High Yield Fixed Income Becoming More High Quality – Investment Moats

Carl Kaufman came on Excess Return podcast to talk about fixed income.

Carl is the co-CEO, CIO of a fixed income fund of Osterweis Capital Management.

Whenever you look at some of these notes, do bear in mind that some may interest you or some may not. But note that some of them are good enough that help me personally connect some minor dots.

Carl’s interview is one of those.

I think if you invest in individual fixed income, are tactical with your fixed income, or buy and hold fixed income in a strategic allocation you would appreciate what Carl says because he will help:

1. There is the textbook theories but how many of them are not outdated and work the same way as what the textbook says?
2. Information and knowledge are sometimes more for short-term fixed income speculators, and some are for buy and holders. Some are for tactical holders. How do you parse the differences?
3. How do you transit from different sub-classes of fixed income depend on market conditions.
4. Which sectors will be good direct bonds fundamentally?

Carl helps explain but Carl is more of a safe, high quality, absolute return, actively shifting portfolio manager.

This is the return of the Osterweis Strategic Income Fund (OSTIX):

Carl is rather defensive right now. If so, why is he 66% in high yield bonds,. which traditionally is not associated with defensive?

The Risk Isn’t Where You Think

Defining the Different Quality of Fixed Income

Here is how Carl defines the fixed income from the higher quality to the lowest quality.

Investment Grade:

1. Bonds rated BBB and up by the rating agencies.
2. Includes government securities, agencies, and investment-grade corporate bonds.
3. Investment grade market has gotten riskier
   • BBB, the lowest rated investment grade used to be 30%. Now it is 50%.

High Yield:

1. Non-investment grade
2. Bonds rated BB and below.
3. Recently, they are higher quality than it used to be due to lower-rated companies migrating to the leverage loan and private credit markets.
   • Now mostly made up of BB (54%)
   • CCC, which are typically the riskiest high yield is halved (20% to 10%)

Leverage Loans:

1. Before 2008: Corporate borrowing was done at the bank level. But banks eventually began arranging loans and then selling them off to investors to avoid taking as much risk. This is known as CLOs.
2. Collateralized Loan Obligations (CLO): Loans are pooled together and sold off to investors.
3. Slicing the loans into different tiers (tranches), where the lowest trenches absorb the first losses.

Private Credit:

1. Loans that are not public and do not trade.
2. Lending to smaller, riskier companies that are unable to get finance themselves in the public markets.
3. They are not mark-to-market.
4. Typically locked up for long period of time.
5. Typically floating rate.
6. Typically very few covenants (governance clauses to ensure that the bonds can be repaid)
7. Carl notes that private credit is generally considered the lowest quality segment of the debt markets
8. Carl notes that the yield spread versus the public markets have shrunk due to high competition.

When Economy is in Expansion and Interest Rate is Rising

Investment Grade Bonds

1. Generally do not want to be invested in this area.
   • Default is not a general concern.
   • When interest rates go up, bond price moves down, resulting in lower returns.

High Yield Bonds:

1. Generally do well because people become more comfortable with default risks (which is lower)
2. Since economy spends more times in expansion, this is why high yield typically does well.
3. Investors require less of a premium (spread) over the risk-free rate (Treasuries) to buy high yield bonds, causing the yield spreads to narrow.
4. The narrowing yield spread counteracts the general rise in rates, preventing the significant price hit that investment-grade bonds experience.

When Economy is in Contraction or Recession and Interest Rate is Declining

Carl notes that recession and contraction are typically shorter in duration.

Investment Grade Bonds

1. A time period when you want safety of investment grade.
2. Interest rate down, bond prices move up, resulting in positive returns.
3. Treasuries do very well in this period.
4. Highest-rated bonds (AAA) will typically do the best in declining interest rates, with performance decreasing down the credit quality.
5. Given that recession typically is shorter, the time you want to be in investment grade bonds should be shorter.

High Yield Bonds:

1. You can do well in high yield in recession if you keep the duration short and quality better (within the high yield space).
2. Carl explains that they have good returns in the first 3 quarters of 2008 by barbell short dated high yield and treasuries.

