Osterweis Strategic Income: Recommended by AdvisorIntelligence

January 2021

Investment Environment & Opportunity Set

Osterweis Strategic Income co-manager Carl Kaufman says the support provided by the Federal Reserve in early 2020 has clearly been effective, pumping trillions into the markets through purchases of Treasury bonds, mortgages, corporate bonds, and even exchange traded funds (ETFs). He says this was obviously critical to the speedy recovery in the second quarter. Now, the team is wondering if the market has pulled forward some of 2021’s equity and fixed-income returns into 2020.

While the Fed has reiterated its commitment to supporting the markets, Kaufman thinks most of the quantitative easing measures are now behind us. From here, he says both the credit and equity markets will need continued fundamental improvement to move higher, not just a supportive Fed. One concern down the road is that the Fed’s plan could backfire should inflation start to pick up. Kaufman believes a meaningfully steeper yield curve would hurt asset prices across the board: growth stocks, longer-maturity Treasuries, and medium- to long-term-maturity investment-grade bonds. A key question now is whether investors are being adequately compensated for long-duration risk.

Kaufman believes the Fed and most central banks are going to stay with 0% interest rates for “a long, long time.” This presents investors with a portfolio construction challenge. What role do investment-grade bonds really play in a portfolio? Investment-grade bonds used to give you two things: yield and ballast in times of stress. The yield is paltry today, but Kaufman believes that if the market declines, long-duration, higher-quality assets such as U.S. Treasuries and the Bloomberg Barclays U.S. Aggregate Bond Index (the Agg) will provide some portfolio protection. For those seeking yield, Kaufman emphasizes the downside risks that come with “stretching”—taking on meaningfully more risk for incrementally higher yield. He says the team is maintaining its focus on selectively investing in strong businesses, bondholder-friendly debt structures, and attractive valuations.

Portfolio Update

Early in 2020, the team took advantage of the selloff by actively buying longer-dated, high-yielding bonds and convertible bonds. Since then, Kaufman says quarterly earnings results have been bifurcated. Some sectors, such as grocers, ecommerce, and technology firms that support telecommuting have performed well, while others more directly impacted by COVID-19 have been hurt. But even in the troubled industries, co-manager Craig Manchuck points out that many companies moved very quickly to cut costs and did so aggressively, positively impacting the bottom line much faster than expected. While this is a near-term positive, he says the difficulty will be establishing growth from here. He points out that the next round of hiring will likely be more expensive, due in part to higher minimum wages. He adds that during the last six months, stronger companies have raised a lot of cash, while many companies have paid nearer-term maturities, reissuing debt with much longer maturities. This has given companies the time and flexibility to manage through a prolonged slowdown.

As the market has climbed higher, the team has been scaling back exposure to equity-sensitive convertibles and bonds, taking a more defensive posture. Kaufman says cash; short-duration, high-quality high-yield bonds; and a smattering of convertibles seem best suited for the current market environment. They feel it is better to “hit a lot of singles right now and be patient while [they] wait for fat pitches that [they] can knock out of the park.”

Specific to team’s convertible exposure, they have been active in the space since Osterweis Strategic Income’s inception. In many cases, they purchase busted convertibles, which are the least equity-sensitive type of convertible; they effectively behave like bonds. Opportunities in busted converts have historically provided the team with very attractive yields. Another type of convertible security they have owned over time is balanced convertibles. These securities have both fixed-income and equity characteristics, where the value of the convertible changes with the underlying stock price. However, their debt-like structure creates an implied floor in the value of the security. A typical balanced convertible will capture a good portion of the upside (50%–60%) in the underlying common stock but only about 25%–35% of the stock’s downside. This asymmetric payoff profile has enabled the team to add some equity risk in their highest-conviction ideas without adding much volatility or downside exposure. The third type of convertible is in-the-money. In-the-money convertibles basically behave like equities and their value is driven by changes in the underlying stock price. The team’s exposure to in-the-money convertibles is the result of successful investments in balanced convertibles. As their price targets are reached, the team will typically trim the positions to reduce the portfolio’s equity-sensitive exposure. Many of the convertibles the team did add during March 2020 were tech companies with strong balance sheets. Names include Zendesk, Tabula Rasa, and Alteryx. The team was buying these issues in the 70s and 80s and felt confident in the fundamentals. A number of these names have since rallied, and the team has trimmed or reduced those exposures.

