January 12 Webinar Replay - Osterweis Strategic Income Fund Q4 Update

Shawn Eubanks: Good morning, everyone. I'm Shawn Eubanks, the Director of Business Development at Osterweis Capital Management. We'd like to welcome you to our fourth quarter update for the Osterweis Strategic Income Fund.

I'll be moderating a discussion with Carl Kaufman, Craig Manchuck, and Brad Kane. After our discussion, we'll open up the line for your questions. Let's begin. Carl, Happy New Year. I know most of us are very relieved that 2022 is over and even after a decent fourth quarter, bonds had one of their worst years ever and other classes struggled as well. Can you give your perspective on what happened?

Carl Kaufman: Sure. 2022 was really about inflation and the Fed. Inflation clearly finally showed up, and so the Fed started raising rates. If you raise rates from historically low levels, you are going to get outsized. You're going to get record moves in bonds, which is what we got because of the low coupon. So recall that inflation is fundamentally caused by too much demand chasing too little supply, and the question is whether, which one is the driver? Is it supply because of supply constraints or is it demand because too much money and too much on liquidity out there? I think it's a little bit of both.

Raising rates clearly increases borrowing costs, effectively taking money out of the economy and thus reducing aggregate demand. And that's how the Fed works at slowing demand by raising rates. Second, the more immediate effect is that higher rates compress asset valuations, and we've had almost 15 years of very low rates. So asset valuations had gotten, in some cases into make-believe land, and so we've had declines across the board in asset valuations with perhaps the exception of energy due to the war in Ukraine, Russia. But even that is starting to come back.

So equities, bonds, real estate, cryptocurrencies, SPACs, the last two being I think a side effect of having no risk free returns in the marketplace. So speculative excesses do happen. They all had a bad year, so you could call it the bursting of the everything bubble. The good news is that supply demand will come into balance. It already has in some areas. But in 2022, we all suffered the pain of rapidly rising rates. The losses in Treasuries were, as I said, not a surprise, and hopefully we are now set up for better returns going forward.

Shawn Eubanks: Great. Thank you, Carl. So what happened in Q4? After falling almost 15% for the first three quarters of the year, the Bloomberg Aggregate Index turned around and gained 2%. Is that because the Fed is finished its tightening cycle?

Carl Kaufman: Oh, definitely not. The Fed remains hawkish, notwithstanding the CPI number we got today, which was right in line. In our view, the fourth quarter rally was a bit premature. It's true that they are starting to discuss the end of the hiking cycle. They're sort of moderating it. They're talking maybe 25 basis points for the next two hikes. But most economists expect at least one to two more, as does the Fed. Their own dot plot pretty much says the same thing. However, that's been a horrible predictor of future rates, so I wouldn't put too much weight on that.

As Powell himself has said, the key question isn't how quickly they raise rates, but how high they get them and how long they will keep them there. We don't believe we know the answer to each question yet. And as you said, the fourth quarter had quite a rally, and I think that was part of last year was sort of a year of opposites, where bad news is good news and we got weaker economic data, which the market interprets as good news that the Fed will stop hiking rates. The problem we see with that is that if you do go into a recession because of a weaker economy, equities typically do very poorly in that environment. So that's why we think it was premature.

Shawn Eubanks: Thanks, Carl. Brad, can you talk about the opportunities that you and the rest of the team are seeing in the bond market now that rates are much higher than they were a year ago? Hopefully, all that pain has created some nice entry points for the portfolio.

Brad Kane: Yeah, rates and yields are definitely higher than they have been a year ago, and as we've been saying on the last few calls, we're still finding attractive yields in names you want to own in the portfolio. You look at the average coupon in the index right now is around 5.8 and the average price is in the high 80s. So you're clipping a very nice current yield, almost six and three quarters percent just holding high yield bonds. And since the high yield market has a relatively short maturity compared to let's say the investment grade market, you see a very nice total return potential as bonds move closer to par over time getting close to their maturity.

So you get current yield, you get upside with over the next couple of years. We think that's quite attractive and as we've... but we've cautioned, it's a market of bonds, not a bond market. So you still have to be selective, stick with fundamentally sound issuers, and I think you'll have some nice returns.