How Do You Know the Turning Point of the Economic Cycle

Carl says it is important to know where you are in the cycle.

The fortunate thing is that cycle turns are usually obvious.

1. Cycle usually changes only once or twice.
2. There will be tell tale signs of exuberances.
3. More difficult to know the bottom but there should be communication of liquidity provided.
4. When you are more certain about future returns than near-term returns, you are probably at the turning point (going down)
5. When you are less certain about long-term returns than near-term returns, you are probably at the turning point (going up)

Carl makes a distinction that we should not forecast but focus on the present.

1. Forecasting is seen as making a “bet,” like predicting the Federal Reserve will cut rates three more times. Carl avoids this.
2. Preferred Approach: He would rather have an economist tell him where they are right now and what to look for, rather than offering a forecast.

The Dangers of Index-based Fixed Income, Relative to Actively Managed

1. Fixed income is different from equities in that for equities the more successful companies becomes biggest.
2. In fixed income, the ones who issue the most debt takes up the largest capitalization.
3. If you own an index-based fixed income, you end up investing in the fundamentally riskiest issuer.

Issuers with Stronger Fundamentals

1. Stewardship of capital. Management is a good steward of capital, meaning they are cautious with their debt and view equity as permanent capital. They are not constantly buying back stock and returning money to shareholders when they have debt.
2. Business uniqueness. Businesses that are unique, have a defensible niche, and demonstrate a need to be there. Carl’s test is: “if they went away tomorrow would anybody notice?”.
3. Financial strength. Companies that throw off free cash flow and have reasonable leverage.
4. Growth focus. Companies that run their businesses for growth.
5. Sector stability. Staple-type and defensive companies that can withstand a recession without going bankrupt and have a constant source of demand (e.g., food distributors, equipment rental firms).

Issuers with Weaker Fundamentals

1. Purpose of debt. Lending money to a company to pay a dividend to private equity holders. Carl views this as a “not productive use of capital”.
2. Commodity / cyclicality. Companies in the commodity part of the market (e.g., E&P oil companies) that lack a unique business model and whose success is entirely dependent on commodity price cycles.
3. High indebtedness. Companies that issue the most debt, which leads to them having the largest weightings in fixed-income indexes. These companies are typically the most levered and most likely to get in trouble.
4. Excessive Leverage. Companies that are overlevered and have tough markets, which Carl predicts will continue to drive defaults, particularly in the private credit area.

Perspective about this AI Capex Boom and Equity/Fixed Income Positioning

1. Echoes of Past Bubbles: Carl suggests that the current AI Capex boom carries echoes of past market bubbles, implying that the level of investment might be unsustainable or excessively optimistic, similar to the run-up during the Dot-Com era.
2. Risk vs. Opportunity: While acknowledging the transformative nature of AI, his perspective likely focuses on the risks associated with the boom rather than the investment opportunity, particularly for a fixed-income investor concerned with capital preservation.
3. Unsustainable Spending: The massive capital outlays by technology companies (often referred to as the “Magnificent Seven”) for data centers, power, and chips may represent poor or highly aggressive capital allocation that is not yet justified by short-term returns.
4. Investment Implication: For the fixed-income investor, this creates a divergence between the equity market (which is fueling the capex through high valuations) and the bond market. Carl’s focus is on maintaining a short-duration, high-quality portfolio to insulate against the eventual volatility that often follows these spending peaks.

Recent Issue with Private Credit Likely Not to be Systemic

While acknowledging the risks inherent in the asset class, Carl implies the issue is isolated and unlikely to threaten the stability of the entire financial system.

• Default Risk is Contained: While he anticipates that defaults are rising in the private credit sector, he views this as a problem for the direct lenders and the firms involved, not for the broader market.
• Insulation from the Core System: Private credit operates largely outside of the heavily regulated traditional banking system. Therefore, distress in this sector is less likely to trigger a domino effect that impairs essential financial services, which is the definition of systemic risk.
• The Issue is Credit Quality: The core problem in private credit is the poor quality and high leverage of the underlying borrowers (often smaller, riskier companies). When the credit cycle turns, these highly levered companies are the first to face problems.
• The Difference from 2008: The issue is not seen as an interconnected financial failure like the 2008 crisis (which stemmed from complex interactions and regulatory loopholes) but rather a localized credit problem in a less transparent segment of the debt market.

