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Excess Returns
The Risk Isn't Where You Think | Carl Kaufman on AI Capex, Private Credit and the Hidden Bond Play
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Is it get optioning those options or.
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
It's kind of interesting that the high yield market is probably the highest quality it's ever been and the investment grade market is the lowest quality it's ever been. Cisco was the Nvidia of its day. It was the ARM supplier and towards the end of the cycle they started financing some of their clients to purchase more routers. It's happening with Nvidia already. They're starting to finance via joint ventures so they can afford to purchase more chips. You're going to continue to see most of the defaults are going to be in the private credit area. I don't think it's systemic because every company has a different business model. The Fed's kind of caught in the box, right? So their two mandates are inflation and employment. Right. Supposed to keep them both steady. Unfortunately, they have to favor one or another. They can't do both at the same time.
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Excess Returns Host
Hi Carl. Welcome to Excess Returns.
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Thank you for having me.
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Excess Returns Host
We're excited to have you on today. You are co president and co CIO of Osperweiss Capital Management and you are also the portfolio manager on the firm Strategic Income Fund, a top rated fixed income fund with 5.8 billion in assets. And it has a track record pretty impressive going back to 2002. So that's 24 years. I'm doing my math right here almost. Yeah, yeah, yeah. Talk about like survivorship in the fund business. One of the things that I pulled from your site is sort of, you have these three principles that sort of guide the firm's philosophy. And that is the firm plays both offense and defense on the strategies. You focus on absolute returns. And number three is you always want to be focused on the importance of looking at and evaluating strategies through a full market cycle. And so, you know, today we'll talk about some of those things as we work through your investment process and how you think about sort of the risk and opportunities in the fixed income market today and sort of how you build portfolios and how you manage your fund. So investors can learn more@osterweiss.com you can just go there. It'll be up on the, on this, on the screen here. All right, so as a starting point, I thought it would be good just to work through. And we don't spend too much time here, but just the various segments in the fixed income investing landscape. And so can you walk us through how you would define investment grade high yield, leverage loans, private credit, and how you think about each of those segments of the market in terms of like, transparency and risk? I know it's a pretty broad question, but I think our audience would benefit from that.
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
It's an important one because we've seen some big shifts over the last 10 to 20 years. It used to be a fixed income investor would show up in the morning and he'd have a choice investment grade, non investment grade. That was pretty much it. In investment grade land, you have government securities agencies and investment grade corporates. Those are determined by the rating agencies. They have, you know, drawn the line between, you know, the bonds. They rate triple B and up as investment grade and double B and below is non investment grade. But these days it's gotten more layered than that. There are different flavors that I'm not going to get into to this point in the discussion. But in below investment grade bonds, there are now two new cohorts, and you mentioned them. One is private credit, which is just what the name entails. They're not public. They don't trade, they don't get mark to market for the most part. The investor has to be locked up for a long period of time. And it is, or at least it was, the shiny new toy of fixed income for the last few years. And a lot of money has been raised to, you know, invest or lend to what typically are smaller companies, we think riskier companies that cannot finance in the public markets. And, you know, there are companies that have been doing this for decades. You know, Aries and you know, Blue Owl, companies like that, that have large networks to source these, these borrowers. The newer players that have raised a lot of money have to put that money to work, but they may not have the networks that these guys do to source money. So they, I mean, I tell you, I must get two or three emails a week. Disaster. Weiss, need money. You know, these are some of these funds that, this is how they find borrowers. You know, I can get you approved for, you know, a million dollars, two Million dollars so they can make a loan. These are typically floating rate bonds. They are looms, they have very few covenants. And you know, there's so many people looking to lend money that the borrowers actually put them in competition. So this spread in the yield that you are getting early on in this game versus the public markets has shrunk because of the competition. To lay, there's also a market called a leveraged loan market. Now back in the old days, before 2008, you know, most of the borrowing by corporate America was done at the bank level. So banks would lend you money, they would do credit work on you, they would, you know, make sure you're a worthy borrower. And then they got the bright idea, well, you know, probably be easier, I won't have to take as much risk if I, you know, arrange a loan and then sell it off the investors. So they make these loans and they basically sell them off to investors. And the way they do that is they'll take a pile of these loans, put them in a vehicle called a collateralized loan obligation, and then what they'll do is they'll slice and dice. So you know, the top tier is they call them tranching. So the triple A tranche may be, you know, 20% of a CLO and they'll back that with say 30, 35% of the loans in the portfolio. So if there are a lot of bankruptcies, you won't get hurt because the losses go to the lower tranches. Now the equity tranche takes the first losses, the triple B, triple A, you know, take the next losses. So that became a marketing tool. You know, basically it's, it's, you can lend as much as you want. You throw them in some good loans, some bad loans. They've come up with rules on how much triple Cs you can have in those because that got them into trouble in 08 09. So that's sort of the next level of quality above private credit. Private credit is the lowest quality. And then you have the loan. Leverage loans are the next highest quality. And then above that is the high yield market, which is the non investment grade. And above that is investment grade. Now what's happened because of that migration of the lower rated companies to the leverage loan and private credit markets, the composition of the high yield market now is, I think it's 54% of the high yield market is now triple B, I mean double B rated, which is the highest rating. Conversely, the triple C, which is the riskiest part of the market has been more Than halved as a percentage used to be about 20%, now it's about 10 in investment grade land, interestingly enough, the same thing has happened but in reverse. So there's the triple B market, which is the lowest rated part of the investment grade market is slightly over 50% of that market. Used to be maybe 30%, 35%. So you've seen this convergence in the sort of the belly of the ratings in BB triple B. So it's kind of interesting that the high yield market is probably the highest quality it's ever been and the investment grade market is the lowest quality it's ever been. If you weight the different rating trashes.
