A Strategic Income Fund that is Thriving in a Challenging Bond Market
Carl Kaufman is the co-president, co-chief executive officer and managing director, fixed income at Osterweis Capital Management. He is the lead portfolio manager for the Strategic Income strategy, which he has managed since its inception in 2002. He is also a lead portfolio manager for the Flexible Balanced strategy.
Prior to joining Osterweis in 2002, Mr. Kaufman was a senior member of the convertible bond team at Robertson Stephens, where he focused on technology and biotech securities. Before that, he spent 19 years with Merrill Lynch in its institutional sales office, specializing in convertible bond and equity sales and trading.
As of 4/30/18, the Osterweis Strategic Income Fund (OSTIX) had an annualized return of 6.18% since its inception on 8/30/02. Its performance exceeded that of its benchmark, the Bloomberg Barclay’s U.S. Aggregate Index (AGG), by 278 basis points (the AGG returned 4.03% over that period). It has approximately $6.1 billion under management.
Carl graduated from Harvard University (B.A. in Music, cum laude) and attended the New York University Graduate School of Business Administration.
I interviewed Carl last week.
You were early in adopting an unconstrained approach to managing fixed income. Can you explain how that came about and what you have seen in the years since the Osterweis Strategic Income Fund launched in 2002?
The decision to pursue an unconstrained approach was a natural extension of our firm’s core philosophy. We were founded 35 years ago by John Osterweis with the belief that managing money requires maximum flexibility and should not be ruled by style boxes. Our objective was to create a strategy that provided the opportunity to deliver alpha across market cycles and effectively manage risk.
Our investment strategy was built around the idea that there are two distinct bond market cycles, and leveraging opportunities within each would be the key to generating sustainable returns. The first cycle, which primarily impacts investment grade (IG) bonds, is the interest rate cycle. The second is the credit cycle, which is generally more important for high-yield (HY) bonds, where defaults are a bigger risk. For us, it is critical to have the flexibility to manage exposures as we move through both of these cycles.
When we started the Fund in 2002, conventional wisdom was that the two cycles moved in sequence with one another. Interest rates typically fell during weak economies as central banks tried to stimulate growth, which favored investment grade bonds. Credit quality, on the other hand, typically increased during recoveries, even if interest rates were rising, which favored high-yield bonds.
What we have seen post-crisis is that the two cycles have occurred in parallel rather than serially, which has created very favorable conditions. Thanks to quantitative easing (QE) by the Federal Reserve, rates have been drifting lower for most of the last decade while the equity markets have steadily rallied.
Only recently have we seen a return to the more traditional temporal relationship between the cycles, as rates have been steadily rising since mid-2017, while the equity markets for the most part have continued to rally.
Tell us about your investment process. Specifically, how do you blend your top-down macroeconomic analysis with your bottom-up security selection?
We combine top-down and bottom-up analysis with a search for opportunistic ideas to construct our portfolios. We begin with a broad investment universe that includes convertibles, HY debt, IG debt, Treasury debt, floating rate notes, preferred equity and high-dividend-paying common equity. We then evaluate the macroeconomic environment and formulate our outlook on the direction of the capital markets to help us determine our desired maturity structure, credit quality and asset class allocations.
Our security selection process includes fundamental analysis, credit analysis, assessment of management, and finally, the evaluation of each new security’s impact on the portfolio. We emphasize a thorough understanding of each company’s income statement and ability to generate recurring free cash flow from its operations. As a result, we perform a significant amount of work to determine the company’s business prospects as well as the positive and negative levers in its financial model that may influence its ability to generate cash flow and its ability to refinance its debt in the future. We believe that we find our best investments in companies that have great products, a competitive advantage that gives them pricing power in the market, a consistent operating history and management that runs the company as if they own it, which in some cases, they do. Finally, we look at current yield, expected appreciation potential and downside risk to gauge the attractiveness of the security versus other investment opportunities.
It seems as though you take an equity-like approach to buying bonds. Is that correct? Is that unusual for a fixed income investor?
Definitely. I like to think of the Fund as a carefully selected portfolio of museum pieces rather than as a benchmark-hugging portfolio. Our in-depth analysis allows us to identify bonds that we believe are truly attractive from a risk/reward perspective, and even as we’ve grown we’ve been able to keep the Fund invested in a relatively concentrated portfolio. So we don’t need to reach for marginal deals that may not pan out simply because they are constituents of a benchmark index.
I do think our approach is unusual for fixed income managers, but for us there really isn’t a different way to do it. We want to be sure that we have strong conviction in every single holding in the Fund.