Shawn Eubanks: Thanks, Brad. Craig, I have a question for you. Can you talk about what's happening in the sponsor-backed LBO deals? I know typically we avoid those, but I'm wondering if last year's selloff has changed your view and created more opportunity there.

Craig Manchuck: No, it hasn't. We still remain fairly negative in our view towards those transactions for many of the same reasons that we've had over the last, call it six or seven years. Leverage remains extremely high. The financings and the deals were done very aggressively, and they were done prior to last year's selloff. Many of them were hung deals that were on the bank's balance sheets and the banks have succeeded in moving some of that risk, albeit at substantially discounted prices.

So a lot of that paper is made it into the market and the bottleneck that it had created is starting to clear. But we just don't think that the structures are particularly good, the adjustments to EBITDA remain fairly high, and the proposed cost savings and synergies that were suggested at the time that these deals were actually announced are pretty lofty, and we think somewhat unreasonable, so I think they'll be very hard to achieve.

So for that and just other general reasons in our views about where we might be vis-a-vis a recession, we just don't think the most highly levered businesses are the ones that we want to be stepping into if we're either going into a recession or just in a deceleration in the economy.

Shawn Eubanks: Thanks, Craig. That makes sense. The yield curve remains highly inverted, and it has been for quite a while now. Generally that's viewed as a harbinger of a recession, but for the moment the economy seems to just chug along, unemployment remains low, and GDP growth is positive. So what do you make of the inverted yield curve?

Craig Manchuck: Again, it's the classic sign of a recession coming. I'm not sure if the recession is imminent or if it takes a little bit... a while to get there. We certainly see signs of business slowing down. Housing being the biggest and most obvious, and housing has a big multiplier effect on the rest of the economy. There are just so many things that feed into the whole housing creation. Consumers still have a lot of cash, so they're okay and they're in reasonable shape. The market is pretty flush with liquidity right now.

So generally speaking, we're not seeing a huge selloff and enormous amounts of opportunities to put big slugs of cash to work. So instead, what are we doing? We're continuing to do what we have, which is pick away at some of the shorter duration opportunities at the front end, because we're getting paid reasonably well now to buy commercial paper or one- and two-year pieces of paper out there in names where we feel very comfortable. Just doesn't make sense for us to want to extend out and go a whole heck of a lot further out on the curve at this point.

Shawn Eubanks: Thanks, Craig. Carl, can you talk a little bit more about the labor market. In your latest outlook, you told a funny story about a mix-up between the Philadelphia Fed and the Bureau of Labor Statistics, the federal agency that measures employment officially. Can you share that story and tell us why it matters?

Carl Kaufman: Well, I'm not sure it matters until we get the right answer, but Bureau of Labor Statistics is the sort of gold standard for releases about employment and the regional Fed banks usually do their own measurements. And the Philly Fed, for the second quarter of last year, had initially estimated that 1.1 million jobs were created on an annual basis, and that jived pretty much with what the BLS had said. In December, they said, Oops, we made a mistake. We used the sum of the state's estimates. And keep in mind these are estimates, they don't go count them.

We really only created 10,500 jobs. So of course the BLS had to defend its position and basically came out and said, no, they're wrong. We have found that their independent surveys or measurements use bad data and use lesser quality methods. So they basically threw them under the bus. So keep in mind it was last year, but if the Philly Fed is correct, it would explain why the labor force participation rate has stayed so low. But we won't know for a while until we get the Bureau of Labor Statistics revisions, but I suspect that the Philly made a second error.

But once that number was released, the market was very volatile based on that. So it just shows that people are watching every sort of twist and turn in the economy to try to figure out which direction to go in, and the market rallied very heavily on that number, because it meant that, oh, if that's the case, then the Fed must be closer to stopping the hawkishness that they've been displaying.

Shawn Eubanks: Thanks, Carl. Thanks for sharing that. Brad, can we come back to what's happening in the markets? I imagine new issuance was pretty robust in the fourth quarter, given the rally. Is that right? And what are you seeing so far this year, year-to-date?

Brad Kane: Yeah, there was a flurry of activity in new issue in November, December. Overall, I would say the whole year was pretty anemic compared to the prior couple of years. Most of the companies that issued in the last few years were refinancing and terming out their debt out to 8 and 10 years. So there was really, at this point, a very small amount of what the press, they used the term "maturity wall" out there. It's about, I think 17 to 20% of the high yield market will refinance in the next three years.