Currently transiting from Equity Bull Market to Bear Market.

Carl explains that the flexibility to move defensive is achieved by either increasing quality or decreasing maturity/duration. His current positioning combines both for maximum safety:

1. Downside Protection and Drawdown Mitigation

• Minimizing Price Declines: Short-duration bonds (those with lower sensitivity to interest rate changes) experience much smaller price declines than long-dated bonds when rates rise or when the market sells off.
  • Example: He notes that a long-dated bond yielding 7% might trade down 20 points to boost its yield by 2%, whereas a short-term bond only needs to trade down about one and a half points to achieve the same yield increase.
• Building a Cushion: The limited decline in short-term bonds acts as a “cushion” against market weakness. This cushion helps the fund avoid the large drawdowns that plague other funds.
• Protecting Clients: Carl’s goal is to be “down a lot less” in a calamitous situation (e.g., down 5-8% vs. the 20-25% experienced by some other funds), which helps retain clients and avoids stress during downturns.

2. Maintaining Liquidity and Optionality

• Cash Substitutes: Carl’s defensive bucket, which was around 40% at the time of the interview, is composed of cash and cash substitutes (money market, Treasuries, commercial paper, and bonds maturing under a year).
• Ready for Weakness: This positioning ensures the fund is “very well positioned and very liquid”. When the market corrects or “unravels quickly,” they are ready with a list of bonds they love to buy on weakness.
• Buying Opportunity: By having cash readily available, they are able to purchase distressed assets when prices fall. Carl refers to the period of March 2020, where they were able to buy high-quality bonds at 70 or 80 cents on the dollar that yielded 9-10%.

Explaining the Economy in the Past Few Years

Carl Kaufman provides a detailed assessment of the Federal Reserve’s position, noting that the central bank is “caught in the box” of conflicting mandates.

The Fed’s Dual Mandate Conflict

• Caught in the Box: The Federal Reserve has two mandates—to keep inflation and employment steady—but unfortunately, they have to favor one or the other at any given time.
• Focus Shift: For the 2022-2024 period, the Fed was primarily focused on inflation to slow down the economy and work through the stimulus from the COVID era without causing too much inflationary damage.

Current Inflationary Environment and Policy Risks

• Inflation Stubbornness: While inflation has started normalizing, it is not yet at the “mythical 2%” target.
• Contradictory Pressures: The administration supports tariffs (which are inflationary) but also desires lower interest rates (which are also inflationary).
• Bond Market Policing: When the Fed cut rates, the bond market effectively said, “Oh my god, I do not need more stimulus now, that’s going to be inflationary,” causing long-term rates (10, 20, and 30-year) to rise in response.
• Money Supply Warning: Carl stresses that if the Fed cuts rates again with the money supply (M2) still at an all-time high, “that’s inflationary”.

The Employment Picture and Data Reliability

• Slower Job Growth is Normal: Because population growth has slowed (due to a stop in immigration), the economy does not need to create as many jobs today as it did previously. A lower number of jobs being created is therefore “not necessarily showing weakness” in the economy.
• Data Uncertainty: Due to government shutdowns, the Fed’s data on employment is unreliable. Carl advises people to “keep your eye on the revisions” because they are expected to be huge once catch-up work is done.
• Tech Layoffs are Small: Layoffs in the tech sector, while publicized, are small (e.g., 100,000 across many companies) and are “not the end of the world” unless the number reaches into the millions.

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Kyith is the Owner and Sole Writer behind Investment Moats. Readers tune in to Investment Moats to learn and build stronger, firmer wealth foundations, how to have a Passive investment strategy, know more about investing in REITs and the nuts and bolts of Active Investing.

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Kyith worked as an IT operations engineer from 2004 to 2019. Currently, he works as a Senior Solutions Specialist in Insurance Start-up Havend. All opinions on Investment Moats are his own and does not represent the views of Providend.

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