What are your current thoughts on interest rates and inflation?
This is obviously a critical issue and we’re monitoring it closely. The Fed is in the process of unwinding QE and has already said they’ll raise short-term rates three or four times this year. Plus, the 10-year Treasury finally broke through the psychologically important 3% barrier, though it has retreated since. So there is certainly reason for concern. On the other hand, the Fed moves have been announced well in advance, so the market has mostly priced them in.
The bigger question is what happens with inflation. Fed data, combined with our own empirical analysis, suggests that inflationary pressures are beginning to build. The widely followed Consumer Price Index (CPI) has risen 2.2% over the last 12 months, which is above the Fed’s annual inflation target rate of 2%. The lesser known Underlying Inflation Gauge (UIG), which has some predictive elements in it, was 3.14% in March, an increase from the upwardly revised 3.02% seen in January. With both measures well above the Fed’s current 2% target, we won’t be surprised they increase their target.
In addition, we are beginning to observe anecdotal evidence that inflation is creeping into the real economy. For example, one under-the-radar indicator we’ve been tracking is transportation costs. On year-end earnings calls we continue to hear from company after company that the rising cost of shipping goods to market is becoming a problem. Tougher regulations and a demographic shift away from trucking jobs have created a shortage of long-haul truck drivers in the U.S., and this has driven up costs. So far, companies have mostly absorbed this increase, but that can only last for so long. As they look to pass along these costs, their customers will have little recourse but to also pass them on to consumers in the form of higher prices.
With the recent Tax Cuts and Jobs Act and the prospects for a federal infrastructure initiative, the deficit is likely to grow. Do you fear that excess Treasury bond supply will be a driver of higher interest rates?
We don’t see this as a big problem, provided that inflation remains under control. Deficits do not always imply higher interest rates. Japan, for example, has the highest ratio of debt-to-gross domestic product (GDP) of any developed nation in the world, but their 10-year yields are still hovering near zero.
Where are we in the credit cycle? When do you expect another recession and how does this affect your fixed-income positioning?
Interestingly, our views on the credit cycle and the health of the economy aren’t completely aligned. We’re fairly sanguine about the economy for the next few years, but at the same time we feel credit risk is brewing within certain segments of the HY market and we’re avoiding those areas.
Regarding the economy, although we are about nine years into the current expansionary cycle, we don’t see a recession in the near future. However, we do think markets will be more volatile, as they’ve been since January.
For starters, GDP growth continues to rise steadily and unemployment is low. And as the Fed pushes short-term interest rates higher, savers are finally earning a reasonable return on their cash.
Perhaps more importantly, the Tax Cuts and Jobs Act of 2017 combined with the latest U.S. budget are the largest late-cycle fiscal stimulus ever. According to Cornerstone Research, those two pieces of legislation will add 1.2% to U.S. GDP in 2018 and 1.6% in 2019. In addition, measures in the tax bill encourage companies to make capital investments, which were long-delayed after the financial crisis. The U.S. manufacturing capital stock is old, so investment in new equipment should be simulative not only to manufacturers of such equipment, but also to the corporate bottom lines as productivity improvements take hold.
Despite our favorable economic outlook, we think the credit cycle may be nearing a turning point for some segments of the high-yield market. We are particularly uncomfortable with many of the private-equity (PE) deals that have been brought to market recently. We find that they are frequently structured such that the interests of the equity partners trump those of the bond holders, increasing default risk.
Overall, we are adopting a defensive posture, favoring short-term HY and convertible bonds.
More broadly, how are you structuring your portfolio to manage risks in today’s environment?
As I just mentioned, our current focus is short-term HY bonds, including convertibles. We feel there is still too much interest rate risk in IG bonds, especially for longer term issues. The duration of the AGG (a proxy for the IG market) continues to hover near all-time highs, so even a modest increase in rates could trigger losses for IG investors
Similarly, although the HY market has traditionally been a refuge from rising rates, we feel it may react a bit differently this time. The extended period of low interest rates has caused a general decline in the cost of borrowing. While this has been a boon to lower-rated companies, about 30% of HY issues now sport coupons below 6% with maturities over five years. So this cohort of bonds, which we have been mostly watching from the sidelines, carries substantially more interest rate risk than in past cycles. Should rates continue to rise, these bonds will likely drop in price faster than bonds with higher, more typical coupons. More importantly, when these companies need to come to market to raise capital or refinance existing debt, they will be facing higher costs to do so.
