January 13 Webinar Replay - Osterweis Strategic Income Fund Q4 Update

Shawn Eubanks: Good morning everyone and happy New Year, of course. My name is Shawn Eubanks and I'm the Director of Business Development at Osterweis. Today I'll be moderating a panel discussion with Carl Kaufman, Brad Kane, Craig Manchuck, and John Sheehan. Carl, I was thinking we would start by recapping some of the major themes from last year and then we can move forward into what you're expecting for 2026.

Carl Kaufman: Morning, Shawn, nice to be with you today. Happy New Year to all of you on the call. We really have to recap '25? It was an unusual year for sure. Markets performed quite well last year, which is obviously what we all want, but normally when markets are rallying, the macroeconomic environment is somewhat calm and predictable. As we often say, markets hate uncertainty. Yet in 2025, both the macroeconomic and geopolitical landscape was anything but predictable and settled. The most obvious stress point of the year was Liberation Day in April when the President announced broad-based tariffs. From that day forward, nobody quite knew what would be assessed in which countries or industries until they were announced and then reduced and even after a deal had been reached, some of them still were changed.

We also endured the longest government shutdown in history. Inflation continued to be a storyline in '25, although the Fed did begin to cut rates somewhat inexplicably, as we'll discuss later. The war in Ukraine rages on, conflicts in the Middle East were also in the news for much of the year. And finally, the administration's aggressive anti-immigration campaign also adversely affected several areas of the economy, particularly in the hospitality service and homebuilding sectors. When you add it all up, we had a pretty disquieting combination of real world events, but somehow the markets were unfazed. Investors had little choice but to stay invested despite their unease. Seemingly nothing could slow the rally down. Many asset classes, including precious metals, posted new all-time highs last year as we believe Asian central banks were the main buyers of gold, possibly replacing what would have been Treasury reserves. That's the recap.

Shawn Eubanks: Thanks, Carl. Very interesting. 2025 was definitely a very strange year. What do you think will happen in 2026? Will it be more of the same or do you think the bull market will finally lose some momentum?

Carl Kaufman: Well, it's obviously harder to answer the second part of that question, so I'll start with the first. Unfortunately, I don't think '26 will be any easier for investors to figure out. Even if markets continue to rally, the macroeconomic and geopolitical conditions are not likely to be calmer, at least in the first half. Already this year we've seen an attack in Venezuela, arrest of the president, and he's talking about other targets, so it seems like Greenland might be next up on his agenda. We'll just have to wait and see. I mean, the fun never stops. The effect on markets, particularly the oil market, has been negligible thus far, but of course it is early days, so we'll need to see what happens. Perhaps, more importantly, the President has telegraphed that continued military strikes on other nations are still on the table. Each time something like that happens, the risk of political and economic destabilization increases, but there are other issues too, some of which are continuation from last year.

Affordability remains a big topic among American consumers and somewhat for good reason. Affordability of course is related to inflation, but more importantly it compares price increases to wage growth. When the relationship is moving in the wrong direction, things become less affordable. Housing affordability is a particular pain point in the U.S. sales of existing homes increased modestly in 2025. That seems like the best-case scenario for 2026. Housing, as you know, has a big multiplier effect on the economy, as new home buyers also purchase furniture, tend to renovate their properties, et cetera. You're seeing the slide on housing affordability and as you can see from the charts we've just put up, housing prices have increased much faster than wages, and we're seeing similar patterns in the automobile market.

New car prices have increased 30% over the last five years and now average about $50,000 for a new car on average. The average monthly payment on a new car is about $750. Used car prices have also increased about 40%, now average about $31,000, so loan terms are extending to six, seven, even eight years from your typical five. The average car on the road is now 12.8 years old, almost 13 years old. Clearly, they're making better cars these days, but all of these numbers are too high for a healthy auto market. The Trump administration believes lower rates will help solve part of this affordability crisis, but it could also exacerbate the situation because lower rates will not cause prices to drop in housing. If payments decrease, demand increases, which drives up home prices. You have a lot of homeowners in the U.S. who are rooting for higher prices. You have home buyers that are rooting for lower prices. One of them is going to have to lose.

