Published on January 18, 2022

If you were unable to join our quarterly webinar, watch the the replay to hear updates on the Osterweis Strategic Income Fund.


Mark Schug: Okay. Hello everyone and happy new year. My name is Mark Schug. If we haven't met, I am the northeast Regional Investment Consultant at Osterweis and I'm excited to host this call while Shawn Eubanks is out of the office.

We would like to welcome you to our fourth quarter and year end update for the Osterweis Strategic Income Fund. At this time, all participants are in a listen only mode. Later, We will conduct a question and answer session that you can participate in via the online chat or through your computer. We will hold all questions until the end, but if you would like to get in the queue, please raise your hand or enter the question into the Q&A. Please note that this webinar is being recorded.

I will be moderating a discussion with Carl Kaufman, Craig Manchuck, and Brad Kane. After our discussion, we will open the line for your questions. So let's begin. Carl, can you start by providing a recap of 2021? It was another memorable year that featured several big story lines.

Carl Kaufman: Thank you, Mark. Sure. Yes, it was one heck of a year. We had a lot to worry about. We all had a lot to be thankful for. Most importantly, despite two Covid variants, Delta and Omicron, which are still very much with us, we've mostly managed to return to our pre-pandemic lives, perhaps with the exception of going to the office. In addition, the economy bounced back nicely in 2021, delivered very strong corporate earnings, despite the continued snarl in the global supply chains and rising inflation. On the other hand, companies still can't hire enough workers to meet demand. I suppose that's a good problem to have. Though we are seeing some fall there. Of course, the Fed finally acknowledged that this inflationary bout may not be transitory after all.

Mark Schug: And as you look forward to 2022, which themes do you think will continue to move the markets, and which do you think may start to fade?

Carl Kaufman: Well, I think it's good that you're asking about the forward looking outlook because that you can only invest in the present for the future. It's important to understand, I think, the magnitude of the potential headwinds versus tailwinds that we face and their impact on the markets that we invest in. Certainly, the headwinds remain continued inflation, rising interest rates, further lockdowns, although, I see those as less of a headwind going forward, and a less accommodative Fed.

The tailwinds are healthy corporate profit growth, strong consumer demand, and continued improvements in labor. So given these crosscurrents, we think it's critical to find the right balance between offense and defense. Given where the markets have come the last three years, I think now it's probably better to play a little defense while finding some calmer ports in which to wait out the storm, than it is to make a prediction and bet on that, which you know is a binary outcome.

Mark Schug: If inflation sticks around, how do you expect the Fed will respond?

Carl Kaufman: Well, I think they have already moved in the direction of being more hawkish. So we think a more realistic approach was certainly overdue, and a result, I think that the QE accommodation is going away first. So they'll be tapering that starting now pretty much. By March, hopefully they're done with asset purchases. Certainly paves the way for the start of a fed funds rate hiking cycle.

So far, the consensus is for three hikes, some people are saying four, and another three in 2023. So if you get three this year three next year, let's go with the base case, that would mean that you would be back to a one and a half percent fed funds rate, which is where we were before we started Covid. So it's going to be a very measured pace. I think it allows for markets to adjust and shouldn't result in any material revaluations. Whether it is enough to stave off the increases in inflation remains to be seen. However, we think that a normalization of rates and a less administered rate is a healthy development for the market, which could dampen some of the enthusiasm for unbridled speculation that we've seen in some corners of the market, such as crypto and non-fungible tokens.

Mark Schug: Great. Thanks Carl. Craig, how do you think the mix of higher inflation and higher rates will impact the economy?

Craig Manchuck: Morning, Mark. Look, we are still very constructive on the economy. The metrics and the numbers all look very sound and solid. So I think we're quite a ways off before we run into a spot where the Fed raising rates is going to break anything and we're coming from zero, so the market is pretty comfortable now that we'll see three or four rate hikes this year. So it's had the ability adjust. I think businesses are well prepared for that as well.

I don't think a 1% fed funds rate is something that is going to change things materially. If the longer end of the curve changed materially higher, that may affect things slightly differently. It'll just make longer term funding costs more expensive. But we do think that we're limited on how high the long end is going go, at least in the short-to-intermediate term. You've got countries like Italy, where their longer rates are 1.25%, in Greece, 1.5%. It just defies logic to think that we're going to be materially higher than that. So maybe we can creep up closer to 2%, but I don't think that's going to necessarily break anything in the economy.

