October 10 Webinar Replay - Osterweis Strategic Income Fund Q3 Update

Shawn Eubanks: Thanks everyone for joining us today. My name's Shawn Eubanks. I'm the director of business development at Osterweis Capital Management. We'd like to welcome you to the third quarter update for the Osterweis Strategic Income Fund. As usual, today I'll be moderating a panel discussion with Carl Kaufman, Craig Manchuck, Brad Kane and John Sheehan. Gentlemen, thank you all for joining us today. I know we have a lot of clients registered for this call.

Before we begin, I want to make sure that our listeners know that starting this month the fund will transition from quarterly income distributions to monthly income distributions. We think this will be helpful for investors who are using the fund for income. Distributions will occur near the end of the month and you can view the updated distribution schedule on Osterweis.com. Carl, as always, I'd like to start the discussion with you. It feels like the geopolitical environment is a little more fraught than usual right now, but somehow the U.S financial markets just keep setting new records. What do you make of that disconnect?

Carl Kaufman: Morning, Shawn, thank you everybody for joining us today. You're definitely right about the state of the world. Domestically of course, we've got the presidential election in about a month. Internationally, we've got the Middle East, we've got Ukraine, we've got China, and to top it all off regarding China, we also have an economic slowdown there, which is not a good thing. Still, as you point out, markets had a very strong third quarter and in truth the matter is that near term, none of the above seems to have any significant economic impact in the U.S. yet.

Clearly we kind of view this two ways. One is we have a clearly a rather robust wall of worry that the market seems to be climbing, no shortage of things to worry about. Of course, things could change if Iraq bombs Iranian oil fields that drive up the price of oil, that could have an impact on the markets, but for now the market seems to say low probability. In the meantime, the domestic economy remains healthy. The Fed has started to ease, to adjust to lower inflation. Wall Street seems to be in a buying mood, so we'll just continue keeping a tight hand on the rudder.

Shawn Eubanks: Thanks. And so do you think investors should be more concerned than they are or do you think these issues will mostly be background noise going forward?

Carl Kaufman: Well, obviously we don't know how these things are going to play out, so if you've been with us for a while, you know that we don't make bets on these type of outcomes anyway, but what we do think is that in general, investors seemed to become a little too aggressive lately. It seems that the risk on mentality of the past few months was driven by more the fear of missing out on the rally than by fundamentals. We see this a lot after long stretches of benign markets. Investors tend to forget about risks and they tend to discount the best case.

Shawn Eubanks: That's interesting. Craig, can you explain why that might be? Is this just a gut feeling or are there specific indicators that you're watching to tell you that the market's rich or overvalued?

Craig Manchuck: Morning, Shawn, thank you. I would say it's a little bit of both. We certainly look at a lot of fundamental indicators, spreads, levered stats, individual company fundamentals, but markets are always emotional. They just happen to tend to be most emotional at the extremes and a lot of times that inflection that could be at extreme lows or at extreme highs.

At lows we tend to see panic and at highs we tend to see fear and fear of missing out. It feels to us like that is the type of environment we are in, and as we look at the numbers, the fundamentals suggest to us, and the technicals suggest to us, that that may be the case. However, markets can stay elevated or they could stay depressed for long periods of time, so it's not as though we're necessarily calling for a collapse or a calamity. We have been spending a lot of time looking at the Treasury market and understanding, trying to understand why it's been trading the way it has.

We were a little bit perplexed in the last quarter to see the 10-year rally as hard as it did, it went from somewhere in the mid-four, to say four and a half percent, got down as low as 3.62 for a brief period in September, and we just thought that that was very, very overzealous. Market was aggressively leaning into what they anticipate will be several Fed cuts, which may or may not happen, but it was a little bit presumptuous we think, and went too far too fast. We have a number of research providers to us. One of whom we like particularly is a fellow by the name of Jim Bianco and we like his work and have looked at it for a long time.

He suggests that we probably should see something into the mid-fours as a more longer-term type of 10-year Treasury rate, and we tend to agree, I think a three and three-quarter to four and a half percent Treasury rate is a very reasonable range to expect. Three and three-quarters was a little bit too aggressive I think for the timing.