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Excess Returns Host
Well, what's, what's also interesting with this is like out of the financial crisis, you know, we regulated the banks and they tightened their standards and then. But it's almost like as a result of that the market is now maybe more fragile with you know, some of these private credit leverage loan type areas and they become more important in like the lending structure of things. So it's like, it's interesting how it kind of hopefully doesn't backfire, I guess.
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Well you know, it's. People will always find a way around.
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Excess Returns Host
Yeah.
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Rules and that's, that's the problem. Banks clearly, because they typically receive taxpayer bailouts, need to be protected against their worst instincts. So they have gone from being lenders to arrangers and that's a lower risk business. Now I will say this, that they are now lending more to institutions, non deposit making financial institutions that actually make those loans. They actually lend them money to fund them. That percentage of the bank's books to those institutions has more than doubled in the last few years. So they're actually can't really help themselves in terms of lending money to these guys. It's indirect now, but it's happened. So we tend to avoid any private credit, we tend to avoid leverage loans. We focus in the high yield bond market, investment grade bond market when it makes sense, and the convertible bond market, which is a entirely different kettle of fish.
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Excess Returns Host
One of the things that we love here and that is important is like these investment frameworks and sort of methodologies that you know, firms have and develop. And one of the things that you guys, you've talked about is this two cycle approach to investing in the bond market, the interest rate and the credit cycle. So can you just sort of walk us through those cycles and how they interact and sort of how they're interacting with each other today.
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Today is odd. But I'll get to traditionally how they Interact. Typically what you have is an economic cycle, is the economy, you know, gets stimulus, it heats up, you know, it's going along well. And during that part of the cycle, interest rates are rising because demand for credit is increasing. Right? You're doing well, you want to spend more money to grow your business, you borrow some of it, you're public, you might issue some equity. So interest rates rise. Now they typically would rise to a point where, you know, it gets too expensive and you know, war and, or the economy starts to weaken so you don't borrow as much and you go into a recession because either, you know, you're getting crowded out by, by the Feds, you know, government borrowing because they're, they're borrowing as well, or the economic cycle has run its course and then interest rates start declining. So in the period where the economy is growing and interest rates are rising, what you don't want to be invested in is what people traditionally think of as fixed income, which is the investment grade market, which these days they call core, core plus, whatever you want to call it, because you're not worried about bankruptcy in those bonds. So the only variable that affects the price of those securities is the interest rate. So if the interest rate is moving up, your bond price is moving down and so are your returns. Conversely, when you are going into a recession and interest rates are coming down, that's when you want the safety of investment grade because rates are coming down and bond prices are moving up and so are your returns. So investment grade, you know, as exemplified by Treasuries, for example, do very well going into recessions as rates are coming down and prices are going up. It's a one to one ratio. Now it tends to be a stepladder function. So the highest rate, triple A bonds will do the best in declining interest rates. The single A's will do second best, the triple B's will do third best, etc. All the way down the credit cycle. And when you, and typically these episodes are much shorter in duration than the recoveries because you typically have the fed coming in since 08, they come in with guns blazing, providing tons of liquidity, lowering interest rates. So it tends to be, you know, heals much faster than it would if you didn't have a Fed. Conversely, when things are going well for the economy, you know, they just kind of stand aside and let things happen. And you know, human nature being what it is, everybody likes growth. So those tend to be longer parts of the cycle. So what you find is the time you want to be in Investment grade is a shorter period of time than the time you should be in what we call economic beta or high yield. Things that benefit from an improving economy. And the reason that subinvestment grade does well in an improving economy is, is that people feel comfortable with risk. They feel more comfortable, they feel more comfortable about default risk and they require less of a premium over the risk free rate, I. E. Treasuries to buy those bonds so that we call that spread. So your spreads are narrowing and as your rates are rising so you don't get that hit that you would on investment grade bonds. That's why high yield has been such a great asset class for so many years. And that's where we tend to focus mostly. Last time we were big in investment grade was when we had the inverted yield curve. We were buying shorter dated bonds and higher yields and longer bonds. That's just common sense.