Mark Schug: Got it. Thanks Craig. Brad, what are your expectations for the non-investment grade market in 2022?

Brad Kane: Glad you said expectations and not predictions. As Carl and Craig mentioned, we've got a strong consumer, we've got corporate profits. We've got a very constructive economy, which is typically good for non-investment grade companies that they are much more levered to a growing economy, and therefore, I think fundamentals for them will continue to improve and that benefits bond prices. Typically, with higher coupons that non-investment grade companies have for bonds have versus investment grade, that should also deliver better yields. So in addition to improving fundamentals, I think we're going to see improved credit quality in a lot of these names.

Mark Schug: Yeah. How has that market evolved over the past five years? How does it compare to more investment grade?

Brad Kane: Yeah, that's a good one. Credit quality for non-investment grade market has improved and it's pretty evident when you look at it versus investment grade. Here's just a touch more detail. Since 2016, so the last five years, BB rated debt, which is the highest credit quality component of the high yield index, it's increased over 5% from 49% of the index to almost 55% of the index. The lowest credit quality component, CCC debt, has declined actually from 14% of the index to touch over 10. So the credit quality and the high yield index has improved. Obviously, that is both from new issues that have come to market and then things that have matured or have left our market.

In the same time period, in the investment grade universe, the highest credit risk segment, which is BBB debt, has increased by over 3%, and the weightings on the two lowest credit risk components, which are AAA and AA, so the highest quality bonds, they've actually declined. So you've seen in the high grade index actually gotten a little weaker where the high yield index has gotten a little bit stronger.

I think aside from the change in credit risk, the other big risk that is not in those numbers is duration. Duration of the investment grade index has risen from almost 7 to over 8 during the same time period, while the high yield index has actually gone down from 4 and a quarter to just over 4. So this means, as you guys know, for 100 basis point move higher in interest rates, which the Fed is talking about doing, the price of an investment grade bond would decline by over 8 points versus only a 4 point decline in non-investment grade. Since investment grade bonds have much lower yields in coupons than non-investment grade, there's much less room for error in the high grade space. Overall though, I think neither the investment grade nor the non-investment grade markets are super cheap on an absolute basis. But again, I don't think either are at extremely rich valuations. So we're still picking our spots, another reason why we like to keep cash and a lower duration. So as we see rates begin to rise, we'll be able to reinvest and hopefully find some cheaper, yieldier opportunities in the non-investment grade space.

Mark Schug: Got it. Let's transition to the fund. We will quickly show performance, which has been very strong. And as we move through that slide, Brad, can you talk about just how the fund is positioned right now?

Brad Kane: Sure. Excluding cash, the portfolio's been predominantly non-investment grade bonds and convertibles for quite a number of years now. Throughout the pandemic, one of the things we did is we actually have been maintaining a little bit of a barbell in the portfolio of strong companies with some longer term maturity debt, coupled with significant position and in shorter maturities. At year end, our cash was about 16%. So with a deliberate Fed tightening cycle looming, questions about how quickly that normalizes rates, we think the markets will adjust on the long end and want to maintain some dry powder, which is why we're keeping cash as high as it is right now.

Mark Schug: Got it. Craig, can you talk about high yield issuance last quarter and so far this year?

Craig Manchuck: The year has started off a little bit slower, I think, as people would expect when we're facing the uncertainty of how the markets are going to react to rate increases and we haven't been in this environment here for a few years of facing higher rates ahead of us. There's been a little bit of caution. But if you step back and look, in 2021, private equity firms raised over three quarters of a trillion dollars in new equity commitments. So if you think about them buying companies on a levered basis, they've got a tremendous amount of buying power and that could fuel another boom year for issuance. Last year, issuance was over $500 billion, which is up from somewhere in the mid-400 billions in 2020. I'm not sure if we'll be able to repeat that. There was a great opportunity for companies to refinance themselves last year, extend maturities at historically low rates. So a lot of those refinancings have already happened. But I still think we will expect to see a healthy issuance this year, albeit, a little bit probably below what we saw last year.

Mark Schug: Carl, we've already heard why the team is constructive on the economy, even if the Fed does begin to tighten, but how do you expect financial markets to react if that happens?