The other thing that's happened in this quarter that was really surprising is the returns in the high yield market were extremely strong, a five and a half percent return for high yield index. You think about that in context, if you look back over the last ten years, that would be I think either the fifth or sixth best year in high yield index returns that was all captured in one quarter. A lot of that was really driven by the CCCs, which had a return of nearly 12% in quarter, which is just astounding. We can see returns like that happen at times, but they tend to happen more frequently, CCCs when we're coming out of a recession, when depressed bond prices rebound sharply as the economic prospects brighten.

In this case, what we saw was a number of different events that drove the entire market up. Instead of them just being idiosyncratic events, they drove the entire CCC market to these tremendous returns. So that leaves a lot of investors holding CCCs with securities that are priced to perfection and probably not something where we expect to see significant total return from this point forward. So as we have said, for a long time we've been underweighting the CCCs, so of course we're a little disappointed that we lagged a bit in returns, but at this point forward we still see that as an area of heightened risk and we'd like to avoid it.

Shawn Eubanks: Thanks, Craig. On a related topic, Brad, I understand there's been an increase in credit events lately, which would support Craig's point that the CCC market rally may not be based on fundamentals. Can you talk about what you're seeing?

Brad Kane: Yeah, sure. What we've seen lately is as Craig said, lower rated companies outperforming, and I think that's because they've been kicking the can down the road and not facing the walls of maturities that they need to. I mean, historically you've seen defaults as the key metric in indicating a borrower hasn't met its obligations. More recently with weak covenants, a lot of companies are doing liability management exercises, or LMEs, to restructure debt now hoping to outperform down the road. And as we've discussed previously over the summer in a webinar, LMEs are typically highly coercive to the bond and loan market. They push lenders and bondholders to take haircuts in exchange for maybe a higher coupon and pushing maturity out. And so what you're doing is hoping that down the road the company will outperform from this, giving them a discount now and then you'll get your money back.

But the way statistically it's counted, it's still actually counted as a default in the way the indices and the rating agencies calculate them. So it's not as much a payment default now, but they count it as a default. And what we've seen this year is 28 companies have completed these liability management exchanges totaling about $35 billion in high yield and leverage loans, and that's two thirds of all default activity year-to-date. And that equals, almost equals a record from 2008 during the Great Financial Crisis. So there is a lot of money out there looking to kick the can down the road.

In fact, August was the third highest monthly total on record according to JP Morgan, and this is just the bond and the loan market that we see. This isn't even the private credit market and the private equity world. One recently, we saw a company called Pluralsight defaulted, and in that case the bondholder and leverage loan lenders wiped out about a billion two of their debt in exchange for adding new debt of about 300 million to the company just to help it restructure and survive.

The private equity sponsor flushed about $4 billion of their original investment. This is all in about 12 months from when it was issued. So we're seeing some high profile failures. We don't think this is the end of that trend and again, it's the kind of stuff that we tend to avoid and I think a lot of these private credit deals you're going to start to see that over the next few years is they've also been extremely over levered issuers.

Shawn Eubanks: Wow, that's a lot of unpaid debt and it sounds like a reason to worry too. John, can you talk about how your team avoids exposure to those types of bonds?

John Sheehan: Sure, Shawn. Our credit approval process is designed specifically to eliminate those types of credits. A concept that we've talked about many times is we like companies that are responsible stewards of capital. The Pluralsight example that Brad used, we wouldn't have thought that putting that much debt onto a company like Pluralsight was a responsible use of capital. Ultimately, they did default and the creditors took over the company and is now tasked with turning around a software company. Specifically to the private credit universe, it is our expectation that a lot of those credit events are going to take longer to come to the fore, one, because of the lack of transparency in the private credit product. Also, there's very little mark to market so you don't see those problems on a day-to-day basis like we do in the public markets. So we do look towards metrics like leverage.

A lot of these sponsor-backed deals have a substantial amount of leverage. We look to the use of the proceeds for the transactions. Many times the proceeds are paying dividends to the sponsors being used to buy back stock, all of which put the bondholders at greater risk. So our credit process is very thorough as we've talked about many times. It is a bottoms-up process where first and foremost we look at the prospects of the company. So we think that that process is going to catch many of those sponsor-backed deals that are starting to get into trouble right now.

