Looking for bonds that will hold their own in a period of rising
interest rates? I think I've found a good hiding place in Osterweis
Strategic Income (
In my view, the 30-year bull market in bonds--which saw yields
on ten-year Treasuries fall from a high of 15.8% in September 1981
to a low of 1.4% in July 2012--is history. Rates are likely to
rise, albeit gradually and with some interruptions, for years to
come. Because prices of most fixed-income investments move in the
opposite direction of yields, bond investors are sailing into the
What to do? The obvious move is to invest in short-term bond
funds. Their bonds come to term quickly so, when rates are rising,
investors can frequently reinvest proceeds from maturing bonds in
higher-yielding IOUs. The problem is that high-quality short-term
bond funds pay virtually zilch. For instance, Vanguard Short-Term
Corporate Bond Index ETF (
), an exchange-traded fund, yields all of 1.4%.
To earn higher yields on short-term bonds, you have to invest in
lower-quality junk bond funds. And Osterweis, in my view, is the
best fund that does that. Strategic Income has a superb record.
Over the past year through January 7, it returned 6.4%, beating the
Barclays U.S. Aggregate Bond index by 7.7 percentage points. Over
the past three years, the fund,
a member of the Kiplinger 25
, earned an annualized 6.4%, topping the index by an average of 3.0
percentage point per year. The fund's 30-day SEC yield is just
3.0%, but its current income distribution rate is 5.8%.
Osterweis should do well if long-term interest rates continue to
rise, which is likely now that the economy finally seems to be
accelerating and the Federal Reserve has begun to pare back its
bond-buying program. Strategic Income's price would fall only about
2% if rates on short-term junk bonds rose by one percentage point.
If the increase occurred over the course of a year, the fund's
yield would more than offset the small loss of principal. Moreover,
although a strengthening economy is likely to result in higher
yields on high-quality bonds, rates on short-term junk are unlikely
to rise much, if at all.
The bigger peril for investors in Strategic Income is credit
risk. The fund's average credit quality is only single-B, which is
firmly in junk territory. Issuers of junk bonds stand a real chance
of defaulting on their obligations.
What's encouraging is that Strategic Income has never
experienced a default. Co-manager Carl Kaufman, who launched the
fund in 2002, says there's no magic to what he's doing. "We try to
fish in the right waters," he says.
Kaufman, 57, has an unusually broad mandate in running
Osterweis. He owned Treasuries in 2008, then turned primarily to
junk bonds in 2009. He started to focus on short-term high-yield
bonds early in 2012.
I do have two concerns about Strategic Income. First, I worry
that short-term junk bonds might not be offering enough yield to
compensate for the risks of owning low-grade bonds. The Merrill
Lynch 1-3 Year High Yield Index currently yields 4.6%. That's well
above the virtually negligible yields of similar-maturity
Treasuries, but it's low in absolute terms.
Second, I worry that Strategic Income, which has grown to $5.8
billion in assets from $604 million at the end of 2009, has gotten
too big. (I'm also not too keen on the fund's annual expense ratio
of 0.91%, which I think is too high.)
No question you're not getting paid all that much for investing
in short-term junk bonds. But relative to everything else, the
payoff looks good. And Kaufman's record of never having a
experienced a default is heartening.
Osterweis's asset growth is a tougher issue. Kaufman ran the
fund himself before hiring a co-manager, Simon Lee, at the end of
2008. Last June, he hired a second co-manager, Bradley Kane. But
that still leaves just three people handling a boatload of money,
much of which is invested in a relatively small sector of the
market. Moreover, Kaufman says, Osterweis has no plans to shut the
fund to new investors anytime soon.
Kaufman says the fund only holds about 100 positions. He says
all three managers review each bond, and they know all of the
holdings inside out. "We know which companies have good chief
financial officers and which companies don't."
The fund rarely sells. The official turnover ratio is 82%,
implying that the fund turns over almost its entire portfolio every
year. But, Kaufman says, bonds that mature or are redeemed early by
the issuing company account for 70% of the fund's annual
My bottom line: Kaufman's record of avoiding defaults is
impeccable--and quite reassuring. He impresses me as a thoughtful
manager who will know when it's time to close. His co-managers both
have long experience investing in junk bonds.
Osterweis Strategic Income is a first-rate fund. But it's not a
buy-and-forget fund. If the economy shows signs of falling into
recession, I'd sell--unless, of course, Kaufman is nimble enough to
have changed the fund's direction by then.
Steve Goldberg is an
in the Washington, D.C., area.