Published on April 19, 2022

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. I'm Shawn Eubanks, and I'd like to welcome you to our first quarter update for the Osterweis Strategic Income Fund. First, I'll be moderating a brief discussion with Carl Kaufman, Craig Manchuck, and Brad Kane. After our discussion, we'll open the line for your questions. Let's begin. Carl, the first quarter obviously was very challenging and most major indexes finished in negative territory. And bonds had one of their worst quarters in decades. Would you provide a little perspective on what you're seeing?

Carl Kaufman: Sure. Certainly, the first quarter was no picnic. We certainly have a lot to think about, and the markets in the first quarter really were a little bit taken by surprise by the war in Ukraine, certainly, but also towards the end of the quarter, inflation started to become the prime worry. And up until very recently, Fed communication on that, on what they were going to do was a bit unclear. And as you know, markets hate uncertainty more than anything else. We can discuss it in more detail if you want. But I think those are the major concerns of the market is inflation, a war with certainly repercussions regarding not only inflation, but humanitarian and possibly a recession down the road.

Shawn Eubanks: Okay. Well, maybe we can just talk a little bit about the effects of the war a little bit more. Clearly energy prices have increased since the invasion, but there are a few other implications that aren't quite as obvious. What are some of the issues you think investors should be paying attention to right now?

Carl Kaufman: Well, certainly, the war has changed the narrative. It seems that economically speaking, Ukraine and Russia are not major powerhouses. They are, however, major exporters of some commodities, such as wheat. They a supply 30 to 40% of wheat exports, mostly into the middle east and Europe. They do supply commodities such as nickel, and we've seen prices on both of those spike quite a bit. And as you remember, back when Arab Spring was in full bloom, part of the reason was an increase in bread prices; there's one thing that you cannot have go on for too long is taking people's bread away. And certainly this will have an impact on people's bread prices, especially in poorer countries that import most of their wheat from Ukraine and Russia. Certainly, commodity prices were spiking, especially oil, although Russia is a powerhouse and one of the largest exporters of oil, whether they sell that oil through back channels remains to be seen, I believe they will, but you can't just turn on a switch and ship it out the back door.

It's not quite that simple. They have pipelines and cargo ships that need to be rerouted. So, this is not going to happen immediately, so there is disruption. We're seeing it here in terms of higher gas prices, certainly affecting people who have to commute or drive for work. And it's affecting everything from plane fairs to shipping costs. So, it is going to have an effect, I think inflation is going to be here longer and possibly higher than expected, which has certainly galvanized the Fed to focus on inflation. And I think now that we have our first rate hike under our belts, we're prepared for more. The markets certainly are discounting some of that.

Shawn Eubanks: Okay. Thank you, Carl. Broadly speaking, obviously the war has increased inflationary pressure on the economy, which isn't great given that inflation was already running at a much higher rate than it had been for a long time. Can you talk about the Fed's plan to combat price increases and discuss some of the risks involved.

Carl Kaufman: Well, you're assuming that the Fed has a plan, first of all, I'm sure they have some general idea, but they have limited tools. They basically can raise rates to curb demand, which hopefully brings prices back in line. That is what they're going to do. They have indicated that they are on it. They have not said how far they'll raise rates, they have not said ... I mean, they've kind of outlined how much they will shrink the balance sheet. I think they need to be more aggressive, but it's just one man's opinion. There is the question of whether they can engineer a soft landing. There are a few examples in the past, but it's not going to be easy.

Roberto Perli, at ISI, which is an economic firm that we use did talk about that and showed sort of in the past how we've had a few soft landings. Since 1961, there have been exactly three times when the Fed raised the fed funds rate above which they considered the natural rate. That's the elusive level where economic activity is neither helped nor hurt without causing a recession. And that was in 1965, 1984, and 1994. We're cautiously optimistic they might be able to do it again, but even if they succeed, there probably will be some collateral damage along the way. In 1994, which was one of those instances, they certainly almost put Orange County retirement system out of business. They had a large levered bet on interest rates that effectively they did send into bankruptcy, but they're back now. But certainly there are a lot of leveraged investors today.