With regards to liability management exercises that Brad mentioned, he used the word coercive. So a lot of times the companies come to the holders of the bonds and say, "We're going to default unless you accept these terms." So they're really terms that are presented as elective, but really the holders of the debt have very little choice. Here today, one of the largest names within the high yield universe, and we've talked about a fair amount Altice, news on the story that those bondholders are going to be forced to take a haircut on their bonds in exchange for equity in the company.

So that is a name that we've been watching very closely and it's just a great example of some of these coercive liability management exercises in the market today.

Shawn Eubanks: Thanks John. Carl, I'd like to circle back to where we started and ask for your near-to-medium-term economic outlook. It sounds like there's a lot happening right now and I'm wondering how you expect things to evolve over the next few months.

Carl Kaufman: Sure. Well for starters, we certainly hope that conflicts in the Middle East and Ukraine don't escalate from this point. They're both tragic humanitarian situations. Looking specifically at our domestic economy, we're of the opinion that despite all the noise out there, it is still in pretty good shape. Unemployment ticked up a little bit in August, but labor markets seem to have strengthened in September. Unemployment remains low by historical standards. This is probably the indicator that we, and clearly the Fed, are most focused on.

As long as this stays somewhere near its current level, we feel like the economy continue to chug along. We are seeing earnings at our companies are pretty good. We're not seeing any warning signs yet, and of course the Fed has begun to cut rates, which is hopefully stimulative to some degree and will help keep things moving along. So we are keeping our positioning accordingly.

Shawn Eubanks: Thanks, that all makes a lot of sense. Before we turn to the portfolio, I was hoping to ask one last question about the economy. We haven't talked much about inflation yet today, and although you mentioned earlier that you think it's still lurking beneath the surface, what do you mean by that and would you mind sharing your views on what you think the Fed may possibly do next?

John Sheehan: Sure, Shawn, I can take that one. So the Fed has a dual mandate. The two pieces of that are maximum employment and stable prices. So what they're trying to manage with their tools is to keep the economy growing, which is measured by employment, and to keep prices stable, meaning keep inflation in check. So if you look at the last several meetings, the Fed had been very much almost exclusively focused on the price part of their mandate. They're almost exclusively focused on bringing inflation down. However, in the last meeting where they chose to cut by 50 basis points, they started discussing some of the concerns that they've seen in the employment market where unemployment is still very low but has started to tick up a little bit.

So the Fed's stated objective is to bring the fed funds rate back to the neutral rate, which is the rate at which they feel the economy is neither being contracted or expanded as a result of their interest rate policy. So since they now were managing both sides of the dual mandate, that is our belief why they elected to go 50 basis points at the most recent meeting. I think if you look forward, as Carl alluded to, inflation has come down a lot, but it's still lingering. In today's CPI report came in above expectations. The month-over-month number came in at three-tenths, which is where it was last, but the market was expecting two-tenths. The year-over-year number came in at 2.4 so lower, but again, not by as much as the market had expected.

So we think with fed funds where they are now and inflation running at that kind of two four that the Fed still has room to come to bring back down towards the neutral rate. So we would expect measured cuts going forward from the Fed, but very much data-dependent and very much focusing on those two aspects of the dual mandate.

Shawn Eubanks: Thanks John. Brad, would you talk about the portfolio positioning and seems like the economy, you think the economy's doing okay, but some parts of the market are a little frothy. Where are you seeing value now, especially that short-term rates are starting to decline?

Brad Kane: Yeah, no problem Shawn. I know it sounds kind of like a broken record, but we've been saying for a while we were leaning into the inverted yield curve because short-dated bonds were yielding almost as much as longer-dated bonds and that approach has continued. Even with the Fed cut recently, we're still finding good value in the shorter term. I would say that depending on future cuts, we may need to reassess that and slowly transition, but again, nothing that we're seeing that's causing us to do it extremely rapidly. We have recently increased our exposure to investment grade bonds, mostly in the one- and two-year maturity range and our base case, as Carl said, still a healthy economy.

We're not seeing the big concerns out there, but if we're getting attractive yields on investment grade, we think that's a good head, should things change, should we be wrong about some of the positives, then we're going to have some cushion in the portfolio to weather some downturn. And of course we're remaining opportunistic. We have plenty of liquidity in the portfolio, so we're always looking for attractive deals when they come up.

