining us. Fundamentally, the economy has been much more resilient than expected. We've been saying it's the watched pot that won't boil. For months now economists and pundits have been predicting a recession, but it just isn't happening, not yet anyway.

We think the strength of the U.S. consumer is the main reason. Consumer spending, if you remember, is 70% of GDP, and unemployment remains low and wages are growing. As you can see by the strikes that are going on, labor seems to be gaining a larger share of capital, and that's basically good for the economy. May not be great for profits at the margin, but good for spending. Consumer net wealth is only slightly off its all-time high. Credit card debt is near 20-year lows in relative terms. Consumer debt burden is near 40-year lows. And as long as the labor force remains healthy, consumers should be able to keep spending, which should keep the soft landing in play at the worst, no recession at best.

Shawn Eubanks: Okay, that's reassuring, Carl. Thanks. But markets obviously performed pretty poorly in the third quarter, particularly fixed income. The Bloomberg Aggregate Index lost over 3% for the period and is now negative for the year. Equities also declined in the third quarter, though they are still positive year-to-date. Why do you think the market struggled if the economy's still in good shape?

Carl Kaufman: Well, ironically, I think that's the reason for the bond weakness. When the tightening program first started, everyone, including the Fed, thought it would be a fairly short process to get inflation back under control. Back in March of 2022, at the beginning of the hiking cycle, if you looked at the Fed's own forecast, the infamous dot plot, it showed that two out of three governors were expecting short rates below 3% by mid-2023. Clearly, that didn't happen. Here we are in late '23 and the fed funds target is 5.5%.

The Fed realizes that to control inflation, it has to keep rates high and can't give up too soon. And since the economy is holding up well, they clearly have been communicating they plan to leave rates where they are for as long as is necessary. During the third quarter, investors, I think, began to appreciate the fact that higher rates are going to be with us for a while, and the markets adjusted. In the third quarter, it was a mini version of 2022 when all the markets sort of fell in lockstep with the Fed when they first started tightening. Also, keep in mind that September historically has been the worst month for markets, not October as some people think.

Shawn Eubanks: Thanks, Carl. Craig, despite the market's poor third quarter performance, I've heard you say that investors still have a risk-on mentality. Can you explain what you mean by that and why it matters?

Craig Manchuck: Sure. Thanks, Shawn. For the most part, it was really a seller's market in the third quarter. In the quarter, we've had tremendous amount of tightening that happened in the high-yield market. Spreads are pretty close to where they had been at their lows. We've had situations where banks were able to unload some of the deals that they've had on their books from the bridged LBO transactions for several years. We also saw a number of transactions that either were explicitly or could be perceived to be dividend deals where the proceeds of the deals were either being used to buy back stock or to return capital to limited partners to their LBO sponsors.

So we're sitting around the 18-month tights both in the IG and the high-yield world and it just makes it difficult for us to find tremendous amount of cheapness, and I say cheapness meaning really cheap stuff out there. Now of course, we always say the same thing. It's not a bond market, it's a market of bonds. So we're finding select opportunities here and there. But we're being increasingly particular in where we're actually putting new money to work. There just doesn't seem to make a lot of sense for us to go out and extend duration again and try to go either out the duration curve or down the credit curve to pick up a little bit of extra yield when the gift horse really that the market's been giving us has been in the higher-quality, one-to-two-year paper where we're earning really attractive returns, much higher than we've seen in a long time.

Shawn Eubanks: Thanks, Craig. That makes a lot of sense. Brad, can you talk about the current portfolio positioning, particularly given what Craig's saying about the high yield market in general?

Bradley Kane: Yeah, sure. Thanks. Well, as we've been saying for a while now that we thought the Fed was going to hold rates higher for longer. And so using that as a backdrop, we've been leaning into the inverted curve and buying a lot on the shorter end where we're getting paid a very generous yield versus taking longer duration risk. And so for example, if you can buy one-month commercial paper, one-year investment-grade corporates in the 6 and 7% area, you're getting paid to sit and wait versus going out and buying 10-year bonds that are yielding something similar, because you're taking a lot more duration risk while you wait to see what's going to happen with the economy.

So really the zero to two-year is where we've been focusing a fair amount of the portfolio. I would say we have bought some longer paper where we think we're getting paid and where it's been reasonable credit. Away from that, it's really just waiting and watching and getting paid to sit and wait. As Craig said, we always try to find the most attractive areas and right now that seems to be the inverted short part of the curve.

Shawn Eubanks: Thanks, Brad. Craig, what's been happening on the new issuance calendar? Did the risk-on mentality impact supply?