I don't think anyone who's sanctioned is unaware that the Fed will be raising rates. So hopefully, no one is too offside. So, we don't expect anything systemically significant this cycle, but certainly equity markets and valuations will get hit. They already have. The question is how much more? The one difference that we have this time is that the economy was very strong going into this. The war has created an extra layer of inflation. And so I think that the economy can withstand higher rates, but sentiment can change things fairly quickly and meaningfully. So, we'll have to watch that. So far, in the U.S., from what I can see, demand is still very strong from the companies we talk to, business is still very, very good. Although we do have supply shortages and labor shortages still. So we have very low unemployment going in. Does it get softer? Absolutely. Does it go into a long and drawn out recession? I don't know.

Shawn Eubanks: Okay. Thank you, Carl. Craig, can you talk about some of the other non-war related inflationary pressures that are still creating problems in the economy going forward?

Craig Manchuck: Sure. Good morning, Shawn. There are still significant problems in the supply chain, especially as it relates to Asia. Right now, we're in the middle of a complete lockdown in Shanghai and we don't really know yet how that's going to permeate to other parts of the country over there. We will continue to see problems with getting product, whether it's raw material or finished goods coming out of China. And I think that will continue to keep prices up, but the industrial metals complexes, copper, aluminum, steel, they were all up sharply before the Russian invasion and they continue to sort of stay at those levels, in some case move even higher. On the other hand lumber, which is very interesting, lumber's had a huge run as well, and that has come off pretty significant recently down about 35% or so in say the last month.

So perhaps that's a sign of some things easing a bit here. Our lumber is fairly significantly domestically produced here between the U.S. and Canada, but we're starting to see signs of some easing of housing prices in Canada and perhaps with mortgage rates moving higher and affordability getting a little bit trickier, that will slow a bit, so some of the raw materials in that industry ought to take a bit of a pause. But I did just receive some information this morning from a company called Winsight Grocer, and Winsight reported today that grocery prices were up 10% year-over-year in March, it's an average across all products, it's according to the Bureau of Labor Statistics.

And that's the highest increase that we've seen year-over-year. So it was up 8.6% over February year over year and 7.4 in January. So, food is still picking up steam and we see beef is up 16% year-over-year, chicken is up 13%, citrus fruits are up 19%. So, still significant pain being felt at the grocery store, and similarly, restaurant pricing is up seven to 8% year-over-year. So, not many places to hide right now from inflation, even away from whatever is going on or being impacted by what's happening in Russia and Ukraine.

Shawn Eubanks: That's interesting. Thanks, Craig. Brad, we've been discussing a lot of bad news so far, but in general, the U.S. economy seems to be pretty healthy, and unemployment is at record lows. What's your assessment of the economy at this point and how worried are you about recession?

Brad Kane: Yeah. Thanks, Shawn. I would say that your comments about it being pretty healthy is an accurate picture. I mean, just using what we've seen as GDP as a rough guide, the economy's continuing to grow at a faster rate than it has the last few years. In addition, consumers, their balance sheet has gotten healthier and household debt as a percentage of GDP is back down to pre-pandemic levels and continuing a trend of declining since 2009. Job opening statistics, I know Carl mentioned unemployment; job opening statistics are at 21-year highs. And the quits rate, which we've talked about in the past, is near a two decade high. So, the employment picture's good, consumer balance sheets are much better, while companies are having to pay more as we've seen in averagely hourly earnings, that's good for the consumers.

And I would say though, we temper this with a little cautiousness about how fast the Fed is going to do its rate increases and how quickly the markets react to the Fed's balance sheet reduction. And, as Carl mentioned, I mean, the Fed is on a path to raise rates. We just don't know how quickly and how long we'll do it. But I would say we don't think we're going to see Volker-type rates again, 20% plus like we did when Volker was head of the Fed. The economy's in a better place though. So it can absorb the higher growth as consumers can, the economy can. We are seeing states running surpluses, which is helping to soften the blow of some of the inflation. Craig mentioned food prices and other things.