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Hi, I'm here to pick up my son, Milo.
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Excess Returns Host
There's no Milo here who picked up.
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Experian Ad Voice
My son from school.
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Streaming only on Peacock. I'm gonna need the name of everyone that could have a connection. You don't understand. It was just the five of us. So this was all planned. What are you gonna do?
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Excess Returns Host
I will do whatever it takes to.
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Interviewer/Co-host
Get my son back.
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
I honestly didn't see this coming.
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Interviewer/Co-host
These nice people killing each other.
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
All her fault.
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Excess Returns Host
A new series streaming now only on Peacock.
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Interviewer/Co-host
I was thinking back to your first answer when you were giving that answer. Because this idea of you wanna be an investment grade around recessions, I'm wondering if that's somewhat minimized by the fact that high yield is better than it used to be and investment grade is worse than it used to be. So maybe there's less case to do that now these days. Is that. Is that fair?
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
I would agree with that assessment. There. There is less of a case. There's still a case to be made, but it's more of a trade than an investment at this point. You've got to know when to get in and when to get out. Whereas high yield, if you buy short dated high yield and some of the Higher quality companies, you're going to be just fine. In 2008 we had a barbell of Treasuries and very, you know, higher quality, high coupon, short dated, high yield. And we had positive returns for the first three quarters of 2008 with that barbell. Now after September of 2008 we decided to, you know, get back into the high yield market because it was, had gotten pretty beaten up. Rates were at one, one and a half percent. We thought they had done what they needed to do. We were two months too early and you know, we were down 5% in 08 as a result of being two months too early on. The big scheme of things doesn't really matter because you know, 2009 everything took off. So we were, we were fine. But, but it just goes to show that you can have positive returns in high yield even in a recessionary environment if you buy the right part of the market.
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Interviewer/Co-host
You mentioned the economy and the Fed and interest rates. How much for what you do do you have to have an outlook like how much do you have to try to figure out what's happening with all that stuff to do what you do and how much does it not that matter that much to what you're doing?
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
It's very important to know where you are in a cycle. Now that doesn't mean you need to know whether you're in the bottom of the third or the top of the fifth inning. But you have to know whether you're in an expansionary part of the cycle or a contracting part of the cycle. That's very important. The good news is it doesn't change but once a cycle or twice a cycle depending on how you define the cycle. And it's usually pretty obvious where you are and you know when away hit. You know, even in 07 you kind of knew that real estate was overvalued, that you are going to have some kind of credit cycle. And it was July of 07 when you know, our Treasury Secretary were bringing out the big bazooka. When they start talking like that, you kind of know, you know, it's time to, that's when we started buying Treasuries. And it's harder to know exactly when the bottom is going to be. But you can start getting a sense for it by seeing the actions that are taken, the liquidity and seeing which companies are going to be the survivors. And a lot of it is just, some of it is just an educated guess. When you are more certain about future returns than near term returns, you're probably At a turning point when you are less certain about long term returns than you are near term returns, you're probably at a turning point as well.
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Interviewer/Co-host
It's funny, I was listening, I was thinking in your answer, I was listening to a guy who's a great macro investor and people were saying, oh, you must be a great forecaster. And what he said is like, I'm not a better forecast than anybody else. What I'm really good at is figuring out what's happening right now. And it seems like that's the same type of thing you're trying to figure out.
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
You know, one of our favorite comments here is we don't make bets. So making a bet is, you know, I think interest rates are, you know, where they are today. I think the Fed is going to cut three more times. I'm going to buy Centennial Treasuries. That's a bit. You're right. You could be wrong. The guys who were right are hailed as geniuses for that part of the cycle. And then they generally can't Repeat for another 10, 15 years. But be that as it may, if you look today and see, okay, the outlook is sort of okay, economy still hanging on. Everybody, everybody sort of knows where we are, but everybody's trying to forecast, as you say, that's what economists get paid. They think they have to forecast. I'd rather have an economist just tell me where we are and what to look for because that's more important.