The gap related to what they call the K-shaped economy seems to be widened. We've always had this, but they have a new name for it now. It's the visual metaphor for the haves and have nots. The higher earners, the haves represented by the upper arm of the letter K, not as impacted by affordability issues. The lower earners, the have nots, represented by the declining arm of the letter K, are continuing to fall further behind. As an aside, rising health care and home insurance premiums are also a factor that could divert spending away from other sectors, especially among the more stressed consumers. The question becomes: When will the strain on consumers be too great to support the economy? Consumer spending still makes up over two-thirds of the U.S. GDP. If more money is being directed towards housing, transportation, health care, what will be left over for other sectors?

Investing in 2026 will require some fortitude, much like it did in '25. There are real headwinds that have yet to show up in the economic data and/or market returns, and we do have fiscal stimulus, especially in the first half from the tax cuts, et cetera, that could buffer us against some weakness in spending. So the first half, probably better than the second half, but don't hold me to that.

Shawn Eubanks: Thanks, Carl. That's a great segue into my next question. Brad, can you take a little time and talk about the challenges we've had in the macroeconomic data in 2025 and maybe tell us if you expect that to continue into this year?

Brad Kane: Sure, I'm happy to, and I want to wish everyone a happy New Year 2025 presented some unique challenges to the official data coming out of the Bureau of Labor Statistics. As we've talked about several times in the past, the BLS collects most of its data from surveys they administer to businesses and households, and for years, response rates have been declining, driving down the quality of information content. Last year introduced some new challenges. First with DOGE that everyone will remember sought to decrease staffing across the government. Sadly, senior BLS staff took the early retirement option and newer staff were let go because they were probationary, so you have less people collecting and analyzing the data without any real experience. And overall, I think total government head count is down about 20% since Trump took office. And then in August he fired the head of the BLS after getting upset the job growth was revised downward for the first quarter by over 900,000 workers.

This is what happens when the declining survey responses and a lack of staff to follow up on them. Currently, they have an interim chief and they still have a lot of senior roles that are vacant. And then finally, there was the 45-day period where no data was collected during the government shutdown. So this has had big impacts on CPI calculations. For October, for example, the BLS assumed zero inflation for the cost of shelter, also known as owner's equivalent rent. And this is over one-third of the calculation that goes into CPI. There's almost no chance there's 0% change. In fact, today's numbers showed that there was a 0.3% increase over for the quarter. So it's clear that the numbers were diverging.

And November data for retail sales were captured late in the month, so they were likely reflecting Black Friday, Cyber Monday sales, so they'll understate actual prices over a full cycle or a full quarter. It seems to us the noise in the data collection has really affected the results to-date, and I think looking forward into 2026, we anticipate some of these issues will continue particularly with CPI. I mean, as I said, the zero OER figure will remain part of the CPI now for the next 12 months, artificially depressing rent numbers and the shortage of staff is going to take time to fix and that'll result in more imputed prices rather than actual data collection. So I think more issues for investors to really wade through.

Shawn Eubanks: Thanks, Brad. Craig, how do you think the BLS data integrity issue will impact the Fed? We know that they rely on that data to help set policy.

Craig Manchuck: Good morning, Shawn. Look, Brad did a pretty good job, I think covering the BLS issue, so I won't belabor that point, no pun intended. I think what is relevant here is the fact that we have inaccurate data and we have a Fed that is going to be increasingly populated by people that President Trump wants in there who will push his agenda forward and try to force rates lower. If you saw recently, Stephen Miran has been out suggesting that we need 150 basis points of cuts. Now I don't know what he's been smoking, but we've got a nominal GDP that's run rating at 5% in a fed funds rate that's at 364, 365 approximately.

So that's a pretty accommodative rate at this point. And I think that the risk we have with other new Fed appointees coming on that want to continue to advance the President's agenda is the Fed becomes overzealous in cutting, and in so doing kind of kicks inflation back into gear. And I know we are concerned about that and I don't think we're unique in being concerned about that, but something to watch for and hopefully the cooler heads prevail here and we don't get too aggressive with rate cuts because I think that is really... That could one, get stocks supercharged and create more speculative activity, but it could also really set the stage for another bout of inflation, which will be most problematic for the lower earning cohort as we said before, who has been getting left behind all throughout this economic expansion.