We're having gasoline prices. Everybody sees that, but you have places like California where they're talking about sending checks to citizens, as long as they own a car, whether it's an electric vehicle or a gas-powered vehicle, they're talking about sending a check to help alleviate some of the extra costs. They say it's for fuel, but I think it's for general increase in prices of things. And just yesterday, I saw the Biden administration's talking about raising the ethanol content in gas for the summer driving season, which would lower the amount of oil product that's in the gas, but it would raise ... Obviously, it's a gift to corn growers, but it would raise demand for corn prices.

So, you're not going to get one benefit without some added cost somewhere else. But I would say that the one thing, as Craig mentioned, we've seen inflation in food and stuff. Other than food in shelter or in used cars, if you're not in the market to buy a new house right now, or in the market to buy a new car, your inflation basket's going to be a little bit different, and you may not see some of the same rates that you see in the headlines. So consumer investor sentiment is impacted by the headlines, but I think as people start to get used to some of these prices and move through, they'll realize not everything impacts them the same. And so we're pretty optimistic on the economy, but we are tempering it with the realization that the Fed is going to be active.

Shawn Eubanks: Thanks, Brad. That's really helpful. Craig, going back to you, can you spend a minute talking about how the markets are digesting all this information? How is high yield and the investment grade (IG) bond market responding to these various market headwinds?

Craig Manchuck: Well, IG obviously has been the most directly impacted by rates and it's just the way that market trades. And so that's why it's traded off as much as it has. Most of the IG market is a longer duration market because historically among corporates, they've been able to, the IG companies have been able to borrow the longest and borrow at the lowest coupon. So as a result, there's a very, very long duration that exists within the IG market. And that is obviously the most negatively affected when we're in a rising rate environment.

Fortunately, high yield with the higher coupons and the, on average, shorter tenor of maturities, it has been impacted somewhat, but not anywhere near to the degree that the IG market has. Within high yield, we could see some spread widening if there are significant fears that grow that we're going to run into a recession in the short run. But if the economy continues to kind of chug along, slows down but doesn't go into a recession, those spreads should stay, and in some cases could even tighten from here. So, while we're in this rising rate regime, high yield does seem to be a much better place to be, and certainly a much better risk-adjusted place to be than IG.

Shawn Eubanks: Thanks, Craig. Can you talk a little bit about high yield issuance in the last quarter and any general trends over the past few quarters that you're seeing in the high yield market?

Craig Manchuck: Yeah. Issuance was extremely light in the first quarter. One of the lightest that we've seen in a long time and total issuance was only about $54 billion. And if you compare that to 2021, it's almost exactly one third of what we saw in '21; we had 162 billion that was issued in the first quarter of '21. So, it was a combination, I think, of companies that were waiting or hoping that the soft start to the year would sort of firm up and they'd have a better window to issue into. But also I think there was some pause given by the investment community, not wanting to just buy whatever the investment banks had for sale. Some of the pressure that we saw on the market though, did come from the investment banks, because there were a number of deals that were backstopped either in the third or fourth quarter of last year.

And those deals were largely sponsor-backed leveraged buyouts, and the investment banks were on the hook. They gave committed financing, they had cap rates at which they were willing to lend money, and then they had to turn around and come to market and try to raise that money in the public market. So that's been a little bit difficult, put a little bit of pressure on new issue pricing in the quarter, which we think is healthy because now it'll create more yield in the market. Where we are now, we haven't seen the yields that we see right now in a few years. We see some very attractive pricing as a result of both rates rising and some of the pressure that's come from these new issues that are being pushed out.

