Published on April 16, 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 our first quarter update for the Osterweis Strategic Income Fund. At this time, all participants are in a listen only mode. Later, we'll conduct a question and answer session via the online chat and through your computer. We'll hold off questions until the end, but if you would like to get your question into the queue, please raise your hand or enter your question in the chat box. Please note that this webinar is being recorded.

As with the last quarter, I'll be moderating a discussion with Carl Kaufman, Brad Kane, and Craig Manchuck. After our discussion, we'll open the line up for your questions.

Let's begin with a question for Carl. The credit markets continued their rise in the first quarter, and how do you feel generally about the health of the markets currently?

Carl Kaufman: Thank you, Shawn.

Well, we are actually very constructive on the economic outlook underpinning the markets. We've certainly have started to pick up speed on the vaccines. We have seen a significant drop in reported infections. There are clearly a few spiky areas still. We're starting to see a gradual reopening of the economy. I think the pent up demand is showing itself. And certainly if you drive by any restaurant they're full, people want to attend, get back to normal life.

The Conference Board Consumer Confidence Index, which hit a low of 85.70 a year ago April, has been steadily increasing and it's about 109.70 now. And certainly the job market is robust. There are lots of job openings now. And I think we still have a ways to go before we get the economy back to pre-pandemic levels.

In terms of unemployment, we've been averaging over 800,000 a week since December, in terms of job creation. Initial jobless claims have been dropping and hopefully we continue to see improvement. So healthy employment, coupled with a recently signed stimulus package, should give consumers more money to spend and should continue to propel the economic recovery.

Shawn Eubanks: Thanks Carl.

Next, a question for Craig. Now that the vaccination effort is well underway, how do you think about investing for the reopening of the economy?

Craig Manchuck: Good morning, Shawn. Thanks.

Reopening beneficiaries have actually been moving for many, many months. You had to look to see which companies the market would support. Meaning, were they going to be able to raise significant money to bridge the decline back when Covid hit last year. The cruise lines, airlines theme parks, restaurants, food service, travel-related companies. These were all industries that were kind of part of everyday life pre-Covid and they were hit very, very hard. And those are the companies that are the beneficiaries in a reopening trade.

But you can't wait until now to play that; these things have been moving from months. So for example, you had Southwest Airlines or Carnival Cruise or Norwegian Cruise or Six Flags. They all raised money in April and May of last year. And had we waited till it was clear that we were reopening, we would've missed some huge returns well within their convertible debt and in their straight debt.

So what we're doing right now is we're kind of reviewing which of the work-from-home companies that have been the biggest beneficiaries are going to be sustained and which will tail off as the economy gets back to the new normal. We have to be looking forward six to 12 months to anticipate where we will be. And that's a lot trickier now that we're in the early stage of reopening. It was actually a little bit easier I think even at the bottom of the market, because we just assumed okay, we're not going to stay down here forever. And we could see which companies were being supported and where the markets would say, "Hey, we'll apply capital because we believe longer-term that you'll recover."

What we don't have right now is any idea how long it takes to get to 90 or 100 percent of normal. We don't know what tax policy is going to be. We don't know what capital allocation is going to be for these companies. And how quickly does government allow business to get back to normal? It's also possible we could get another spike in winter time.

So we're just being sort of very careful and cautious about trying to identify which companies have visible and sustainable runway here. And so for the next sort of 12 to 18 months, we'll be able to protect us from any real hiccups or ugly fundamentals.

Shawn Eubanks: Thanks Craig.

Carl, given all this positive kind of macro-economic news, are there any flashing or cautionary lights in the market today that are giving you pause?

Carl Kaufman: It's a good question Shawn.

As with any time when the Fed floods the market with liquidity and to keep things in perspective, the liquidity that they flushed through the system was bigger than all of the liquidity they flushed through following the 2008 great financial crisis. So there's a lot of money sloshing around out there. Not all of it is finding its way to the real economy. A lot of that is finding its way into the markets and creating, whether you call them bubblets, or bubbles, or excesses, I'll go over a few of them.