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Interviewer/Co-host
You've described your approach as buying bonds like a stock picker. Can you explain what you mean by that?
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Sure. Most funds that, when I started this fund, it was started to be the only fixed income investors our wealth management clients would need in their portfolios over many cycles. And so we had a very flexible mandate. And most mutual funds back then did not have, I mean, multi sector funds weren't a thing back I came up with the theory of, you know, buying high yield at the bottom of cycles, buying, you know, Treasuries at the top of cycles, combining them with convertibles here and there's. And I said, let me go see if there's some funds that have done this, see how they've done through cycles. I couldn't find one. So most funds are marketed according to style boxes. So Morningstar has done a really great job in convincing people that there are nice neat boxes that they should invest in. So if you want a high yield allocation, you go buy a high yield manager. His mandate is he has to be in high yield even when high yield looks horrific. Core has to be an investment grade even when interest rates are rising. And you saw that the last five years, their returns have been, you know, virtually nil. They're just starting to get some returns now because they were there in 22. It's sort of a race. When you start with zero percent interest rates and you raise them to five and a half percent, guess what, you're going to get hurt. But they can't avoid it because that's their mandate, that's the box they're in. And we don't believe in boxes here. So what we do is, and take that a step further to answer your question, is a corporate bond fund or a high yield fund that is sort of benchmark, you know, driven, typically owns most of the names and the benchmarks. You may not own every tranche of every issuer, but he pretty much owns every name. And I would, if I had to guess probably 10 to 20% of those he really doesn't want to own, but he has to own because they're big issuers. So they may have three to 700 positions in their funds. We say, okay, I'm not going to do that. I'm going to find really good companies that we can invest in for the long term and I'm going to buy what I think is the best value in your bond stack. Typically they have one or two bonds. We prefer that rather than the big issuers because in, in, in indexing, in fixed income, it's different than equities. In equities it's success based, right? The best performing companies get the biggest weightings. But we have the Mag 7. They've been terrific performers and huge market caps. They've been the most successful stocks. That's how they're weighted. And fixed income is the other way around. The companies that issue the most debt have the biggest weightings and the companies that issue the most debt are usually the most levered companies and those that are most likely to get in trouble. But as a, as a benchmark investor, you have to own because if they move up and you don't have them, you're short to the index and people are asking hard questions. So we typically have many fewer positions than a benchmark fund. So we pick and choose, we do research. We have four very senior portfolio managers on the team and we structure ourselves a little differently than most funds. So we all take a look at each name. So we'll all be on with the management and then we'll reconvene. And what we try to find are companies that are One, good stewards of capital and by what we differ with our equity peers on that in that we think a good steward of capital is not constantly buying back stock, returning money to shareholders. When you have debt, if you're throwing off a lot of excess free cash flow, sure, return some debt, we hold it. But be, be, you know, careful with your, with your cap stack because you know that could come back to bite you. Equity is permanent capital that has to be repaid. So we look for that. We look for businesses that have a need to be there. One of the questions we ask ourselves, if they went away tomorrow, would anybody notice? You know, a lot of EMP companies went through two bankruptcy cycles and those that disappeared, you couldn't name five of them because they're all the same. They all dig for oil in the ground and they come up with oil. They have times when the price is high, they do great. Price is low, they don't do so great. So we tend to eschew that commodity part of the market. We like companies that are unique, have defensible notes, throw off free cash flow, have reasonable leverage and you know, run their businesses for growth. We don't want to lend money to a company to pay a dividend to private equity holders. That's not, that's not productive use of capital in our view. So we have about 120 portfolio companies versus the three to 700 that other funds have our size. And we will take multiple tranches. So we have about 160 positions. And what that does is two things. One, you have management access because you're typically the largest or second largest holder of whatever bond issue that you own. So you get management's attention. As I said, we don't make bets. When we buy a bond if it's at the right price, the right yield and the right characteristics that we like, we buy it with the intention of holding it. So our turnover is very low. We've been with some companies now for 17 years. We've been with one company, various issues. Of course, you know, because they refinance their bonds, but we get to know the company really, really well. We're on first name basis with many of our company CEOs and when it comes time to refinance, you know, we, we, we fight above our weight because a lot of times the management will tell the underwriter, give these guys what they want because they like having us at bondholders. We tend to leave them alone if they're performing and when they don't performing, they hear from us.