But we're treading cautiously because the tide still seems to be going out a bit, although as we get down to levels of 7 and 8% where we can find some really good companies and invest in those kind of rates, we find those pretty attractive. The one interesting dynamic, I think that's happened though, that sort of bears watching, and it doesn't have a direct effect on us per se, but it's somewhat indirect is that we're starting to see private credit start to step in and disintermediate some of the banks and investment banks. And what they're doing. I'll give you one example, there was a very significant deal announced, a leveraged buyout of a company called Anaplan Software Company that's been purchased by Thoma Bravo for about 11 billion dollars. And what's interesting is Thoma Bravo said, they're going to put somewhere between 3 and 4 billion in and borrow between 7 and 8 billion dollars.

The investment banks looked at the credit metrics and said, "This is a company that only generates 600 million dollars in revenues, so if we put seven or 8 billion dollars in debt on that, that's going to be somewhere between, maybe call it 700 and 800 million of interest expense annually." These numbers don't add up to credit investors. So, the banks paused and passed on that deal. And private credit guys stepped in. Now, we looked at that and we said, "Gosh, this is crazy." It's uber aggressive for somebody to lend a company seven or 8 billion dollars and have interest expense exceed the top line revenues of the business. So, it sort of raises a bit of a red flag for us about what's going on in the private credit world?

And interestingly in the first quarter, some of my conversations that I've had with people where they've thought private credit has done really great because we haven't seen the markdowns that we've seen in the public markets. And my comment on that was just, "Well, I guess you'd better wait and see, because they don't necessarily have to mark the market the way we do." But that could be a sort of lurking landmine, if you will, out there that we start to see some private credit markdowns and things coming in future quarters. So, it definitely bears watching. And that's kind of a stress point that lurks underneath the surfaces of the markets out there.

Shawn Eubanks: Thanks, Craig, that's an important consideration in private credit world. If it's okay with you guys, why don't we transition to the fund right now, Strategic Income Fund, and we'll quickly show the performance, which has been strong particularly on a relative basis. And as we move through that slide, Brad, can you talk a little bit about the fund positioning right now?

Brad Kane: Sure, sure, absolutely. As I mentioned before, we're optimistic on the economy and growth and the uncertainty of course of how the Fed's going to raise rates. So that's been tempering our positioning. But as you know, we don't change the portfolio quarter to quarter just based on a whim. It really is a gradual change over time based on the macroeconomic outlook. So, I would say that the portfolio is actually somewhat similar to how we started the year. It's a pretty defensive posture. We've keeping plenty of cash and very short term like one month CP on hand so that as that stuff, as we see market opportunities, we can easily take of them. Since the end of the year, we've increased our double B exposure a little bit and decreased the single B and below.

But again, just a little bit, it hasn't been a material change in the way the portfolio is laid out. We have been putting cash to work and at the same time we've had some bonds called or refinanced out into levels where we didn't think you were getting paid in the new deals.. But as we always talked about the cash is changes, the content of what made up the cash changes, it's still some getting put to work. But as Craig mentioned, yields are starting to get into interesting levels, but they're still not quite there yet. So when we find an opportunity, there are not tons of them right now, we're taking our time and really staying as defensive as we can.

Lately, spreads have been moving quite a bit. As you just look at the headlines and how stocks are doing and where Treasuries are, I think spreads have been a little bit more volatile lately, but we're really waiting to see a trend in one direction, hopefully wider so that we can buy stuff at better yields. But at the same time, if you look at the shape of the yield curve, what was kind of ... everyone was a few weeks ago, a month ago, everyone was talking about all these inverted curves. Well, the curve is actually starting to normalize and look like a typical yield curve. And so right now though, short-term yields are pretty comparable to long-term yields. There's not a big difference in our market. And so we're still finding that we'd rather stay very short-term focused and not really take the duration risk, or until we can see some longer yields.