One is, you read earlier this year, Robinhood traders seemed to have latched on to some of these names in day trading. If you saw GameStop went from $19 to $483 in a month. We've since raised the margin requirements for accounts at Robinhood and brokers like them, so it seems to have settled down a bit. But you look at Bitcoin has gone from 29,000 to 63,000 recently.

SPACs, which are an area of the market that you may not be familiar with. Special Purpose Acquisition Companies. They have been around for a long time and they typically represented ten percent of the IPO market. What they are, are "blank check" companies that allow the issuers to take two to three years to find a private company to acquire. And since your SPAC is already public, it's another way of taking a company public.

There has been a rash of issuance over the last year or so. I said they used to be ten percent of the IPO market, year-to-date they are 75% of the IPO market. So everybody's issuing one. We keep on thinking, we should probably issue one, but we haven't done it yet.

The other one that sort of caught our eye recently is this notion of non-fungible tokens [NFTs], which I'm sure you've read about. These are basically rights to an electronic version of something. Typically a work of art or a film clip. The NBA, for example, has sold $400 million worth of these. Now you don't own the clip. The NBA can show that clip anytime they want, they can resell it if they want. You just own a digital copy of it. And someone paid $69 million for a piece of art from a graphic designer who is laughing all the way to the bank on that one. And Sotheby's just had an auction. And it's ongoing today, the second day of it, for NFTs.

So, whatever you call it, they are signs that we do have some excesses in the marketplace and excess liquidity. At some point when the economy recovers, hopefully that liquidity will get pulled and we'll have a more normal, these excesses will not exist anymore. Hopefully.

Shawn Eubanks: Thanks, Carl. Brad, how should we be thinking about these excesses when building the portfolio?

Brad Kane: Thanks, Shawn.

You know, we've been careful and cautious. I think a lot of this, while we've seen a lot of the run in equity prices in these non-security products, there has been a big rush of cash into the fixed income markets. And you're seeing a lot of long duration new issues get done at pretty low yields. So you're seeing things right now come to market where there's not much difference between what we may hold in a two- to three-year maturity yield, the company may come with a new eight- to 10-year piece of paper that's only 50 basis points wider in yield. So there's not a very big difference there. And I think that's where we're seeing it. You're essentially not getting compensated for that volatility risk, which is why we were staying very research- and duration-focused.

I think you need to look at all these business models and these investment products and figure out how many of them are based on hopes and dreams and how many are actually based on good business models and good sustainable ideas.

As Carl mentioned, are all SPACs going to find good companies to buy at good valuations? Probably not. NFTs, we're not sure if it's the next Beanie Baby craze, if it's already peaked and we saw as soon as that $69 million art piece traded, the next art piece that traded was a lot lower. So we don't know how much of this is coming in waves. But we're definitely keeping an eye on it because it could bleed into other sectors of our market.

Right now it's really just the amount of cash going into long duration fixed income, which is driving yields down. And obviously that does drive shorter term yields down too. But much of what we're seeing in the market right now is based on fear of missing out and getting rich quick. And we know those schemes don't last forever and typically don't end well. So what we're doing is focusing our research on good, sustainable business models, as we have been, and trying to not let those excess levels that we see out there, kind of get in the way of finding good entry points.

And where we do see valuations elevated in our market, we're going to take profits and pare down positions and wait for a correction or better entry points to add some of that back or to add on to positions.

But overall, I would say that a lot of that excess that we're seeing, it hasn't been as direct in our market, which is a good thing.

Shawn Eubanks: That's great. Thanks Brad.

Craig, how should we think about inflation and the recent rise in long-term yields and Treasuries that have really had an effect on the investment grade market so far?