Shawn Eubanks: Thanks Brad. Carl, any thoughts before we move on to the Q&A?

Carl Kaufman: For those who have with us for a while, know that we don't make bets on our expected outcomes, because that's fraught with risk. As always, we're going to keep looking at what the market is giving us and do our best not to stretch and find the areas that are most attractive and try to find the least risky way to play them. I know you've heard that before, but it's worked for 22 years. 

Shawn Eubanks: Music to my ears. Before we open up the floor to Q&A, here's the fund performance slide and we'll follow up with a few key portfolio statistics. Okay. Now we'll begin the Q&A and as noted on the slide, please ask a question to the Q&A at window or raise your hand to ask a question over computer audio or by phone. I know we had a question come in prior about the presidential race and: How's the election factoring into how you manage the fund in this environment?

Carl Kaufman: I'll take that one. As we've answered in the past, elections cause a lot of emotional distress but usually do not cause much economic distress or exuberance. Economic cycles and political cycles don't usually coincide. The economic cycle is going to do what it's going to do regardless of who's in the White House. They may have dent the direction a little bit here and there and sentiment, but people generally go about their lives and we've had good and bad economies under both administrations historically. So we will just have to wait and see who wins and take it from there, but I don't think much is going to change.

Shawn Eubanks: Thanks. Do you see any risks to your portfolio or the broader credit markets stemming from Helene and Milton?

Craig Manchuck: I'll take that. The answer is no, but we used to have, one of our favorite portfolio companies was actually based in Florida and they were hurricane window provider. Sadly they were merged with someone else. So unfortunately we're not still invested, but I recently spoke to a couple home builders that we have the portfolio that operate in the Southeastern U.S. They were unaffected. They did say that there would probably some modest near-term effects on lumber prices. We thought we were concerned about the possibility of lumber being cut off and maybe a spike in the Southeast due to the unusual nature of the flooding in central North Carolina, which is typically a big supplier of lumber, but that's mostly hardwoods and the pine suppliers to the general builders is a little bit more broadly disseminated.

So the answer was no there from them and we may see some labor dislocation as typically happens, the labor ends up moving around to areas hit by disasters for the rebuild, so that could happen with some of the home builders in particular, but we think that that's sort of a temporary situation. So at this point, nothing permanent and nobody tremendously disrupted.

Shawn Eubanks: Thanks Craig. I have a general question here about how do you avoid all the LMEs that are happening now on the market?

Brad Kane: I'm happy to take that one. It really comes down to doing your credit work and buying the types of companies that we like to look at. So when you're looking at companies that have lower leverage, are using the capital for growth and good stewards of capital not using the debt to pay a dividend or buy back stock, you're not levering up the company for ineffective purposes. You're using debt strategically to build a business and grow a business and grow your cash flow. We're big believers in free cash flow, so if a company is generating tons of free cash flow, that's how you pay your debts, that's how you keep current, but really it's coming back down to looking at low leverage. The higher the leverage, the more risk that you have that you have to grow into your capital structure and that's not a way that we look to invest.

The other thing is we, because of the way we manage and because we're benchmark agnostic, we can avoid and we can ignore large parts of the market and what happens there is you're not just buying, you're not following an index, so you're not having to buy some of those large levered LBOs that come to market because they're in the index and if you don't own them and you're an index fund, then you're going to be missing, you're going to have tracking error, not something we really worry about. And I think those are the types of deals where you're seeing guys have to go through the LME just because they're in the index and they're in the name, they need to stay in it.

If we find a name that for some reason one of our credits, something happens to it, they have a hurricane or they have earnings or they lose a big contract and it looks like financials are not performing, we can just sell out of the name and not worry about missing it because it's not in the index. And so if we see a name that something changes and it does look like, Hey, down the road this is going to be an LME, we can sell it and move on to the next name. That is kind of the beauty of having a very curated portfolio with less names in it.

Shawn Eubanks: Thanks, Brad. I do have another LME-related question. Are the LMEs and course of activity being allowed to occur due to covenant light issues and is this mainly in the CCC segment of the market?