And I think that's what's going to take is continued raising, the Fed raising rates and the market starting to digest that, get used to it and raise the yields that they're looking for, or we get another taper tantrum type freak out. And we get yields ratchet higher quickly, and we get that fat pitch we've been waiting for. And we're able to put cash to work in a significant amount, as opposed to ones and twos or one deal or two deals at a time. So staying defensive, but ready to pounce when the market gives us those opportunities. I would just say stay tuned.

Shawn Eubanks: Thanks, Brad. That sounds very prudent. Carl, while we display the portfolio characteristics and statistics and before we open up the floor to Q&A, do you have anything you'd like to add?

Carl Kaufman: Sure. I just want to remind people that this is a long game and we do have quarters here, quarters there where performance and the markets are down. But given the way we are positioned, we believe that we will come back. We have in the past. I don't think markets stay down forever. Humans are generally optimistic. And I think wars do end, although they're not good things by any stretch. But from what we can tell, we try to control the things we can control and not worry about the things that we, well, we worry about them, but we don't try to control the things we can't control. So we're trying to find good companies that will continue to do well even in tough times, inflationary times, and we will get through this. And hopefully, as Brad said, we will get an opportunity either over time or in a tantrum situation where we can put some really good company bonds in the portfolio at very nice yields, which should pay off over time.

Shawn Eubanks: Okay. Thank you all. I guess we'll now begin the Q&A. So, we do have a question that came in before today's call. China has been fairly supportive of Russia throughout this war, and experts are warning that they may be thinking of taking a similar action in Taiwan. What do you think the economic ramifications of that would be?

Carl Kaufman: The U.S. and China are for better or worse linked at the hip. They're still our biggest trading partner and they need us, we need them. So they are walking a very fine line right now trying to be as neutral as possible while not taking sides. It is a very tough position they are in. They also, from what I understand, this zero Covid policy is damaging their economy as well as hurting our import prices. Because when you shut down a major manufacturing hub, that's got to hurt. So it flows into shipping, and I understand there are hundreds of ships waiting to unload and reload in the ports of China. And they're just not being let in because of the shutdowns.

I mean, personally, I'm an amateur virologist now, but I think that the zero Covid policy is just going to extend their waves in China, rather than letting a lot of people get sick, get them natural immunity and move on the way a lot of the rest of the world has. They have not. Viruses don't take to that. They'll wait until the opportunity shows itself to infect as many people as possible. And the way viruses do that is they get less potent, but more transmissible. So, it's a pretty tough job they've got. I think we're about to enter into trade talks with China. I mean, phase one, which has been going on for years, they still haven't lived up to that. They haven't bought as much as they said they would. But as food prices rise, they're going to feel that as well. So, it's unclear how this all pans out, but I think eventually economic self-interest does win out and I think it's in their economic best interest to keep good relations with the U.S. Hopefully, that answers the question.

Shawn Eubanks: Yeah. Thank you, Carl. I have a question, usual question is what's the portfolio yield and duration, and I know Brad talked a little bit about deploying the cash, but kind of how are you thinking about deploying cash or building up cash in this last quarter?

Carl Kaufman: Well, as Brad mentioned, the cash is pretty much the same in terms of a nominal level or percentage of the portfolio. In terms of yield, the yields are slightly higher. I think they're in the mid fives. The duration is still in the mid to high twos. That compares to the high yield market has a yield at the end of the quarter high fives, probably 6% and a duration of 4.23, somewhere around there. So, we are similar area in terms of yield. That includes in our portfolio, but not the benchmark convertibles, which have a negative yield to maturity.

That brings down our stated yield, if you were to look just at the high yield bonds, I think we're equivalent to the high yield market. But our duration is much lower. So we have less risk. In terms of cash, it's opportunity based. If we don't find any opportunities, we're going to let it grow. But we are finding some. As Craig likes to say, this is a market of bonds, not a bond market. So you'll find bonds will come down own sort of one by one to levels where eventually the market ends up, hopefully. And so as opportunities present themselves, we'll utilize the cash.