Craig Manchuck: It has a little bit, but there's been increased issuance. A lot of it is really refinancings. And some of the companies that might've otherwise waited a little longer to refi have seen this tightening in the market and said, "If we're going to be in a higher for longer rate regime, it makes sense for us then to try to do something now." So we've seen most of the activity really come among the refinancings.

The good news is for the market, deals are getting done and coupons are higher. So what that means in aggregate, there's a lot more coupon out there in the market. I think that's healthy for us. It creates a better opportunity set for us to find things that we would like to own in the future. We've found a few other things out there recently that we like but that aren't quite at our price, so we're adding to our watch list a number of names. So again, as that opportunity set grows, it's really good for us.

The other thing I think it's interesting is just to watch what's been going on with flows. Interestingly, flows in both IG and high yield have really been quite negative in the last quarter or so. So I think a lot of that money has moved to the sidelines either in short Treasuries or in cash, and that suggests to me that at some point in the future that money probably comes back in and again, will provide even further support for the market down the road.

So very interesting time to be here right now, and we kind of like where we're positioned in the opportunity set that's in front of us.

Shawn Eubanks: Thanks, Craig. Carl, I'd like to zoom out a little bit and ask you about the latest dysfunction in Washington. As I'm sure the audience knows, early last week Congress forced Kevin McCarthy to step down as Speaker of the House and there's currently not a new speaker in place. Do you think the situation in our nation's capital is a concern for investors or is this just a lot of noise as long as the economy remains healthy?

Carl Kaufman: So far, it's just noise. Other nations are clearly watching and they're not very impressed with our government at this point. But it doesn't really impact the markets that are mostly focused on the economy and interest rates. The next budget deadline is coming up in mid-November, which is only a few weeks away, so that may have an impact. But as we've seen, there always seems to be an 11th-hour deal to extend and kick the can down the road.

Markets could get a little jittery if we don't have a speaker in the House in the next few weeks, but we'll have to see. Fingers crossed that we don't get to a point where we can't even pass "kick the can down the road." Generally, I think government does find a way to get it done with or without a speaker.

Shawn Eubanks: Thanks. Before we open up the floor to Q and A, I wanted to pull up the performance slide if we could. And Carl, do you have anything that you'd like to add?

Carl Kaufman: I don't know that there's much I can add to that slide except that we continue to invest the only way we know how, which is to be comfortable playing defense as long as it takes and have enough liquid capital to pounce when necessary.

Shawn Eubanks: Great, thank you. And we're going to start the Q&A in a few minutes, so please ask a question through the Q&A window or raise your hand if you'd like to ask a question over computer audio or by phone. I know everyone always wants to hear about the portfolio statistics. So here's a few stats as of quarter end, at the end of the third quarter. The weighted average coupon was 5.69%. The weighted average effective duration was 2.28. The weighted average years to maturity was 3.04. And the weighted average yield to maturity was 8.47%. And the 30-day SEC yield was 7.23% as of the end of the third quarter.

And while we're waiting for questions, Carl, can you talk a little bit more about inflation? You mentioned the Fed is planning to keep rates higher longer, but most inflation metrics have been coming down from their peaks. So why is the Fed keeping rates so high?

Carl Kaufman: Well, a few things. One, inflation is still well above the target, the Fed's 2% target, depending on which measure of inflation you look at. And there are many flavors of inflation that they look at, but the ones they look at are still above that. So they want to keep the pressure on inflation, make sure it doesn't get out of control. Also, they want to avoid a 1970s-type rebound where they have to really overreach in terms of fed funds rates to get it back under control.

There is some hope in their strategy because they have been playing it very deliberately, but hopefully it works. Powell knows well the story of the '70s and does not want that happening again. Also, with energy prices soaring right now due to the conflict in the Middle East and labor costs continuing to rise, I think the Fed knows its work is not finished yet. So stay tuned.

Shawn Eubanks: Thanks, Carl. So I have a question here about the percentage of cash and cash alternatives. Can you talk a little bit about that?

Carl Kaufman: Sure. We're keeping roughly 20% in cash and cash alternatives right now. And the one shift that has happened in the last, call it three to four months is that commercial paper is not as widely available because corporations are seeing the inverted yield curve and funding to the three-year area, which is a little bit cheaper for them in investment grade than funding at six months or one month or three months. So they're choosing to put in some shorter-term financing at yields that are equivalent, but at least they're fixed for the next three years. So hopefully they will take those out if rates fall. And if they don't, they fix their rate for three years. So that's why we have been gradually shifting away from commercial paper and into one-to-two-year type, higher-quality paper where we're getting better yields than commercial paper.

Shawn Eubanks: Thanks. At what point do you get concerned with reinvestment risk when consistently buying at the short end of the curve?