Brad Kane: I would say yes to the first question. LMEs are allowed to happen because of the weak covenants. Historically, you would see companies either go into default or do an out-of-court restructuring with all the parties working together. With LMEs, because of the weaker covenant protection and some of the articles you've heard about creditor-on-creditor violence, what's happening is companies are moving out because the covenants allow them to, they can move assets away and force you to do coercive exchanges, and so it is typically one because of the covenants, two, because these deals raised a lot of debt for what I would consider ineffective purposes.

Whether or not it's all CCCs, that's what we're seeing so far. I'm sure there are, even if they're happening in the CCCs, if they have a secured piece of paper at the top of their capital structure, it may get par back and it may be let's say double B or single B-rated, it's still going to be part of the LME. It's just that they may not take that haircut as some of the lower rated tranches.

Shawn Eubanks: Thanks. I have a question regarding portfolio composition. Okay. Has the portfolio changed meaningfully over the past year? I'm thinking mostly about high yield versus investment grade percentages, but also convertibles.

Carl Kaufman: I'll take that one. It hasn't changed meaningfully. There have been a few items of change. One, as we mentioned, we are starting to lean a little bit more into investment grade and, as a matter of fact, I think we have the highest investment grade holdings, ex-commercial paper, that we've had since 2007, mostly in the shorter dated. On convertibles we have been finding more busted convertibles interestingly, so we have been increasing our exposure there. We're finding yields there to be competitive or greater than typical high yield or investment grade issues yields for mostly shorter dated under a year type convertibles. And most of those tend to carry a much higher cash balance on their balance sheet and a number of them are actually virtually de-feased, so it's a pretty easy purchase.

Shawn Eubanks: Is that new in just the third quarter that you're seeing that in the convertible-

Carl Kaufman: Mostly in the third quarter, correct. It seems to get ignored by high yield investors. Not all stocks are doing well and you'll find that most convertible managers are looking for beta, they're looking for equity beta and these just don't have that. They're just good fixed income investments, but they don't have the equity beta and with the market making new highs, you'll find they'll reallocate to other things and not really be too concerned about giving up basis points that we love to collect.

Craig Manchuck: Overall Shawn, I just want to add, we just continue to upgrade the quality of the portfolio. Again, if we get longer into an economic expansion and if the Fed is concerned about an economic slowdown, the last place we want to be is someplace where we're adding credit risk to the portfolio at a late stage. So by adding more IG, continuing to add busted convertibles mostly which are very short maturity also, create more balance in the portfolio and a much better positive asymmetry should we have a hiccup in the market].

Shawn Eubanks: Question here, do you see a weaker dollar impacting emerging market debt? I know we don't invest there, but maybe you could provide your thoughts on that.

Carl Kaufman: Well, typically emerging market debt to the extent that that emerging market exports or does trade with the U.S., take Mexico for example, clearly a stronger dollar can hurt. A weaker dollar can help, because if you're importing, clearly a weaker dollar makes your currency go a lot farther, but I don't think the dollar is going to weaken meaningfully. I mean it's taken a little bit off the top, but I think it had gotten a little ahead of itself, like interest rates, tends to follow interest rates, but I don't think it's going to have a huge impact.

Shawn Eubanks: I have a question about cash levels and what would make you want to get the cash levels down and one other, I have a couple people asking if we could put up the stats slide again, so maybe we can do that while you're talking about the cash levels.

Carl Kaufman: Let's get that slide up. Our cash levels have remained fairly consistent, but we look at cash in a number of ways as cash and equivalents. So cash itself is pretty low. It's about three to 4%, but we also buy, have some Treasury bills. We have some commercial paper, so you see cash and equivalents at 18.9%. I think it's down a little bit from the quarter before, but that's only because we're probably buying more one-year paper, which doesn't show up in the cash. So we're keeping a healthy liquidity in the portfolio. It's pretty much not quite at record levels of liquidity, but we're certainly getting paid a lot more than the last time we had this much cash and equivalents.

Brad Kane: I think that's the biggest thing is that we're getting compensated for the cash now, that's not really detracting from the yields we're giving up by not buying 10-year bonds right now.

