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Osterweis Strategic Income: Ready for Rising Rates

By: Kiplinger
Posted: 1/9/2014 9:13:00 AM
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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 ( OSTIX ).

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 wind.

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 ( VCSH ), 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 turnover.

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 investment adviser in the Washington, D.C., area.