As for current portfolio characteristics, at the time of our December 2020 interview, the fund’s yield to worst was 6.11% with a duration of 1.6 years. This compared favorably to the high-yield benchmark, which had a yield to worst of 5.31% and a duration of 3.9. Cash and other short-term, high-quality securities accounted for 22% of the portfolio, up from September 30. Kaufman says there will be volatility one way or the other and opportunities will present themselves, at which point the team will put the portfolio’s cash to work.

Investment Philosophy & Process

The Osterweis Strategic Income team seeks to preserve capital and attain long-term total returns through a combination of current income and a moderate level of capital appreciation. The investment philosophy is predicated on the belief that strong long-term investment results are best achieved through a compounding of reasonable gains and the avoidance of major losses. Co-managers Kaufman, Bradley Kane, and Manchuck are absolute-return oriented rather than relative-return oriented, seeking out the most opportunity for the least amount of risk. To accomplish this goal, they build a portfolio of credits through bottom-up credit analysis, while opportunistically emphasizing different segments of the fixed-income universe based on their view of relative attractiveness. They employ this risk-averse approach during all stages of a credit cycle and will not stretch for yield in a low-yielding environment to boost returns.

The investment approach is based on Kaufman’s analysis that the bond market consists of sectors that behave differently under different economic conditions. For instance, during periods of economic growth, high-yield and convertible bonds tend to perform well as rising corporate profits lead to improved credit profiles. Conversely, these bonds tend to perform very poorly during periods of economic contraction as credit profiles deteriorate. During these recessionary periods, higher-quality bonds (for example, Treasuries) generally prove to be the best performers because of their responsiveness to declining interest rates. Kaufman believes that limiting a portfolio to just one broad fixed-income sector, such as high-yield bonds, investment-grade bonds, or convertible bonds, would force the team to be invested in that sector not only when it is performing well but also when it is overvalued or performing poorly. So with Osterweis Strategic Income, he avoids the “style-box” trap and has the flexibility to invest in multiple asset classes and credit ratings of bonds. As such, the portfolio Is managed in such a way as to emphasize the most attractive opportunities at any given time.

Typical portfolio holdings in Osterweis Strategic Income are corporate bonds, including short-dated, and to a lesser extent, longer-dated high-yield bonds, convertibles, investment-grade bonds (though exposure tends to be limited), floating-rate bonds, and Treasuries. Convertibles can account for a meaningful percentage of the portfolio, as the team has many years of experience investing in convertibles. Typically, they purchase busted convertibles, which have more bond-like characteristics (because a decline in the corresponding equity has rendered the conversion option valueless) as opposed to equity-sensitive convertibles, though they will selectively own these when they deem the risk/reward tradeoff to be appropriate. Kaufman typically avoids mortgages, municipals, and TIPS, as well as distressed issuers and industries. The fund’s average duration will be in the two-and-a-half to three-year range, though we expect there will be periods where duration could be shorter or longer. Kaufman believes that one- to three-year high-yield paper has unique defensive characteristics over multiple time periods, while producing consistently positive performance. Furthermore, company managements are typically focused on ensuring repayment of shorter-term maturities; therefore, price volatility is usually lower than for longer-term debt. Plus, many companies have only a few pieces of debt outstanding; this improves the ability to analyze risk in shorter-term paper.

Kaufman, Kane, and Manchuck select individual securities based on bottom-up, fundamental credit analysis. They look to understand the company’s balance sheet by determining the company’s ability to generate recurring free cash flow from operations. As a result, they strive to understand a company’s business prospects, which influence the company’s ability to generate cash flow. They believe they find their best investments in companies that have great products, a competitive advantage that permits pricing power, a consistent operating history, and management that operates the company as if they own it. Lastly, they determine what they believe to be the appreciation potential versus the downside risk to gauge the attractiveness of the security versus existing holdings and other investment opportunities.