Craig Manchuck: That cash is also, it's not static. Things are constantly maturing because we have so much short maturity paper, things are maturing and then getting reinvested, so it's constantly reinvested. But the question for us is about timing when we want to take some of that cash and be more aggressive with it, extend out if we found attractive names. Remember our portfolio has historically been and continues to be somewhat of a barbell, right? We find a very attractive name where we're getting paid further out in the curve, we'll buy it. If we can lock in an eight or a 9% yield in a name that we feel really comfortable with, we're going to buy it.

It's just that with this recent rally and it's really the last three months has just pushed everything at that part of the spectrum to be very, very tight. We did have a few names that came to market during the quarter which were attractive and we were able to put some money to work, but that cash shouldn't be viewed as static even if the numbers don't change, the securities within that bucket are constantly changing. So we get a little bit of volatility, things cheapen up, that number could change pretty rapidly, but we just don't know exactly what that's going to be.

Shawn Eubanks: I have a question here on sell discipline. What would lead you to sell out of a position?

Carl Kaufman: A couple of things. As Brad mentioned earlier, if fundamentals or macro change has happened that we think will negatively impact the credit for a long period of time and possibly lead to an LME, we're going to exit. The other thing is that it's reached our price target. Occasionally bonds will rise too fast and go too far and just not yield enough to warrant holding them versus other opportunities in the marketplace. Those are really the sell disciplines.

Shawn Eubanks: Okay. Let's see. Is there a point in the credit cycle where you would look to take advantage of some stress or distress in more leveraged sponsor-backed deals that you tend to avoid?

Craig Manchuck: I'll take that one. I would say unlikely and the reason there is structural. Again, you've probably heard us talk about this for years. Structures in which these deals are underwritten are tended to be so porous that they will allow the sponsors even in dire distress, to do some very damaging thing to bondholders. So it's a really a dicey game, try to buy securities at press prices if you think that they may recover, because as we were seeing, we referenced earlier in the case of Altice, even if the company survives, they can still do some very damaging thing to bondholders and the bondholders may not ultimately recover their full investment.

So I just think there are other areas of stress that may occur and we may find opportunities, but with regard to the sponsor-backed area of the market, that is fraught with risk, it really is. It's really not an area that I think we'll be dipping our toe in.

Brad Kane: Yeah. What I would just say to that is we've talked about this in the past too, is some of the better companies that are getting really low coupons just because they are large enough and they're more index-eligible, index-rated, or in the index. And so what happens is when you get a market correction, you'll get those better companies will also trade down because the coupons are lower, the maturities are longer. So, the effect of essentially the effective duration impacts price. Those might be the "stressed" areas where we would look to add, because that's just finding good quality companies that happen to have the wrong coupon maturity for us now, but down the road they don't. I agree with Craig, I mean when it comes to the LBOs, you'd have to find a bond that has a lot of tight covenants, and that's extremely rare in the LBO world these days.

Shawn Eubanks: I have a question from a client who agrees with our assessment about the political environment not having long-term economic, or policies not having long-term economic effects, but each of the candidates are talking about policies that could increase inflation if implemented. Do you discount this as campaign rhetoric or do you think it's they're possible?

Carl Kaufman: I'll take that one. Clearly there's a lot of things said on the campaign that maybe the candidates truly believe they would like to do, but when they're in the White House find it very hard to get passed. I'm thinking tax here, a lot of the things they promise have yet to come to fruition. So I would put the worst fears aside. Now, it is true that both candidates are talking inflationary policies, and they're talking about deficit finance policies. One side wants to have fiscal stimulus giveaways and things like that. The other one wants to have tariffs, which raise the cost of things. So inflation goes up and possibly slows the economy down. Both are deficit and tax cuts, which also widen deficits. So both of them are talking deficit widening. How much of that comes to fruition? We'll just have to wait and see, but we'll know in a month.

Shawn Eubanks: Can you describe the credit quality and sector exposure of the CP holdings specifically?

Brad Kane: Sure, I can take that. So first of all, for a commercial paper, we're typically buying one month, sometimes two month paper, and it's all investment grade. So as Carl said before, it kind of falls into our investment grade bucket, whether you count CP or not, but typically A2 rated and there's no, I guess I would just say it's a very broad sector allocation because what we're doing is looking for just good names, good quality names that are issuing, and every month, it really depends on who's coming to market. We're never looking for a specific industry to have exposure to. Typically, I would say we look for industries to avoid if anything. Really what we're looking is... we're looking at the credits. Even in commercial paper when it's one month, we're still doing credit work and looking at who we're lending money to.