- [27:12]
Interviewer/Co-host
A few follow Ups on that one is I think what you said about in the bond indexes is really interesting because I think that's a thing a lot of people who come from my world in the equity side don't understand, which is that, you know, everybody's used to The S&P 500 dominates all active managers. You should never use active managers. And then you go into the bond world and the indexes are constructed in a much less sensible wing. So there's much more of a case, I think to be using something active on the bond side than there is on the equity side.
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Well, it's actually constructed the same way. It's those that with the largest caps, largest weightings are the largest, you know, weightings in the index. And the problem is how you get there is different in equity. You do it through success in fixed income. You get through excess borrowing. So you know, these cap, these companies that are, you know, some of them are large companies that have, you know, 30, 40 bond issues and they're issuing a new bond every couple of months. It seems those are the big weighting. You find that I think seven out of the top 10 companies in the high yield index are triple C. You know, it's, I haven't looked at it in a while, but they, they don't tend to be the higher rated companies. They tend to be the lower rated companies that constantly need the borrow money.
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Interviewer/Co-host
And going back to the type of companies you, you own, it sounds like you would be more like more inclined to own staple type companies rather than cyclical type companies. Am I thinking about that, right?
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
You're absolutely thinking about that. Right. You know, some of our, and some of them are, I mean, look, I'll give you a couple of examples of industries that we really, really like. We like distributors. So food distributors, you know, U.S. food unified. Katie's an organic food distributor, Performance Food Group. We own all four of them. We don't have to make a choice. It's a great business. You know, if the economy goes into recession, are you going to stop eating? I don't think so. I don't know about you, but I'm not growing my own food. So I go to the supermarket and guess who supplies them food distributors. You go to a restaurant, who supplies them food distributors? No matter where you go, they're supplied by a third party. We love that Wesco, an electronic equipment distributor. They distribute, you know, for building all the wires and electrical connectors and what have you conduit, you know, they don't go buy that from separate, they Just go to Wesco and just get it all in one package. So distributors are a terrific decent. The other one is equipment rental firms. Think of the equipment rental business. When times are great, these guys are growing like a weed. But they do it by spending a lot of money on new equipment because they need new equipment because their customers are building lots of stuff. When times get bad and everybody pulls their horns in and don't build as much, these guys shrink their sleeves, they sell off their equipment. So what happens is during the growth period their revenues and earnings are growing and EBITDA is growing, but their cash flow is not. The cash flow is actually shrinking because they're buying new equipment. Now that's an asset on the balance sheet when a recession hits, they're selling off equipment. There are companies that have huge operations that do cash on them. Their cash flow goes up. So when everybody's in recession, their cash flow is rising, which is very defensive. So if you think about what type of companies do I want to lend money to, it's those that A can withstand a recession without going bankrupt and B, have a constant source of demand and not a lot of competition.
- [31:00]
Excess Returns Host
What do you, I'm just curious because in the news, you know, recently with Meta and Oracle, you know, issuing debt to finances, you know, AI build out and just that whole entire development, you as a fixed income investor, like what are your thoughts when you see something like that and you've been through these boom and bust cycles, does that give you any pause or like, okay, this is now I'm seeing signs of this isn't good or how do you sort of think about that or have you thought about it?
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Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Gives me the willies. We had a big long discussion in our internal research meeting with the other teams today as a matter of fact, about that and the real, I mean those of us who have been around long enough saw it in 2000, right? There was the Internet build out. Cisco was the Nvidia of its day. It was the ARM supplier and towards the end of the cycle they started financing some of their clients that purchase more routers. It's happening with Nvidia already. They're starting to finance via joint ventures so they can afford to purchase more chips. It's an Nvidia centric bubble. It bubble, whatever you want to call it. We don't know how much it's going to, how long it's going to last. I mean the plans are to spend five and a half trillion dollars on infrastructure. I came up with a new saying today. Trillions don't grow on trees. But think about how much revenue this is going to have to produce to get even a 10% return on capital, which would be $550 billion in profit. There are clearly going to be some winners, but they're also going to be a lot of losers. And Meta, by the way, is smart enough to have structured that bit non recourse to them. It's recourse to the projects and they are not committed to build those. And if they don't, they're not on the hook ship. So that tells you one thing. We tend to read covenants when we buy stuff. People benchmarks, you know, may or may not, depending on how much staff they have. But you know, these, these bonds are. I mean, Oracle did a big deal in September. They had $18 billion worth of financing for data centers. Those bonds are already down seven points. We'll see where this all shakes out. But it has echoes of 2000. I don't think it's going to repeat, but it's certainly rhyme and there will be winners. I mean, AI has some great uses. I think the tech layoffs that you're seeing as a result, they're using AI as an excuse, I think, I think a lot of those layoffs are just because they hired too many during COVID Amazon. Perfect case in point. Hire a lot of white collar employees. They don't meet them, not because of AI, I don't think, but you know, they just have to cut back. And the excuse is a good excuse, but I don't know if you've ever used an AI assistant for customer service. I always have to end up with a real person on the other end of the phone. These companies figure this out, you know, and as AI needs to continue to raise prices, they're going to say, I'm paying. I'm going to have to pay a ton for this, this application. I can hire people cheaper. So it's not going to be as demonic as some of the Cassandras make it out to be in terms of eliminating everybody's job.