Shawn Eubanks: Thanks, Carl. And had another question kind of about the overall use of the cash in the portfolio. But the question was also asking about areas where you're seeing opportunities. So are there any areas that seem particularly attractive in the last quarter?

Carl Kaufman: No, it's been company by company.

Shawn Eubanks: Okay. And then we have a question here. When do you start positioning the portfolio for a soft or not-so-soft landing or potential recession? What changes in the portfolio would you begin to make and when will you start positioning the portfolio for those types of events?

Carl Kaufman: Well, I think we already have positioned the portfolio for a soft landing, in terms of a not-so-soft landing, we'll have to see on that, but we're pretty well positioned for a soft landing. The typical positioning for that is to buy Treasuries. But, in this case, we are not at the point yet where the Fed is going to be cutting rates anytime soon. So when we get to that point, and hopefully that will be accompanied by much higher rates in Treasuries, we can look at it at that time, but that's typically the way you do it, but it's far too early for that now, because rates are just starting their increase. So that would not be a smart positioning for us.

Shawn Eubanks: Okay. Have you noticed very many changes in the overall credit quality in the high yield market in the last few quarters?

Carl Kaufman: Last few quarters? No. But the last few years we've talked about this, the quality of the high yield market has gotten better. 53% of the market is now double B. That was probably 44% four to five years ago. So we are seeing a higher quality market, and I would expect that to hopefully continue unless we get a long and extended bear market and recession, then you might see some downgrades in the quality of the overall market might come down a little bit.

Shawn Eubanks: Okay. So it sounds like your cash position is relatively stable since the end of last quarter, but are there any kind of specific changes that you would say were made in the quarter in terms of higher quality companies or better yields available in this market? Any just kind of general themes?

Carl Kaufman: Well, one of the things we have done is we have added commercial paper. So we have cash, which some people may look at as being relatively low at 14% or something, that it's actually 8%. But if you look at cash, commercial paper, and bonds maturing under a year, it's around 18%. I think that in terms of major changes, Brad said we don't make major changes to the portfolio. We are mostly buying more of names that we already own and know, but at lower levels, so we're just adding to the position, lowering our cost basis.

Shawn Eubanks: Thanks. That kind of leads to the next question which is, 14% cash is relatively low for you, in uncertain times in the past, wasn't the cash position higher over previous quarters?

Carl Kaufman: Cash position was higher, we've been putting some of it to work on weakness, which is - that's our goal is when we do have weakness like this, we do put it to work. It's still fairly high and there's still a lot of cash coming in from companies redeeming their bonds and just maturing. That's the nature of a shorter term portfolio, you have things maturing all the time.

Shawn Eubanks: Okay.

Craig Manchuck: Yeah. Hey, Shawn, we also do have, I think it might even be as much as 4%, but I think between three and 4% of bonds outstanding of companies that are being acquired and the deals haven't closed yet, and they've announced that they're going to be redeeming the bond. So, those don't officially count as either being called or being matured in less than one year, but those are most likely a case like renewable energy, which is being acquired by an investment grade company, Chevron. Those bonds are going to be taken out as soon as the deal closes. We just don't know if it's going to be three months or six months. So there is still a fair amount of incremental ballast there that we could say is going to act cash-like, but even have a slightly higher yield than cash.

Brad Kane: Yeah. And I would just also add, there's a couple of higher coupon names in the portfolio that the maturities might be something like 2025, but they're callable in about two months, and given where the existing paper's trading, it highly likely some of those high coupon bonds will also get called. So if they don't, great, we've clipped yields longer. But again, a lot of what you don't see in the portfolio that doesn't show up as maturing in one year is either as Craig mentioned stuff getting ... may get take out because of M&A (merges and acquisitions) that's happening or bonds that are callable. And that's always the stuff that we're looking to buy in the short term, anyhow, is short-term callables.

Shawn Eubanks: That's great. It sounds like there's a lot liquidity there to take advantage of opportunities. We have a question about, it looks like you have a little over 5% of assets in equities and busted converts. In this difficult equity market, what are your thoughts on those positions and any opportunities going forward?