So those were the '19, '20, '21 deals. The deals that came in '22, a lot of them were deals that couldn't get done in those years, were clearly weaker companies. A lot of the big LBOs that Craig had mentioned. That's the stuff that we saw coming last year. Now, in this year, the deals are getting a little bit better. Usually when you have a break in issuance for a while, when the door opens or the window opens for new issuance, it's usually the better companies that come first, because they're the easier deals to get done.

So right now we're seeing some better companies coming. Yields are not exactly where we would want them to be, to be taking big positions, but you're starting to see the windows open again. There's still quite a bit that is sitting on the banks' balance sheets that has to get done. The big Twitter bank loan that was done last year to take Twitter private, Morgan Stanley's still sitting on a lot of that.

So you're still going to see some of these big headlines about banks taking big write-downs to sell off some of these LBO loans. But I think we'll keep an eye out, as we always are, of what's coming to market and if there is some good interesting names, that's when we want to step in. But in the meantime, I think you got a blank slate of a new year in return. So there will be deals that are risky that get done because managers are willing to take the risk early on. We're still going to be selective as we always have been, but I think you're going to see some volume.

It's not going to be anything close to what it was the last couple of years because unless you get a lot of M&A in the market, a lot of corporate spinoffs, transactions like that you can't plan for because you don't know what's going to come down the pike. But I think it'll be interesting to see how the year develops.

Shawn Eubanks: Okay, thanks Brad. Let's talk about the fund now and we'll quickly move and show the performance, which has been very good on a relative basis. As we move through that slide, Brad, can you talk about how the fund's positioned right now? I know you've touched on it earlier in the discussion.

Brad Kane: Yeah, actually I feel a little a broken record because the last couple of calls I've said basically the same thing. We're keeping a fair amount of powder dry. Right now, in fact, in one month commercial paper, you're getting yields of 5%. So for us, that's a better place to just sit out and hide out until we can find some opportunities in really cheap bonds. So we're not getting aggressive. We are finding ideas. We are picking up some bonds as closer to yearend. There were some nice opportunities.

And especially with the inverted yield curve, it makes sense to stay on a shorter side right now until you get some more closure and closure on what the Fed's doing and when they're done and then how inflation's reacting to that. So we have a fair amount of cash, a lot of high yield, we still have our convertibles. We had been taking down last year a fair amount of the equity sensitive convertibles, and we're starting to see that market issue again early in the year too. So we're keeping an eye out for the right opportunities, but still staying relatively defensive right now.

Shawn Eubanks: Thanks. Carl, before we open up the floor to Q&A, do you have anything you want to add?

Carl Kaufman: I think the most important thing is that '22 is over and it was a pretty bad year, and typically you don't get a whole string of bad years in a row. This year, it's off to a great start. I wouldn't annualize these returns just yet, but I think the best strategy is still to invest in companies that are profitable and are responsible stewards of capital and make sure our incentives are aligned and wait for better buying opportunities to layer in better yielding bonds. It's been our strategy for 20 years and continues to work. I guess we'll open it up for questions.

Shawn Eubanks: Okay. Well, we did receive a couple of questions beforehand, so let me start with one of those. Our first audience question was sent in before the call. The first few days of Congress have been a bit chaotic. Are you concerned about the implications for the debt ceiling debate, which will take place sometime later this year?

Carl Kaufman: I'll take that one. It's pretty easy. I'm not too worried. Congress has always found a way to keep themselves working and getting paid. I don't think this will be any different. What I do worry about is the absolute level of debt, which Congress seems to have no feel for what real money is all about, but that's been a concern of mine for 30 years. So it's not going away. The numbers just keep getting bigger.

Shawn Eubanks: Okay. And we had a question come in via email. I was wondering if you could discuss how you think about consumer discretionary exposure and consumer durables exposure in the portfolio and how you think about weighting those given the market environment.

Carl Kaufman: Sure. We typically build the portfolios from the bottom up, so it's one company at a time. So if we find an attractive company that has the characteristics we're looking for - good management, strong competitive position for cash flow, reasonable leverage. Where the company is categorized is less important to us. We do monitor the exposures, but consumer discretionary is an area that we have been overweighting a little bit, because as we come out of Covid and we did last year, we're seeing consumers want to spend, they want to do things, they don't want to buy things.