Shawn Eubanks: Thanks, Craig. John, maybe you can provide a little counter perspective. Despite all these concerns, several markets reached all-time highs in 2025 and many commentators are anticipating another good year in 2026. Can you talk about where all this optimism is coming from?

John Sheehan: Sure, Shawn, happy New Year to everyone. I think one way to look at that and point to some of the reason for optimism is if you look at some of the underlying economic indicators, the labor market is always a good place to start when you're looking at the health of the economy and despite the unemployment rate ticking up a little bit in '25, it's still very much at a healthy level. There are some factors to consider in addition to some of the reporting issues. If you look at the impact of immigration, when you have less immigration or even people leaving the country, that shrinks the denominator. So even if you have a similar number of people employed, the unemployment rate ticks up as a cause of the impact to the denominator.

Another thing to look at is if you look at the number of total job openings, that has remained relatively constant throughout the year. And again, if you look at the number of unemployed workers, those two numbers are pretty similar to one another, just a little bit over seven and a half million. So from that perspective, it looks like the employment market is pretty close to equilibrium, so that definitely gives us a cause for optimism.

And there has been talk, especially with some of the backdrop around AI, around the skills mismatch. That's what people point to most when they're talking about the job openings. There is a little bit of a lingering impact from Covid, where companies felt like they were caught flat-footed with some of their labor. So they're hoarding some of the employment and probably a little slower to release than they would've ordinarily. But for the most part, the labor market looks to be in good shape for us, and quite frankly, we don't see a material change to that in the near future.

Shawn Eubanks: Thanks, John. Carl also mentioned that precious metals reached an all-time high, some all-time highs in 2025. What's the significance of that?

John Sheehan: Yeah, absolutely. Metals had a very strong year in '25. If you look at the two most commonly cited, gold and silver, those were used by foreign governments largely to hedge themselves or express some concerns about replacing the U.S. dollar. I think there's some commentary around the move in Venezuela, about that being a move to protect the dollar's dominance, especially in the oil markets.

But even if you look away from gold and silver, some of the metals that are used in manufacturing such as copper and aluminum, etc., also had very, very strong years. So there is definitely an element where the metals markets lagged for quite some time, so it could just be a little bit of a catching up, but it's also another indication of just the devaluing of fiat currencies across the globe. The more that our government spends in deficit, the more dollars that we print, the more that it drives demand for physical assets.

Shawn Eubanks: Thanks, John. Craig, can you talk about the new issuance market? Have companies been taking advantage of this risk-on sentiment?

Craig Manchuck: New issue market is relatively robust. Year-to-date, the IG market has printed about a hundred billion year-to-date, which is pretty solid, if you compare that to last year, we did about 200 billion in the month of January. So I'd say we're running a little bit ahead of where we were a year ago. High yield similarly is, depending on how you're counting, some people have it at 11, others at 13 billion year-to-date, and last year in January did about 31 billion, so call it tracking roughly the same, maybe a touch behind. We haven't seen this many LBO transactions printing yet, but we're one or two deals away from sort of being right on track with where we were last year. So the market's fine, it's open, deals are getting done, they're pricing fairly tightly, so I don't see anything unusual going on in the new issue market at the present.

Shawn Eubanks: Thanks, Craig. So obviously a really complex picture out there. Issuance is strong, markets are rallying, and the economy is obviously doing quite well in some very important ways, yet there are a number of issues lurking in the background that could potentially create problems down the road. Carl, would you like to wrap up the discussion today to talk about our fund's positioning?

Carl Kaufman: Sure. There's no major changes as you might expect. We've been in a holding pattern for a while now. We probably got defensive a little too early, but that's okay. We have plenty of dry powder. We've been investing opportunistically in longer-term bonds when they do show up. We've been reluctant to go too far out in the maturity or credit spectrum at this point in the cycle because we're probably in the late phases here. Some people think we might be starting a new one, but I think that's optimistic. But the rally may not have run its course yet, but it definitely feels like we're somewhere nearer to a market top than a market bottom for sure. And we prefer to buy when things get much cheaper and everybody else is bailing. In sum, we continue to be patient and wait for better entry points.