Carl Kaufman: Sure. The busted convertibles are more like bonds. So I would think that you'd want to look at equity sensitive convertibles and equities together. In terms of the equity sensitive convertibles, we have a lot of convertibles that are deeply in the money and we have been lightening up on those on days like today. So we have been consciously taking some profits there. In terms of the equity, I going to let Craig talk about the equities.

Craig Manchuck: Yeah. So, the two equity positions that we have, and we've talked about them for the last couple years, Real Alloy is one of them. And Real Alloy is a private aluminum recycler that we decided to take through a restructuring. The company has been restructured and we just announced in February, I guess, a significant asset sale where we're selling off the European operations and the proceeds from that should basically repay all the debt in probably roughly half of the value of the equity, even though the U.S. business is significantly larger. So we continue to own the U.S. side of that, but there'll be a fairly significant paydown that'll be coming later in the year. So, our dollars invested in that will go down significantly and the business will be substantially de-risked. Second one, Southeastern Grocers, as we talked about earlier with the grocery price inflation that's going on and food inflation, they're doing extremely well.

They just reported recently had another terrific quarter. Net leverage there is 0.1 time. So, the business is completely de-levered. We just were paid another dividend in the last month. And so the business continues to do well. We have been systematically reducing our exposure there as the new buyers have shown up that want to step into our position in that one. So we're very happy with the way both those have performed, not only performed, relatively will it perform positively on an absolute basis. But we will continue to manage those positions down and redeploy into more attractive fixed income opportunities as we see them coming along.

Shawn Eubanks: And Craig, those are the same equity positions that we had at the end of 2021 and have been in the...

Craig Manchuck: Correct. No new additions in the existing equity positions. We're just managing them down slowly and profitably.

Shawn Eubanks: Okay. I have another question here. This is a million dollar question. Do you think anyone can predict inflation, and are there any models or data sources that you rely on more than others for inflation?

Carl Kaufman: No, I don't think anybody can predict inflation. They can do it very short term, but not over the long term. Clearly, if you went back and looked at commentaries at the end of last year, there were still people saying that inflation would die down, not to worry about it. And then you get a war and everything goes to heck. So there are external factors that no one can predict that make it very difficult to forecast inflation. The measures of inflation that we look at, land of Fed has sort of two measures, sticky and non-sticky that we look at to see how persistent inflation will be. And those have always trended a little bit higher than reported CPI. So, we tend to look at those, but the Fed has no idea what really causes inflation nor can they predict it. And if they can't, I don't know what makes me think I can.

Shawn Eubanks: Okay. I know, Carl, our investment grade team does spend some time looking at UIG. Do you have any thoughts on UIG?

Carl Kaufman: That's one of them.

Shawn Eubanks: Yeah. Okay. Okay. Is the yield curve normalizing due to the Fed's minutes notes acceleration of the balance sheet runoff? What does this mean for MBS and fixed income markets in general? Any thoughts on that?

Carl Kaufman: Well, as we mentioned, the yield curve was inverted slightly for a while, now it's looking more normal. You can always find an inversion if you want it today. But I think generally two tens are what people look at, and that certainly has steepened. I think that what it means for mortgages and mortgage backed securities are still unclear because mortgage rates are very sticky on the way down and very fluid on the way up. And with mortgage rates being above 5% now, certainly it has not been great for mortgage backed securities. Certainly, refinancings are way off. That basically extends duration in the mortgage backed securities. Now, what's going to happen now, presumably is as the Fed raises rates, the whole curve will move up, as will mortgage rates. So, you'll get more of an increase in duration in mortgage backed securities. And at some point, they're going to be a screaming buy, but it's not yet.

Shawn Eubanks: Okay. I have a question on the maturity schedule for the holdings, saying it looks longer than normal. How will you create flexibility to take advantage of volatility on the come? I think you've kind of talked about your cash position and then your kind of cash substitutes. Maybe you can just elaborate a little bit more on that.