So things like traveling, gambling, cruising. We have exposure to all three of those. The other thing is - and hotels. The other thing is that a lot of our bonds are very short-dated in maturity. So if you find a company that for example, has cash on the balance sheet that equals or is greater than the short-term debt that's coming due, and we can buy that short-term debt at attractive yields, it doesn't matter what it is. It just happened to be that a number of those were in consumer discretionary. So that may account for the slightly heavier weighting that we typically have in consumer discretionary.

Shawn Eubanks: Thanks, Carl. I have a question about the yields available in the longer end of the high yield market in terms of what yields are available in say 5, 7, 10 years out.

Carl Kaufman: Well, there's not a lot of 10-year paper out there in high yield. Typically, it's 8. So all the stuff that was issued in the last couple of years is now 6 and 7. The yield curve is fairly flat, so 5 to 10 and 5 to 8 in high yield is fairly flat. You might get 50, 70 basis points more by going out. Given the inversion in the yield curve, we've actually found better bargains close in where you can get the same yield or just slightly less than going out farther and not take that risk that you get into a recession and spreads blow out. We'll buy the longer term stuff. We do want longer term paper in the portfolio near market bottoms, because then you can collect that yield for much longer periods of time. But we're not there yet.

Craig Manchuck: And Shawn, just to add, there are certain names that we have that are yielding 10, 11, 12%. We see these opportunities. We look at them very, very carefully to see is if there's something wrong here that we're missing, or is there a reason for this mispricing, is this mispricing an opportunity or is it a risk? And we find both in certain cases and where we find opportunity that we think makes sense to take advantage of, we have and we'll go out at the longer end of the spectrum.

Craig Manchuck: Yeah. Yeah, and Shawn, also, we talked about this and we've had conversations with people who are looking at market spreads again, and what we've seen is there's just been a gigantic divergence between what's happened with the triple Cs throughout most of last year versus the higher quality names. And so even though it may seem on the surface that spreads are not widening out, they are in certain areas. The yields on triple Cs, Carl, what are they?

Carl Kaufman: 14%

Craig Manchuck: 14% is the average, what you're getting on triple Cs now versus-

Carl Kaufman: 6.5 for double Bs and 8 and change for single Bs.

Craig Manchuck: So the market is functioning as people expect. The spread widening has happened, it's just a matter of being positioned to try to avoid the areas where you're faced with those significant headwinds and where people are most concerned because they're either smaller companies or most levered businesses that are in that triple C cohort.

Shawn Eubanks: Thank you. What's your biggest concern for 2023? What keeps you up at night?

Carl Kaufman: My biggest concern always is out-of-control hyperinflation. So my biggest concern is that the Fed doesn't do enough and inflation comes roaring back. Other than that, I think we know what the risks are out there. Some of them are unknowns such as how's the war going to shape up. But the world adapts and people adapt to things and market's doing just that.

Shawn Eubanks: What are your thoughts on quantitative tightening and its potential impact on capital markets?

Carl Kaufman: They're not going to do enough of it is my fear. They should be taking advantage of the strength in bonds to get rid of as much of their balance sheet as they can. But that's the Fed for you. I don't think it's going to have much of an impact at all because there's such demand for low risk or "risk-free" bonds at this point that I don't think it's going to have much of an impact at all.

Shawn Eubanks: Okay. Do you see any issues coming down the pike for credit and interest rate markets from the BRICS potentially reducing their Treasury purchases?

Carl Kaufman: They already have reduced their Treasury purchases and they have sold. China has sold Treasuries, I think as has Japan a little bit, because China has to stimulate their own economy. And as you can see with 10-year nearing 3.5, it hasn't really caused any problems at all.

Shawn Eubanks: Okay. That was our final question. Do you have any final comments?

Carl Kaufman: I want to thank everybody for attending. I want to thank everybody for the faith you put in us. We'll continue to do our very best. And as I say, it's too early to annualize the first week of the year, but we're keeping our fingers crossed.

Shawn Eubanks: Thank you, gentlemen.

Brad Kane: Thank you.

Carl Kaufman: Thank you, Shawn.