- [34:54]
Interviewer/Co-host
How do you think about sector concentration when you think about your portfolio? That's something we ask equity people all the time. But I'm wondering how that's different in a bond portfolio. Like how much you have to be concerned about your sector allocation.
- [35:03]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
We are aware of it, but if it's a good sector, we don't mind being overweight. So for example, distributors, I mean, we own all of them. That makes sense. The only one that doesn't make sense right now is Cisco which is investment grade. It doesn't yield enough. So for us, if we like a sector, we don't choose. So an equity investor probably wouldn't own MasterCard and Visa. They'd pick one or the other because they don't want to be overweight. The sector we would buy both. They're both good companies. Because in bond lane, all I'm worried about is getting paid back and getting my interest. One can be a slight winner over the other and the stock can perform much better. But in terms of fixed income, they'll both pay you off and they'll both get, you get refinanced because they're both high quality. So that's a little bit different fixed income investing than equity investing per sector. We were clearly aware of our, of our exposures. Industrial has always been a big sector for us. But industrial has such a wide swath. I mean, it's everything from car manufacturers to makers of widgets to whatever. You know, it's, it's, it's a big sector. So they're not intertwined in the same dynamics, if you will.
- [36:26]
Interviewer/Co-host
I'm also curious how position sizing is different. That's another question we always ask equity investors. In terms of how many positions you have, but also in terms of the percentage in each position, how do you think about that?
- [36:35]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Well, for us, you know, we have 120 companies in the portfolio. So you can just do simple math and figure out that, you know each one's going to be slightly less than 1%. Some of them are greater than 1%, some of them are less than 1%. But we think in terms of about 1% as a full weighting. For us, when we have a greater than 1% position, it's typically a higher quality company with what will have multiple bonds and what puts them over the 1% is we'll have a big weighting in the shorter maturities. But unlike equities, where you get an Nvidia or a Google or an Amazon, that you can start as a 1% position all of a sudden with a 5% position because it's grown so much, doesn't happen in fixed income. Funds don't go up fivefold.
- [37:27]
Interviewer/Co-host
I want to shift back to private credit because we talked about the beginning. I know you're not optimistic on. It doesn't seem like you have any positions in private credit right now. But I'm just wondering like you're someone who sees what's going on behind the scenes. And we've had some guests with what happened with Tricolor and What happens first? Brands are saying like there's cracks in the system and this could be a systemic problem. Just wondering, as someone who sees what's going on behind the scenes, like what are you thinking about what's going on at private credit and do you think there's any merit to that type of stuff?
- [37:51]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
I think that in those two cases they were company specific. One was outright fraud, incompetence and the other one was just, I mean, you know, when you're hypothecating the same asset four or five times, that's just fraud. Now should the underwriter have done a little more work and found what that lone researcher found and made public? Yeah, he should have. Could he have found that out easily? Probably not easily. Fraud is usually pretty well hidden. But those are the types of companies and managements that can finance in the private markets. And you know what we found is that when you have hedge funds and these guys all talk to each other, they're all in the same trades, they all, you know, they all, they love the warmth of the herd. So you'll have a bunch of guys in the same names. I think that, you know what we've seen so far and it's pretty opaque but Fitch had a report that they saw year to date defaults in private credit were as high as nine and a half percent. You've got loans year to date, default is in the low threes and high yield defaults are about 1.7, 1.8. So you can see the tiering of defaults there. I think defaults in private credit are going to rise and some of that is just these companies are over levered and their end markets are tough either through tariffs or whatever and they're just not going to make it. So you're going to continue to see most of the defaults are going to be in the private credit area. I don't think it's systemic because every company has a different business model. And what it seemed to me was that those two companies, one was sort of parts and retail and one was lending subprime. You know, they're both different businesses even though they both are in the automotive area. I think automotive is an interesting one because you know, as prices go up and wages stagnate, people spending more and more of their, of their income dollars on their transportation car. Cars and cable are the last two things people want to give up. They want to live in their, live in their car, give up their home. But you know that, that's a, that's a tough one. But I read somewhere the average car payment is $600 a month in the US and the average age of a car is 14 years. Now, you guys know that when you go into a subprime situation, you're buying a used car, first question they ask you is, what monthly payment can you afford? So you're shopping based on your monthly payment, not the egregious interest rate that they're slapping on you to get to that payment. So there are, there's going to be probably more defaults there going forward. But that's always been the case with subprime auto. You're always going to recycle there.