Carl Kaufman: I would add that we do not play banks or financial engineering issuers of commercial paper, and they're huge issuers, but we avoid those - too opaque.

Shawn Eubanks: Where do you see duration in the portfolio going if the front end of the curve comes down meaningfully?

Carl Kaufman: Well, it really depends on why it's coming down. So if it's coming down just because the Fed feels they have to lower it to get it in line with inflation, that is not a reason for the markets to panic and correct. If they are lowering rates meaningfully because there's been a change in the economic landscape, or we're going into recession, that's a different scenario. Under that scenario, I would expect the high yield and equity markets to correct meaningfully, and you should expect our duration to move up as we base load longer dated maturities with higher coupons into the portfolio. If it is the former, we're probably going to continue the way we are just nipping and tucking here and there, but keeping a defensive posture, so you probably won't see too much change in the duration.

Shawn Eubanks: Thank you. Question here, any thoughts on the massive rise of private credit funds?

Carl Kaufman: Craig, Brad, I'll let you handle that.

Brad Kane: I'll let Craig take this one.

Craig Manchuck: Yeah, the private credit came in at an interesting time and grew rapidly at a time when the banks were backing away from lending to the LBO sponsors. They didn't have a tremendous amount of competition with the banks, so they were able to put large sums of money to work by helping these sponsors get some of their deals done. There are also a number of private credit investors that have been around for a long time via BDCs or other things, like Aries or Blackstone, but the recent rise is, I wouldn't say troubling, that may be too harsh a word, but it's going to be problematic, because what we expect to see is some consolidation in that space or some of the companies actually having to give money back. We talk about this all the time, but from where we sit, we're able to have people come to us with securities and say, "Do you want to buy or sell them?"

We don't have to go out and knock on doors of companies in order to get ourselves invested. Private credit world, they have to have teams of bankers going out and finding and sourcing deals for them to put their own money to work. And where that can get problematic is number one, maybe they don't find any deals, so they can't put money to work. Or number two, banker who hasn't had a whole lot of luck has to get something in the portfolio in order to get paid. So they start to put weaker credits and sketchier situations in there just to get the portfolio loaded up. So too much money, too fast, never a great thing when we see it happen, it's happened a lot in hedge funds, private equity. And the other thing is these are levered vehicles. Everybody in the private credit world levers stuff that they buy.

Any levered security, excuse me, any levered vehicle, whether it's been real estate, private credit, will see returns come down. So the promised returns that these guys have been out suggesting over the last several years are probably not going to be realized. So their returns will be less and they'll probably converge with what you're able to find via the public markets over time.

Shawn Eubanks: So I have a question from a retired investor who has a goal of reliable, predictable income over time. Could you help me understand how OSTIX could contribute to that goal and how I should think about duration when building a portfolio of multiple bond funds?

Carl Kaufman: Oh I can take that one. Clearly we have a skewed view on how Osterweis Strategic Income Fund can help that. We've had a very steady performance, we protected in down markets. We participated in up markets. . The second question, a little more nuanced, and I'll answer it this way. I think it's important to have a view on where we are in the cycle and where the opportunities are. And that is really what will drive your duration decision-making. So to have various durations in the same portfolio, it doesn't really optimize your investment dollars, because it's kind of like if you have a matrix of all the available investments too, and you buy a little bit of each one, you're going to end up with pretty average performance.

If you happen to buy a long duration fund and a short duration fund and the market goes one way or the other, the short duration fund isn't going to hurt you, but the long duration fund could if your timing is off. So I think the way to think about it is understand where you are on the credit side, which is what we try to do at Osterweis, we originally started this fund to be the only fund that our wealth clients would need to own throughout a cycle. So I hate to say unless you have strong views on the economy and can make a duration determination, it might make sense to sort of take a middle of the road approach.

Hopefully that answers your question.

Shawn Eubanks: That is the last question for today. Thank you, Carl, Brad, Craig, John. Any final comments before we finish the call?

Carl Kaufman: I just want to thank you all for attending. That was a record number of questions in 22 years. Thank you very much.