Carl Kaufman: Well, intuitively one would think that they would trade off substantially, but in the real world, that generally does not happen. It doesn't happen. The reasons that we're raising interest rates are that we have a strong economy. We have low unemployment and we also, unfortunately, have inflation. So the reasons are that we have strength, and with strength comes good fundamentals, and good fundamentals are what you look for when investing in debt.

So what typically happens when rates rise is that spreads tighten and they tighten because the risk-free rate rises and I would say that the high yield market and also the investment grade market typically stands still. Then as rates continue to rise, people start worrying about a recession. So spreads start to widen a little bit. So it's possible that if the Fed increases the pace of their interest rate normalization, that you could see some spread widening in the second half the year. Remember that any monetary interest rate changes by the Fed typically don't impact the economy till 12 months out. So you won't see the economic impact of that for a while until you probably won't see the spread widening for a while either. I think we're in pretty good shape right now.

Mark Schug: Good. All right, well, let's move to Q&A.

Brad Kane: Yeah, why don't I take that? That's a great question, especially with the Olympics supposed to start there in a few weeks. I guess it's more a worldwide question. It really depends on how they weather Covid. There's still a big backlog of demand for product out of China. China still has a very large demand for commodities. But the timing's tough to figure out. We've seen over the last few weeks, and they've shut major cities that produce computer chips, and recently shut a port over just a few cases, in order to try to nip it quickly. That's having impact here.

In the U.S., we have a huge backlog at our ports. The Port of Long Beach in Los Angeles, there's a shortage of dock workers, because 1 in 10 has been out with Covid. The Wall Street Journal reported on Monday that two container ships were unloading with less than the dock workers they needed, and 13 other ships couldn't get any dock workers. So we're seeing whatever happens to China actually flow through the supply chain. But I think it's just a question of how quickly they get through Covid. I think economy wise, their economy is still growing and world trade is still happening, so that's good for it. But it's really just a question of when it fully opens up.

Mark Schug: Another question, "Could you revisit the cash component? When, and to what level, would cash be deployed?"

Carl Kaufman: We deploy it opportunistically. So I would say if we were to get a major correction or see some big opportunities, we would put it to work. But as you know, if you've been an investor for a while, we're very careful and we're very patient.

Mark Schug: Got it. Another question, "On the 10-year range for this year, what do we expect the range to be?"

Carl Kaufman: Another interesting question. We have seen various economists come out with their forecasts ranging from 1.5% to 3%. Our guess is that given the countervailing forces in Japan and Europe that Craig mentioned briefly, and the measured pace of increase of the fed funds rate at the short end, I don't think the 10-year moves a whole lot. Typically, when you get an interest rate cycle, there is a fulcrum in the curve. In 2004 to 2006, it was the 7-year, I think somewhere between 7 and 10 years, typically is where the fulcrum is, where rates move on either side, but the fulcrum stays pretty steady. I am guessing, and this is just a guess, one and three quarters to two and a quarter will probably be the range for the 10-year in the next year.

Mark Schug: Okay, good. Another question on high yields, "Can you discuss the high yield book more, general industries or opportunities you're finding?"

Carl Kaufman: Anybody else want to take that one or should I take it?

Brad Kane: You're on a roll.

Carl Kaufman: I'll take it. We typically build the portfolio one company at a time. So we don't start with a position of "we want so much in health care, we want so much in industrial, we want so much in finance." So we do it opportunistically one company at a time. If there is an industry that's particularly resilient and attractive and there's more than one company in that space, we don't limit ourselves to just buying one credit.

So right now, we tend to be overweight in industrials, because that cuts a broad swath of companies that do very, very different things. Also, because we have a barbell on, a lot of the shorter-dated bonds, if they're in good shape, have good liquidity and can easily refinance their bonds, or take them out with cash on hand. It almost doesn't matter what industry that is. So as I say, we're probably overweight industrials and companies that actually make things. We are grossly underweight energy. We have a couple of midstream holdings, one of which is getting called, I think very soon. We have a smattering of specialty finance companies, and that's pretty much it.