Shawn Eubanks: Thanks. One more question before we open it up to the audience. You mentioned the Venezuela strike earlier and I'm wondering if you have anything else to say about that?

Carl Kaufman: Not much. I mean it's symbolic of a changing foreign policy in America for sure, or back to gunboat diplomacy. But given their deteriorating infrastructure in the oil field, oil companies seem to be resisting going there. It is also very heavy crude, which is tough to transport and process. So let's hope this doesn't become a regular occurrence elsewhere. We don't need to destabilize any further than we have, and we don't need to embolden China and Russia to behave similarly.

Shawn Eubanks: Thanks, Carl. That was my last question, but before we open up the audience, we're going to share the fund performance slide and we'll also follow it up with some key portfolio statistics. We'll now begin the Q&A, and as noted on this slide, please ask a question through the Q&A window or raise your hand to ask a question over computer or audio or by phone.

Shawn Eubanks: Okay. Given the lack of will on spending cuts or tax increases, will this country have any choice but to resort to continual Fed monetization of the debt, and does this worry you?

Carl Kaufman: Yes and yes. I think you're probably going to see tax increases. That generally is where these things end up when you can't monetize enough debt. The Big Beautiful Bill didn't really cut much in taxes for the top earners. It did for the lower earners, but the percentage of tax sort of take, if you will, has remained remarkably steady over time. The only times it was really bigger was in the sixties and seventies following World War II when your top rates were much higher, but it wasn't materially higher than it is today because people did find ways around that. But it does worry us that we continue to spend profugately and we continue to monetize our debt. Japan has shown you can go a lot higher in debt-to-GDP than we are right now. So we do have some headroom.

Brad Kane: But this is one more reason why we've said for a long time that we are not sure interest rates can cut down materially.

Carl Kaufman: No.

Shawn Eubanks: Okay. Thank you. Can you walk us through the fund's 2025 performance at a high level? How would you explain to clients what worked and didn't work this year?

Carl Kaufman: Sure. What didn't work was our aggressively defensive posture because the market just kept going up. I mean, we lagged by a couple of hundred basis points versus the high yield and Agg . So duration positioning that we had, which was much lower than the markets, did not work. What worked was, what we did perform as we expected, we expected a four to 6% year. We came in right around a 5% plus and it was an 8% year. I think if we do get a correction, as in past cycles, corrections tend to be pretty violent. We've never been down double digits. So what you make up in those more than compensates for what we lagged this year.

Craig Manchuck: Yeah. Shawn, can I add? Just to add to that, typically in a year like this, you have very strong performance out of triple Cs, but interestingly, double Bs, single Bs, and triple Cs all ended up roughly performing the same plus or minus to say 20 basis points, which is odd. And the reason that happened is because within the triple C cohort, there is a really wide dispersion of returns. We had the names that performed, they were earning much higher coupons than the rest of the market, so that they generated pretty good returns for the triple C index. But then you had a lot of names that went through liability management exercises and fell out of bed sharply.

So for us, part of what worked for us was continuing to avoid those LMEs and staying away from some of the names that people got caught with in downdrafts. And we're going to continue to try to do that as we go forward because we don't see generally the LME exercises as fruitful. It's just a matter of which... The companies kick the can down the road a little bit and oftentimes end up in bankruptcies later. Sometimes they work, but generally it's continued problems. So staying away from that was actually something that we were pretty successful with last year.

Shawn Eubanks: Thanks. Any comments about a new incoming Fed chief and who you like or maybe who you don't like for that?

Carl Kaufman: No, who we like and who we don't. It's not really going to matter. However, I think the voting, the betting market seemed to have their money on Hassett and Warsh, and I think if Hassett is the winner, I think the Fed governors that have been there a while will probably resist him more than Warsh, who is considered more of an insider. So you probably actually get fewer cuts with a Hassett than you might with Warsh. But other than that, now they're interviewing Rick Rieder of BlackRock. So I mean, it could have a surprise candidate come in there at the last minute. It's just hard to tell.