- [40:58]
Interviewer/Co-host
I just bought a car and good, good luck getting them to tell you what the price of the car is. You know, it takes forever to get them to tell you what you're actually paying for the car because they've got all this monthly payment stuff they're throwing at you.
- [41:08]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
No, exactly. I just go through the fleet dealer and I say, you know, this is, I have the information, this is what I pay. Let me know and you can do it.
- [41:15]
Interviewer/Co-host
I'm just curious, as you're familiar with the space, do you have any thoughts on. It seems like there's a lot of efforts being made to bring private credit to the masses. I mean, there's an ETF now that has at least partial private credit behind the scenes. Like, do you have any thoughts on that? On this whole idea of trying to bring private credit to everyone?
- [41:29]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
It's revolting. I mean, private, private equity, private credit alternatives. Their returns have been mediocre at best. And the, and the institutional buyers are selling. You saw some of the college endowments have been selling their private investments off at 10% discounts. So they're not buying their new funds. So they need new buyers. And what better buyer than the little guy? I don't like it. I don't think it's right. And I think that people should be very careful when you're looking at these things, especially in their retirement funds. That's just my personal opinion. I'm sure a private equity guy will give you a different answer.
- [42:18]
Interviewer/Co-host
So I was looking at the. And I don't know if this is completely up to date information, but I was looking at the positioning of your fund and it seems like you have most of your portfolio in high yield now. And that kind of goes back to what you're talking about before, but it also seems like you have a pretty short duration on right now. And I'm just wondering what the basis, what the reasoning behind that is okay.
- [42:36]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
What we typically do is in a perfect world when the market keeps climbing and climbing and climbing, we get more and more defensive. And the way you do that in fixed income, you can do it two ways. You can go up in quality or you can go down in maturity or duration as they call it, the sensitivity to interest rates. And we tend to do it by building short term positions. Last time we did this was sort of 1819, I don't know if you remember, you know, rates were very low in high yield. I mean I think the high yield market yielded 5%. That wasn't enough yield for us to justify even though spreads were bigger than they are today because the investment grade universe was trading at near 0/2 percent, you know, 1% in the 10 year. So spreads were okay, but the absolute yield was not acceptable. So we built cash, let cash, build cash. And by cash, I mean money market Treasuries, commercial paper bonds maturing under a year. That's kind of the way we view our short term bucket. So coming into 2020, we had 35% in defensive short term assets. That worked really well during COVID Everybody was selling, we were buying. We've never been down 10% in any time period ever. We hope to continue that. Right now I think we're going through another phase where companies are issuing bonds with five handle coupons for eight, 10 years, going to approach four again. So going through that again where there's too much money chasing too few bonds and for the better companies, they're very shrewd and they finance very cheaply. We tend to buy those when the market cracks. So right now we have probably been too defensive too early. But we're up to about 40% in short term defensive position. And some of that is investment grade, some of that is double bees. But we are very well positioned and very liquid because when the market does crack, we never know what's going to set the market off. You know, who knows what it's going to be. But when it does, it usually happens. It unravels pretty quickly. And we have our list of bonds that we would love to buy on weakness and we'll be ready. People always ask after the fact, they say, well, aren't you finding liquidity really difficult? So if you're a buyer and everybody's a seller, no liquidity is really nice.
- [45:23]
Excess Returns Host
So is there.
- [45:24]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
We are pretty defensive now, but most we have about, you know, 60, I think 68% in non investment grade. Right.
- [45:33]
Excess Returns Host
And so is cash in there as an optionality. I haven't looked at the holdings, so I don't know but. Or is it just rolling off and as those bonds sort of mature that you're kind of looking at those opportunities to deploy?