Performance & Opinion

When evaluating Osterweis Strategic Income’s performance, we consider two benchmarks. Our primary benchmark is the Agg. Our view is that the strategy was designed such that it could serve as someone’s entire fixed-income allocation, and therefore it should beat the broader bond market over the long term. Over shorter time periods, we compare performance against the FTSE 3-Month U.S. Treasury Bill Index given the team’s goal of preserving capital.

Since the fund’s August 2002 inception (through December 31, 2020), Osterweis Strategic Income has generated a 6.53% annualized return, compared to 4.45% for the Agg and 1.28% for three-month T-bills.

We continue to be impressed with the quality of the team’s analysis. In our opinion, they continue to place a lot of emphasis on stacking the deck in their favor by focusing on favorable outcomes: They do not speculate or stretch for incremental yield. The team is willing to accept lower absolute returns if they believe it is appropriate given an unattractive risk/reward environment. Conversely, we have observed the team put money to work when the market sells off and valuations become more attractive. To that end, we like that the success of the fund is credit-specific and not dependent upon making macro calls.

The team is very selective about the types of companies they own and how much they will pay for a bond given the company-specific characteristics and risks. For over a decade we have seen a consistent theme of identifying stable businesses with consistent operating histories and competitive advantages that can lead to recurring revenues as well as pricing power. There is a clear focus on understanding a company’s balance sheet, a company’s ability to generate recurring free cash flow from operations, and the risks to those cash flows, which could impair a company’s ability to meet debt obligations.

We do not currently have any material concerns and believe Kaufman, Kane, and Manchuck remain disciplined in the execution of their strategy. We rate Osterweis Strategic Income Recommended in our Absolute-Return-Oriented bond fund category and own it across many of our model portfolios.

—Jack Chee

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With respect to this reprint, please note the following: The attached article has been reprinted with the permission of Litman Gregory AdvisorIntelligence. The original article first appeared in January 2021. 

The Fund’s average annual total return for the one year, three year, five year, ten year and since-inception periods ending 12/31/20 were as follows:

	1 Yr.	3 Yr.	5 Yr.	10 Yr.	Since Inception (8/30/2002)
Osterweis Strategic Income Fund	9.02%	4.50%	6.06%	4.95%	6.53%
Bloomberg Barclays U.S. Aggregate Bond Index	7.51%	5.34%	4.44%	3.84%	4.44%

Expense Ratio as of 03/31/2020: 0.87% / 30-Day SEC Yield as of 12/31/20 is 4.61%.

Performance data quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the Fund may be lower or higher than the performance quoted above. Performance data current to the most recent month end may be obtained by calling toll-free (866) 236-0050.

Investing involves risk, principal loss is possible.

The Osterweis Strategic Income Fund (the 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.

While the fund is no-load, management fees and other expenses still apply. Please refer to the prospectus for more information.

Opinions expressed in the article are those of the author and portfolio manager and the information has not been verified by Osterweis Capital Management. These opinions are subject to change at any time, are not guaranteed and should not be considered investment advice.

Click here for OSTIX’s top ten holdings as of 12/31/20.

Click here to read the Osterweis Funds prospectus.

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

Credit Quality weights by rating were derived from the most recent data available as determined by Standard and Poor’s. Grades are assigned to bonds by private independent rating services such as Standard & Poor’s and these grades represent their credit quality. The issues are evaluated based on the bond issuer’s financial strength, or its ability to pay a bond’s principal and interest in a timely fashion. Ratings are expressed as letters ranging from ‘AAA’, which is the highest grade, to ‘D’, which is the lowest grade.

The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index which is widely regarded as the standard for measuring U.S. investment grade bond market performance.

The FTSE 3 Month U.S. T Bill Index Series is intended to track the daily performance of 3 month U.S. Treasury bills. The indexes are designed to operate as a reference rate for a series of funds.

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

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

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

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.

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.

Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g. depreciation) and interest expense to pretax income.

Criteria for Recommended Funds: Recommended funds are evaluated by Litman Gregory based on a combination of qualitative and quantitative measures, including absolute and relative long-term performance metrics when compared to an appropriate benchmark and peer group, manager skill, investment process and the discipline by which the process is applied, quality and tenure of research team, shareholder orientation, assets under management, and fund expenses. Recommended reflects Litman Gregory’s confidence in a fund’s potential to outperform a relevant benchmark over the long term.

Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [OSTE-20210107-0101]