Shawn Eubanks: How does the quarter end allocation to high yield of 58% compare to previous periods?

Carl Kaufman: It is a little lower than it has been only because we've been building cash and the cash-like instruments, which tend to be non-high yield.

Shawn Eubanks: Okay. We did have a request to show the performance slide again, so maybe we can do that real quickly. And then also while that's queuing up, please provide the bond sector comparison of non-rated exposure and how they're mostly the busted converts. Or maybe you can just discuss that.

Carl Kaufman: No, that's very true. We have about 11% in convertibles, and they're all short term under one year except for one issue, busted convertibles, and they are, as most convertibles, unrated, so that's-

Shawn Eubanks: The majority of the non-rated

Carl Kaufman: Probably 80 percent of the unrated.

Craig Manchuck: And a large number of the busted names are names that have more cash than debt on their balance sheet. So unrated, but they would be strong B or a lot of times even double B-rated names, I think were they to be rated by the agencies.

Shawn Eubanks: That's great. Where are you finding interesting opportunities right now?

Carl Kaufman: That's a really good question. Generally in one-off situations, but the market is pretty efficient. They've pretty much tightened everything up. So it's either in the new issue market occasionally for a first time issuer, that is where we're finding some opportunity. We're not really stretching, we're not finding a ton of "load up the truck" opportunities, but we are finding some good two to four year paper that has reasonable yields where the companies will do well in a downturn and continue to do well as long as the economy is trucking along. So we've been adding those selectively.

Shawn Eubanks: And what percentage of the portfolio is in cash and bonds maturing in less than a year?

Carl Kaufman: Sure. Cash is 8.5%. Bonds maturing under one year are about 16%, and commercial paper is about 15%.

Shawn Eubanks: Okay. Any meaningful industry sector changes today?

Carl Kaufman: Nope. Pretty much, we have a fairly low turnover portfolio, so they don't change very often. I'd say as a broad category, if you're looking at the market in three buckets: Industrials, Financials, and Utilities, we tend to be overweight Industrials, which is a broad swath of companies doing very different things, but they get dropped in those big buckets.

Shawn Eubanks: Okay. Had a question here about the composition of cash and equivalents. I think you kind of answered that, but what would be the total of all those cash and cash-like investments?

Carl Kaufman: Roughly 40%.

Shawn Eubanks: Great.

Carl Kaufman: But we're getting paid on the short-term bonds.

Shawn Eubanks: Perfect transition. What's your average yield on the cash and equivalents?

Carl Kaufman: It's about 4%, So it's probably low fours on the commercial paper, probably mid-fours on the corporate bonds that are under a year, and high threes on the cash money market.

Shawn Eubanks: Okay. That's quite different from what we had experienced in the past with our cash position.

Carl Kaufman: Inverted yield curves are a lot of fun for people like us, but this is not one of those times.

Shawn Eubanks: Okay. Are there any alt areas of the fixed income market that you guys ever look at? CAT (catastrophe) bonds, for example.

Carl Kaufman: We find that if we're not really knowledgeable about an area like that, we typically not going to play it. We're knowledgeable in enough of the bond market that we have enough to play with.

Shawn Eubanks: Okay. Let's see. Does the wealth effect from last year's stock market gains enter into your calculation for the 2026 economic performance?

Carl Kaufman: It's interesting. The upper echelon should be euphoric right now given the wealth that they have created over the last year. But we're starting to get a sense that even among the high echelon of earners and wealthy people in this country and others are starting to... I mean, they're humans too. They read the papers, they have unease, they're not going to go berserk. So I think you're seeing it somewhat in the modern art market where people have been spending like crazy, the yacht market, you're not seeing as many announcements of half a billion dollar yachts getting delivered. I think that you might see a little pullback in that sector as people maybe take some chips off the table. We'll have to wait and see, but it's just anecdotal at this point.

Shawn Eubanks: What would convince you to buy longer duration Treasuries, and what would be the maximum duration you would take?