Craig Manchuck: Inflation? Well it's here and more is coming. And the Fed is probably going to continue to let the yield curve do what it's going to do unless we see a big selloff in risk assets. I don't think they want to get into a yield curve control that would be potentially problematic for longer term.

If we do see a sharp selloff in equity prices or other risk assets, I suspect that they're going to want to quell any ascent in the rise in sort of eight- to 10-year Treasuries. But look, we're about to see significant inflation in certain pockets here, because we're coming up against very easy comps. So for example, airfare, lodging away from home, and apparel all had precipitous drops last March, April, May. And so when we see reported numbers, CPI, that part of the market is going to look like there's significant inflation because the comps year over year are so depressed and easy.

Other areas there'll be some amelioration. But my guess is overall, we've been talking about this for years, about how there is inflation but because of the hedonic adjustments that that makes, it doesn't count as inflation. Pars go up in price but because they offer more features, those hedonic adjustments down suggest that there isn't any inflation in our price.

So we think that there will certainly be a temporary spike. The Fed wants it, and they're going to get it. Do we think that structurally long-term, it's going to be sustainable and impossible to manage? Probably not, but it still does bear close watch. I think we've got expectations of a slightly higher rate on the ten-year Treasury over the next six-to-12 months than where it currently is right now. But not terribly painfully so for the way we're invested. I do think it's probably still quite a significant headwind for the typical benchmark IG strategy though.

Shawn Eubanks: Thanks, Craig.

My last question is for Carl. How is the portfolio position now, and how has that evolved since year end?

Carl Kaufman: Thank you, Shawn.

We tend to make incremental changes to the portfolio as you know, we don't tend to go crazy. Convertibles are about ten percent, which is similar. What we have been doing is we continue to replace some convertibles that have gotten too far away. A number of our convertibles have more than doubled. One has more than tripled. We've been shaving those and buying more new convertibles near the par level. So while the weighting has remained the same, the equity sensitivity is coming down a little bit.

In terms of the duration in the portfolio. It's about 1.9 at quarter end, which is higher than it's been. And that has partly a couple of things to do with that. One is we are losing at an accelerating rate, our ultra-high coupon, and by ultra-high I mean anything over eight percent, bonds as companies that come up on their call-ability and companies refinance them into lower coupons. So those are going away. And they're generally being replaced with bonds that have lower coupons and a little more duration.

The yield to maturity on the portfolio has also come down a little bit as we lose these high coupon bonds. It's about 440 right now, which is equivalent to the single B portion of the high yield markets. So we're happy with that. And we do have about a little more than half the duration. So we're happy with that.

And we continue to underweight things like triple Cs, we only have about two percent of the portfolio in triple Cs and more speculative names because we feel now is the point in the marketplace where you are seeing a little more speculative performance. The triple Cs have been the best performing part of the high yield market for a couple of quarters now, but that typically doesn't last forever. So we're being very cautious there.

So all in all it looks similar, but we're making some small changes beneath the surface now to give us a little more downside protection and give us sort of better quality in the portfolio.

Shawn Eubanks: Thanks Carl. With that I think we'll now begin the Q & A and as noted on the slide, please ask a question through the Q & A chat window, or raise your hand to ask a question over computer audio or by phone.

We do have a question from the participants. Brad, maybe you can answer this one. Do you think the economic recovery will cause the Fed to taper their QE program this year? And what would be the implications if they do decide to do that?

Brad Kane: Yeah, that's a good question. I think they're doing everything in their power to say they will not be tapering for quite a few years. And Powell has been out talking about it. It really is something that we keep an eye on only because it will impact. You've seen a little bit of it back in the 10-year and the 30-year yields. The Treasury's yields, backing up a little bit. Given that they want to keep short-term rates pretty low until they really see inflation. And as Craig said that the inflation that we see coming is not what the Fed calculates, and for some of it, it's what the Fed actually excludes in their calculations.