We are also increasing our exposure to U.S. Treasury bills and 30-day commercial paper. The rise in short-term rates has allowed us to invest our cash at favorable rates. It is always nice to find new areas of the market where we can earn a good risk-adjusted rate of return in higher quality assets while maintaining a defensive posture.
Over much of the recent past, bonds have been good diversifiers against equities (i.e., they have had a low or negative beta). That relationship broke down this year. Do you expect bonds to have their traditional diversification benefits?
It really depends on how rates behave. If inflation remains under control and rates drift up slowly, then the traditional relationship should resume. But if inflation becomes more acute and rates begin to spike, you’ll likely see selling in both equities and bonds, as we saw during the first quarter.
Which areas of the HY market are most attractive?
It’s probably easier to answer this by talking about areas we don’t particularly like right now. Broadly speaking we divide the HY market into four major subgroups: (1) private family-owned businesses; (2) mid-sized public companies with controlling stakeholders; (3) larger public companies; and (4) and private financial sponsor-backed companies, usually resulting from a leveraged buyout.
As I mentioned earlier, we are avoiding the last group, as we feel many PE sponsors place their own interests ahead of the bondholders. Although the headline elements of a typical PE transaction (e.g., coupon, maturity, seniority, etc.) are on-market, hidden deeper in the indenture are all manners of ways for the sponsor to redirect both cash and collateral away from bondholders.
We also see risks with the third group as a lot of those bonds are purchased by benchmark-oriented investors (such as exchange traded funds that track an index). These funds will buy essentially any bond that is included in their benchmark, even if the terms are sub-optimal (i.e., low yield support), so we tend to avoid them, also.
Currently we’re focusing on bonds in the first and second groups – family-owned firms and smaller to mid-sized public companies. We like those types of investments right now because the borrowers are usually committed to the success of the business and place a greater emphasis on their long-run viability.
We also like some convertible bonds, and in the past few months we have seen a diverse collection of higher-quality companies issuing bonds in this market. And of course we’ll opportunistically invest in any of the four groups if we see something that looks appealing, just as we’ll try to take advantage of market volatility to purchase quality debt at a discount.
Let’s talk about the active versus passive situation. Indexed products have grown exponentially in the past several years – how do you think this affects active managers?
Indeed, indexed products have enjoyed remarkable success over the past few years. But I think it is helpful to place their growth in context. As I mentioned before, this has been a historically favorable period for fixed income, fueled by QE and a multi-year equity rally, which have boosted returns across the board. As the saying goes, the rising tide lifted all the boats.
But it appears we’re nearing an inflection point where the tide may be turning. The Fed has already stated that QE is ending and that they’re raising short-term rates. At the same time, inflationary pressures are beginning to mount. All of that is against a backdrop of elevated duration in both the IG and HY markets, so returns will be highly sensitive to rising rates. And, as we discussed, there are segments of the HY market where credit risk is also in play, especially if borrowing costs rise too much.
In other words, although the last few years have been a great time to invest in passive products, we think it’s likely to be tougher going forward. To put a finer point on that statement, at the end of the first quarter, the AGG was down 1.46%, and it’s mostly been losing ground since as rates have edged up further.
In our view, this could also be the point where the pendulum begins to swing back in favor of active managers. Assuming passive strategies deliver sustained negative returns and begin to experience net outflows, the forced selling should provide active managers with an opportunity to pick up attractively priced bonds as indexers are forced to be price takers when selling.
What role does the Fund typically play in clients’ investment portfolios?
We designed the Fund to be the core fixed income allocation for our high-net worth clients’ portfolios, but over time we’ve seen advisors use the fund in a variety of ways. In particular, as we’ve increased our HY holdings, many clients now position it as a diversification play to complement their IG allocations. Given our track record over the past 15 years, we believe the fund has shown that it is a valuable addition to any fixed income portfolio.
What are the biggest uncertainties facing bond investors?
First off, I am not sure investors appreciate how much interest rate exposure they have in their portfolios right now. With the duration of the AGG at all-time highs, the situation is much more precarious than it’s been for the past several years, and investors may be surprised by their returns.
So keeping an eye on both rates and inflation is really the key, particularly since rising rates will impact both IG and HY bonds. And of course if lower rated HY companies have difficulty coping with increased borrowing costs, we could begin to see defaults accelerate also.
The last major concern is geopolitical instability, which is very difficult to predict or prepare for. Attention-grabbing headlines dominated the news cycle during the first quarter of 2018, but in the end not much actually happened. So far the trade war with China has been mostly talk, as has been the saber rattling with North Korea and Iran. If the news out of Washington D.C. becomes more than Trumpian bluster that could have a major impact on markets.