Carl Kaufman: I don't have a maximum number. It really depends on what I'm getting paid. You pay me 8% on a 30-year Treasury, I'm buying it, but I'm not doing it in the fours.

Shawn Eubanks: Okay. Another question here. If spreads stay persistently tight, would the portfolio's current positioning essentially remain the same?

Carl Kaufman: Likely. It depends where yields are. The spreads can stay tight, and if Treasury yields rise, you could still have tight spreads, but higher yields. So if you had 6% Treasuries and 200 basis points spreads in high yield, that's a pretty good yield because you know that rates are going to be coming down. We'd probably be buying some Treasuries at that point.

Craig Manchuck: But it also depends on what other opportunities are coming down the pike. Where the equity market is, what we're seeing in the convertible world, and what type of companies and the quality of the companies that are coming to market to issue. If we see a significant deterioration and more highly levered or poorly structured companies coming to market, then we'll look to other places to go, because a continued deterioration and continued strength in the market without any disruption usually leads to deterioration of structure and deterioration of investor protections. And that's one thing that over the long term we think is important to invest alongside and not get caught stretching for yield into something that's really weak or poorly structured just to try to keep propping yields up.

Shawn Eubanks: Has your strategy ever in the past or would you consider prospectively investments in hybrid securities like bank preferreds?

Carl Kaufman: I'm going to let John answer that one.

John Sheehan: Yeah, we've discussed it many times. The vast majority of those bank preferreds are perpetual, so it's a little bit longer duration than we're used to, or we prefer. There are some high yield funds that try to play it to the call, a little bit of picking up nickels before the bulldozer, so not really something that we're interested in, but it is certainly on our radar, but I think it's going to be a very unique situation for us to add it to the portfolio.

Carl Kaufman: We have played some bonds that have a step-up in yield coming, where we buy it before the step-up with the understanding that the bank will most likely call that. So we calculate by that on a yield-to-call basis. And if they don't call them, we would get the step-up in coupon. But so far we haven't gotten the step-up yet.

John Sheehan: And the current structure of bank preferreds are non-cumulative. So you have a perpetual non-cumulative security. So if they were ever to get in a situation where they turn the dividends off again, you'd have a perpetual zero coupon bond, which is not the greatest security out there.

Craig Manchuck: We're not necessarily calling for that. And look, the environment right now is kind of favorable for banks if we have an upward sloping yield curve. For us to buy hybrids now would be a real example of stretching for yield to try to prop something up. And after three years of good performance in the markets, this is the type of security that a lot of people will stretch into and they'll talk themselves into buying something like that. And generally it may work, but it's probably not the right time, which is part of the reason why we tend to stick to our knitting because at some point in time we'll see a disruption of some sort, and those are the names that would be a drag on performance and it would tie up capital and prevent us from being able to deploy cash into the types of names we'd like to own over the longer term.

John Sheehan: And just one last analogy. If you think about our experience in convertibles when we play in equity-sensitive convertibles, we like that return profile because they have tremendous upside relative to the downside. Preferreds are the opposite. They're incredibly negatively convexed, so you have the upside of a fixed income security and the downside of an equity security.

Shawn Eubanks: Thanks. I know you don't like to, or you don't make bets on the shape of the curve or the 10-year Treasury, where it's going to be, but do you have any expectations for maybe the year end of 2026 in terms of the yield and the 10-year?

Carl Kaufman: Somewhere between three and three-quarters and four and three-quarters?

Craig Manchuck: I'll take-

Carl Kaufman: It's going to be in the range.

Craig Manchuck: I'll take the slightly higher range of that myself.

Shawn Eubanks: Okay. I think we've answered all the questions for any final comments in the team.

Carl Kaufman: No, I think people should proceed with caution. We are getting a little long in the tooth in terms of the equity market rallies we've had. May not be a bad time to take some chips off the table as we have in our strategy and wait for a better buying opportunity. I mean, it could go parabolic on us, but it already feels like it has.

Shawn Eubanks: Okay. Thank you gentlemen for being with us today, and thanks for all of our participants.

Carl Kaufman: Thank you, Shawn, and thank you everybody. See you next quarter.