And so I think they're doing everything in their power to keep that tapering at a minimum, if any. But if they did taper, I think you would start to see rates begin to creep up. And they may creep up on their own just as we see the economy continue to grow as we reopen. But I think the Fed has done everything they can to try to say they're not going to taper anytime this year. I don't know if Carl or Craig want to chime in and add anything to that.

Carl Kaufman: Well, I think you've pretty much covered it. The Fed is sitting on the short end of the curve and they are not going to stop until the economy has recouped all of the job losses that they've lost during the pandemic. And inflation is above two, two and a half percent for a bit of time. So we have a while before that takes place. They keep on raising the bar on inflation. So they're leaving themselves a lot of options to stay where they are.

Shawn Eubanks: Great.

Carl, can you talk a little bit about how that economic recovery and then now the infrastructure plan impacts high yield markets compared to the investment grade bond market?

Carl Kaufman: Well, it's a nuanced answer because there are, as you know, high yield companies tend to benefit to a greater proportion from small positive changes in the economy. And also if they are in the sectors that we're talking about, like a lot of home builders, for example, are not investment grade, a lot of building supply companies, aggregate companies. There are a lot of companies that feed into the infrastructure spending if we do get the bill passed soon. So they would benefit inordinately versus, say, a huge investment grade company, which would benefit, but their bonds are already trading very, very tightly and at very low yields. So I don't think that they would see the impact to their bonds that you would in say a high yield issuer. But we have to see the shape and the duration, they're talking a ten-year infrastructure program. So it's not like you're getting a trillion dollars a year. You'd be getting $200 billion a year, which is better than nothing. And we need infrastructure in this country, rebuilding certainly. But it may not be the panacea that people are thinking about.

Shawn Eubanks: Thanks. I'll throw this out to the group, but can you give a few examples of positions that you've taken profits in during Q1?

Craig Manchuck: I'll take that one Carl.

Carl Kaufman: I was going to give it to you.

Craig Manchuck: Yeah. Look, we've had a number of convertible positions that have done extremely well. And one example is Cree. Cree is a company that is in the process of building a, I think it's going to be a billion and a half dollar Fab in the Hudson Valley in New York to make silicon carbide wafers. And the important thing of silicon carbide is, it is both lighter and uses less power than typical silicon. It's the next generation of silicon for semiconductor chips. The silicon carbide is a very, very difficult product to actually work with. They've got the longest history in the world of manufacturing and tremendous amount of IP. But this is all going to lead into electric vehicles [EVs]. So all the EVs want to transition from silicon to silicon carbide because it's lighter and it uses less power and it'll ultimately extend driving ranges on their car.

So it's a great long-term project for Cree to enter into. However, the stock has run from 40 to 120 over this period of time. So it's significantly discounting the success of the production coming out of this plant, which really doesn't start until late '22 or 2023. And we just felt that the convertible, which had been in the 80s and had rallied to about 200 and were getting a little bit equity sensitive for us up here, we just thought the risk/reward doesn't look as attractive. And so we have been scaling back that position.

There have been other convertibles that we've done similar things with, another: Chart Industries, which is a company that makes tanks and those tanks are going to be used for hydrogen storage. So now that hydrogen is becoming the energy source of the day for how people see the future, that stock rallies, the same thing, those bonds rallied from the 80s up to double par. So we just feel like when they get up to that level they become purely like equity trades and the risk/reward didn't look as favorable. Nice successful trades, but we're happy to move on and look for new ones that provide better risk/reward characteristics.

Shawn Eubanks: Thanks Craig.

I'll throw this one out to the group as well. Have you considered adding to floating rate or inflation protected securities, given your expectations for higher inflation?

Carl Kaufman: I'll take that one Shawn, this is Carl.

We look at them all the time, but the problem with floating rate notes is that most of them are investment grade. And as you might imagine, they float off of short-term rates, LIBOR or SOFR, and those rates are near zero right now. So the yields that you're getting on those securities are extremely low right now. We still have a few floating rate notes in our portfolio that are left over from when they were cheap in 2018 when we bought most of them. But they're going to be maturing this year.