Mark Schug: Okay. Then another question here on the equity holdings, does somebody, Brad or Craig, do you want to-

Craig Manchuck: Yeah, I'll take that one. We have two equity positions, both of which were companies that, as we've discussed in the past, we decided to stay with through restructuring. The first one and the largest position is Southeastern Grocers, one of the largest grocery store operators in Florida with also some operations in Louisiana and in Mississippi. But Southeastern Grocers owns the Winn-Dixie brand, as well as Harvey's and Fresco y Mas, which is a Latin-centered concept. That position has grown significantly, because the business did extremely well post-restructuring. We, as the owners of the business, along with Fidelity and AllianceBernstein, we allowed the company to pay down over $400 million in debt in 2020. The value of the business has grown substantially, as has our holding. So over time, what we've been doing there is reducing it, , so we've been selling down our position systematically as opportunities present themselves. So that's been a great winner.

The other one, Real Alloy, is an aluminum recycling business. It's a really, really great position to be in right now in the aluminum industry, because with extremely high costs of power it is much cheaper to recycle aluminum. Aluminum is one of the only metals out there that is infinitely recyclable. So it can be recycled over and over and over again without losing any of its characteristics and strength, and pliability, so really great spot to be in. News announced yesterday that Novelis is going to be spending $365 million to build a 240,000 metric ton facility in Kentucky. Our facilities generate about 850,000 metric tons. I think we are currently valuing that business somewhere around $350 million. So we think there's still probably some significant upside that can potentially be realized in the value of that as especially ESG-centric investors, either the strategic or financial investors will probably be focusing more and more on recycled aluminum in 2022 and 2023.

Mark Schug: Great. Thanks.

Carl Kaufman: I would also like to point out, just add that the Real Alloy went into restructuring because of the Toys "R" Us bankruptcy that caused their payment insurers to pull all their lines, so they had a liquidity crunch. Unfortunately, they had to go through it and now we own it.

Mark Schug: Thanks for clarifying. One more question here on risks. "Of the risks mentioned earlier, what is the biggest risk to the portfolio currently and what changes would you make to the portfolio to help hedge against those risks?"

Carl Kaufman: I think the biggest risk to the portfolio now is an exogenous risk, like a new pandemic or a nuclear attack, or so something that we can't foresee. We've done a pretty good job of scraping the portfolio over the years, making sure our credits are durable. The biggest risk, historically, has been to lagging to the upside, because we typically have shorter duration or lower duration and more conservative profiling. I don't think that's going to be a major risk this year. So we don't really need to reposition the portfolio and hedge against those. You really can't hedge against those risks unless you just constantly pay insurance for a market put. But that's about all we can do is invest with the knowledge that we have and deal with those risks. But I think we do a pretty good job of managing the known risks. It's the unknown risks that you never know when they're going to crop up. But typically with our cash, that's usually an opportunity for us to do some buying, so we actually look forward to air pockets.

Mark Schug: Right. Okay, great. I don't see any more questions in the queue. Carl, you have any closing remarks for us?

Carl Kaufman: No, I think it's going to be an interesting year this year. I don't think it's going to be as bad as people fear. Markets like to climb walls of worry. We have had three really great years in a row in equities. I think I would temper my expectations there. But I think the way we're positioned, we're very happy with the way we're positioned, and we're just going to stay the course and do what we do.

Mark Schug: Okay. Great. Well, thanks again everyone for joining. Thank you for your time and attention and our best to all of you.

Carl Kaufman: All right. Thank you everyone.

Opinions expressed are subject to change, are not intended to be a forecast of future events, a guarantee of future results, nor investment advice.

The Bloomberg U.S. Aggregate Bond Index (BC Agg) is an unmanaged index which is widely regarded as the standard for measuring U.S. investment grade bond market performance. This index does not incur expenses and is not available for investment. The index includes reinvestment of dividends and/or interest income.

Fed is short for Federal Reserve.

QE, or quantitative easing is a monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.

Investment grade includes bonds with high and medium credit quality assigned by a rating agency.

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.

Coupon is the interest rate stated on a bond when it’s issued. The coupon is typically paid semiannually.

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

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.

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

Spread is the difference in yield between a risk-free asset such as a U.S. Treasury bond and another security with the same maturity but of lesser quality.

Treasuries (including bonds, notes, and bills) are securities sold by the federal government to consumers and investors to fund its operations. They are all backed by “the full faith and credit of the United States government“ and thus are considered free of default risk.

A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.

The yield to worst (YTW) is the lowest potential yield that can be received on a bond, assuming there is no default.

Yield to maturity is the rate of return anticipated on a bond if it is held until the maturity date.

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-20220112-0417]