Carl Kaufman: Well, as we said, we have a lot of bonds that have long maturities, but also have above market coupons that are callable and a much shorter period of time. And we are very happy to hold those past those call dates, but we buy them with the intent that the companies will refinance those even in a rising interest rate environment, they usually do it with bank debt, which is much cheaper. And if they don't, we have a very steep yield-to-call curve. So yes, while we have a bit of a barbell on, we have roughly, call it 24% of the portfolio over a five duration. It's not excessive, but it is there, and it's mostly in bonds that we picked up at good prices and like longer term. We're base loading longer, we don't think high rates are going to be around forever. So, now is the time that you want to start looking at some longer-dated bonds when they become attractive and some have.

Shawn Eubanks: You mentioned that rates are higher in general for the high yield market, more in the double B category. I guess I know you guys don't rely too heavily on the rating agencies, but how comfortable are you with those general ratings and does your credit work validate that?

Carl Kaufman: That's a good question. As you know, we do our own credit work, and we basically feel as comfortable with the ratings today as we did five years ago, rating agencies today as we did five years ago, 10 years ago, 15 years ago. We don't think that they're right all the time. They generally get it sort of right. And there are more than one rating agency, sometimes they have differing opinions. As I say, we do our own work. It's just a measure for lack of a better source of at least a perception that the high yield market is in a better place from a credit perspective. And most of the time the companies that they rate double B are pretty good companies in many cases, not many of them.

In some cases they are fallen angels as well. Companies like Xerox that have been downgraded and probably will get upgraded at some point. So, they're generally bigger companies, more mature companies, have resources to see them through. So, I guess that's the only way I can answer the question is that we still look at them with a jaded view, they're typically behind the curve a little bit, and whether we see a bunch of downgrades and get the market back to where it was five years ago in terms of rating buckets, we'll have to see.

Shawn Eubanks: I know in the past, Carl, you've mentioned that the rating agencies tend to be a little bit more, I guess, backward-looking in terms of the current situation for the company and going back. But there's still opportunities when you're more forward looking to generate alpha-

Carl Kaufman: No question.

Shawn Eubanks: ... credit selection.

Carl Kaufman: No question. They take their time and want to see a lot of progress made before they upgrade or downgrade, guess progress lost. And the markets, unfortunately, don't wait for that. They try to be more predictive, especially in high yield, not so much in investment grade, which is a more homogenous market. So yes, if we see improvements coming at a company and we've seen it and we are comfortable with it, that's something that we can take advantage of. Not that an upgrade automatically means that people just pour into the bond, sometimes you feel like the guy in the far is screaming and no one's hearing you, but to the extent that that happens, we try to stay a little bit ahead as we are more forward-looking. And they will be the first to tell you that they are not forward predicting in their ratings. The ratings are not meant to predict the future, they are meant to reflect the present.

Shawn Eubanks: Okay. Well, thanks for all of our participants today for joining us. Carl, do you have any closing comments?

Carl Kaufman: I just want to thank everybody for their support and faith in us, and let's hope for sunnier days.

Shawn Eubanks: Thank you, Carl. Thanks, Brad. Thanks, Craig.

Brad Kane: You're welcome.

Craig Manchuck: Thank you.

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 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.

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period.

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

Investment grade (IG) 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.

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.

CP refers to Commercial Paper.

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

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.

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.

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.

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.

The Underlying Inflation Gauge (UIG) captures sustained movements in inflation from information contained in a broad set of price, real activity, and financial data.

Convexity measures the sensitivity of a fixed income security’s duration to changes in interest rates. Securities with lower convexity generally are more sensitive to interest rates than securities with comparable duration and yield but greater convexity. Option-Adjusted Convexity is a convexity calculation for securities with embedded options and takes into account that expected cash flows will fluctuate as interest rates change.

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.

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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-20220412-0483]