Also, inflation protected securities like TIPs, the breakevens on those, you want to buy those when the breakevens are very low, meaning the hurdle rate they have to surpass versus cash-pay treasuries is low. They have moved up. And so the hurdle rate is higher.

So you're basically forgoing current income in the hopes that you make it up with higher inflation. The problem is that we feel that Treasuries, although they have moved higher in rate recently, are still not terribly cheap. And when you factor in a discount for the inflation protection on the back end, they get pretty rich. So it's a cheaper version of a rich bond, so to speak.

So there are no effective ways for us to play that and get a return that we feel is meaningful. So while we look at it constantly, I think our investment grade team will do that, because their mandate is to play an investment grade, which we feel is not quite cheap enough for us to play yet. But we'll keep looking if there's an opportunity, we'll certainly take it, in floating rate especially. But right now the spreads are very tight and the yields are very low. And we can get much better yields in non-inflation, non-floating rate paper.

Shawn Eubanks: Thanks Carl.

I know the strategy was really designed to have the flexibility to make gradual shifts or move opportunistically between credit and investment grade bonds. Maybe you can just talk a little bit about when you've bought investment grade bonds in the past and what it would take to make them attractive again for this portfolio.

Carl Kaufman: Sure.

The time you want to buy investment grade bonds as a cyclical play is when rates are, I'm going to use air quotes here, high. And the Fed is about to embark on a rate cutting cycle.

The last time rates were sort of high was in 2007, when the Fed Funds was at five and a quarter. And the Fed was about to embark on a rate cutting cycle because we had the whole mortgage morass to deal with. That was the last time we actually made an allocation to Treasuries in the fund.

Since then, rates have been low. And while they have gone lower, as they did last year dropping from one and a quarter to zero percent, they weren't high to begin with. Clearly, money could have been made, but you see this year, investment grade is down three to four percent in the first quarter, down more than that since. And the problem when you play with low interest rates and investment grade vehicles is that you can lose some principle fairly quickly. And that's something that we just abhor in our fund. So we'll wait for the Fed to raise rates and hopefully they raise them too much and they choke off the recovery and we can buy Treasuries again.

Shawn Eubanks: Thanks Carl.

So I don't believe we have any additional questions. Do you have any kind of closing remarks, Carl?

Carl Kaufman: Yes. I just want to thank everybody for calling in and investing. And I just want to sort of close with this thought, that there are times in the market when you can stretch to get more yield either by going down in quality or out in duration. And as Brad mentioned, you're not getting paid that much more to go out in duration and take that volatility. So this is one of those times where you just have to accept that you're going to have a slightly lower yield in the portfolio for a period of time until we get back to an equilibrium where we can start putting away some bonds with decent yields on them again. So with that, I just want to thank everybody and look forward to talking with you in the future.

Shawn Eubanks: Thanks Carl, Brad, Craig.

Brad Kane: Oh, our pleasure.

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.

The Bank of America Merrill Lynch U.S. Cash Pay High Yield Index tracks the performance of U.S. dollar denominated below investment grade corporate debt, currently in a coupon paying period, that is publicly issued in the U.S. domestic market.

Fed is short for Federal Reserve.

A special purpose acquisition company (SPAC) is a company with no commercial operations that is formed strictly to raise capital through an initial public offering (IPO) for the purpose of acquiring an existing company. Also known as “blank check companies,” SPACs have been around for decades.

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.

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.

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 Conference Board Consumer Confidence Index® (CCI) is a barometer of the health of the U.S. economy from the perspective of the consumer. The index is based on consumers’ perceptions of current business and employment conditions, as well as their expectations for six months hence regarding business conditions, employment, and income.

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.

QE refers to Quantitative Easing.

The secured overnight financing rate (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans that is replacing the London interbank offered rate (LIBOR).

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.

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-20210413-0189]