Carl Kaufman: I am not worried about it. A, because we can move fairly quickly and B, because we're predominantly... I mean, reinvestment risk typically happens when you have high coupon paper rolling and yields are lower than what you expected. With an impending recession and a slightly weakening economy, although still healthy, I just don't see yields getting low enough to cause us to have a problem to reinvest. There's always a part of the market that you can invest in that is attractive and has low volatility the way we've always done.

Bradley Kane: The thing I would also add is, as everyone knows with finite maturities on bonds, as we move through time, a lot of those bonds get shorter, and so they start to fall into that shorter-term or medium-term bucket. So there may be bonds that are a little long today for us and three months down the road they're starting to fall into that kind of yield range and maturity range that we would look at. And as we've pointed out before, or at least the high-yield market is a trillion three and we're a $5 billion fund. So there is a lot of opportunity to find paper in the markets.

Craig Manchuck: And Shawn, just one more thing. That cash, just remember the cash is not a static number. The cash is cash that moves through the system. So new cash comes in, other cash is constantly being reinvested. So the cash doesn't just sit there. While it's been around the same area, it's just because of where we're finding opportunities and how we feel about the rate environment and wanting to keep a fair amount of ballast. I keep using that word ballast in the portfolio because it just anchors us and keeps us from getting hurt really badly as a lot of people have in the last few weeks, prior to yesterday, as rates have backed up. It really benefits us by having all that at the shorter end until there's greater clarity in our sort of rate environment.

Bradley Kane: Well, and on cash you're earning over 5%. So there's definitely benefits. There's not a drag as there was a year and half ago on cash or shorter term.

Shawn Eubanks: Good point. How are you thinking about the maturity wall that many people are talking about and what's your perspective on the overall economy based on the maturity wall and then in terms of managing the strategic income portfolio?

Carl Kaufman: Well, I will say this, that 24% of the high yield market matures in the next three years. That's a fairly low number. CFOs have done their job. They have pushed out maturities when rates were low, and they have longer fixed bonds outstanding. . These are big high yield issuers that have a lot of resources and a lot of cash currently. So they'll be able to take care of those pretty well. We're not too worried about the maturity wall. I've been hearing about this maturity wall for the last 20 years and it has yet to cause a problem.

Shawn Eubanks: Yeah. At what point do longer Treasuries and agencies become attractive to you and the team?

Carl Kaufman: The long-term Treasuries become attractive when A, rates are high, but that's not enough. You also have to be sitting right on the verge of the Fed cutting rates. Otherwise, you're giving up returns by buying the highest-quality instrument. Last time that happened was July of '07 as some long-term investors remember,. Rates were high, fed funds rates were at the high point in the cycle, and the Fed was talking about bringing the big bazooka out. That means they're going to be lowering interest rates. So when you get that kind of chatter and rates are high, that's the time you want to buy.

Shawn Eubanks: Okay. Are there any sectors in the economy that give you pause regarding credit risk...

Carl Kaufman: Oh, absolutely.

Shawn Eubanks: ... concern?

Carl Kaufman: Absolutely. We typically avoid sectors that A, don't throw off any free cash flow. We avoid sectors like biotech, for example. So we don't play biotech. We avoid companies that have very high leverage and have diminishing cash flows. We try to avoid deep cyclicals. So things like chemicals and things like that that really get hurt in a downturn. And we avoid, it's not really a sector, but it's bonds. As you've heard Craig talk in the past, bonds where management and owners' interests are not aligned with bond holders. And that principally is private equity-sponsored deals where they add a lot of leverage to the company, sometimes too much. And especially today with the market demanding high coupons, places an undue burden on the company, but also you're always wondering how that sponsor is going to suck cash out of the company and weaken the collateral. So we just would rather not play there. We do avoid large swaths of the market that has those characteristics.

Craig Manchuck: We continue to stay away from banks and regional banks as well because any deposit-taking institutions, we saw what happened in the first quarter, if people get nervous, how quickly those can kind of dry up and evaporate. So those I think are just not good risk/reward investments for us at all either.

And there have been areas of telecom too, certainly the wire line parts of telecom and cable that are showing signs of cord-cutting as more sort of video moves to streaming. There are still opportunities in those sectors, but we've chosen to sort of lean more into the secured part of the capital structures in those areas versus the unsecureds, because the unsecured debt there has really been taking a beating in a number of those different companies in the telecom space.

Shawn Eubanks: Okay, that was our final question. Any final comments?

Carl Kaufman: I would just like to thank everybody for their support, and we will continue to manage money the only way we know how, which is worked for 21 years, hopefully it works for another 21.

Bradley Kane: Cheers.

Shawn Eubanks: Thank you all. Have a great day, everyone.