- [45:44]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Typically we do that a little differently than most. See most funds when they get cash in, they reinvest across their portfolio. So they'll go out with a program, bid electronically or otherwise and say I need to buy, you know, $40 million worth of bonds spread between 300 issues. So we'll go out, get an offering on those and put it to work. So portfolio looks the same from day to day. We don't do that, goes to treasury first. Then we look at commercial paper, we look at short term bonds and we'll reinvest as we find opportunities which only may take a day or two or three or four, who knows? So that's how we do it. Depending on how we're positioned, if that cash happens to show up in a period like March of 2020, we're going to be buying, you know, bonds at 70, 80 cents on the dollar that you'll 9, 10% as opposed to rolling it into short term.
- [46:40]
Excess Returns Host
Yeah.
- [46:41]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
So you have the opportunity set is.
- [46:43]
Excess Returns Host
At the time and you have the.
- [46:44]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Cash coming in that we always have cash coming in.
- [46:48]
Excess Returns Host
Yeah, yeah, that's good. What, is there anything else in terms of like risk management that you can think of? I mean it seems like to me the risk management is embedded in the due diligence and looking for those high quality companies like you, like you explained before, like a stock picker would. And that is sort of how. But is there. Because you know, you're, you're more concentrated than your, you know, typical bond index fund, but you're, you know, doing much more deep like fundamental research. And so is, is that, is that the secret sauce of the risk management in your opinion?
- [47:28]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
That is one of them. That's a very important one. The other one is duration. I mean, quite frankly, when we set this up, you know, we, we made sure that we had the flexibility to go to cash if we needed it. Cash substitutes. And that's a really important part of it because when the market sells off, everything sells off, including the short term stuff. Short term bonds trade off a lot less. So you can have a short term bond yielding 4.5%, it trades off a point and a half and it's yielding 6.5%, whereas a longer dated bond yielding say 7%. If to get that up 2 percentage points, you probably traded down 20 points. So that's the cushion that we like to build into our portfolio because when it does happen, there will be weakness across the board. We're not immune to being down, but we're down a lot less. So we'll be down, you know, 5 to 8% in a calamitous situation, whereas most funds are down 20, 25. They will bounce back eventually, but I gotta tell you, most of our clients are RIAs and endowments and foundations and some, some you know, independent broker dealer networks. I guarantee you they're getting more calls about the fund that's down 20, 25% than they are about our fundamental right.
- [49:02]
Excess Returns Host
Yeah, yeah, it's those drawdowns that, you know, get, get clients and investors worked up and worried for sure. And if you can control that, then that's that, you know, investors will stay with you for a long time.
- [49:13]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Now the risk tolerance is very asymmetric. When things are going up, they're always asking, why are you lagging? Our clients actually aren't asking that. They know why. But you know, when it trades down, it's like, why were you in there? When it's going up, it feels good, goes down, barely sense it. Yeah, yeah.
- [49:33]
Excess Returns Host
Let's talk about the Fed for a second here. So I'm not going to ask you to like predict like where you think interest rates are going, but it's an interesting time for the Fed. So they sort of started this easing cycle. There's now seems like there's maybe some doubt around a December rate decrease. You have, you know, government data basically non existent for the last two months essentially. You know, there does seem to be some weakness. Seems like in the labor market. You have, you know, their inflation's running higher than the, their target, but okay, 3%. It's not like off the chains or anything, but just like what do you think? I mean, how do you.
- [50:21]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Do, do.
- [50:21]
Excess Returns Host
You think you would think like an easing cycle would be a start of an expansionary sort of time for the economy as more fuel comes on the fire. But it might be an interesting time where they're easing and then you have this weakness in the economy that the rates don't maybe affect in some way. I don't know, just, just share your thoughts on sort of how, how you guys are thinking about this here.
- [50:43]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
The Fed's kind of caught in the box, right. So their two mandates are inflation and employment. Right. Supposed to keep them both steady. Unfortunately they have to favor one or another. They can't do both at the same time. So for 22, 23, 24, they were focused on inflation. Let's get inflation down. Let's slow down this economy because you know we have so much stimulus during COVID that have to work its way through the system without causing too much inflationary damage. Okay, so we've gotten through that now inflation has started normalizing. As you pointed out, it's not quite where they want it to be. A mythical 2%. And you've got an administration believes in tariffs which are a tax and inflationary. But they also want lower interest rates because they're real estate people and like low rates. But lower rates are by themselves inflationary. So if you lower rates, what happened, you know, at the end of last year when they lowered rates in September, October is the bond market said oh my God, I do not need more stimulus now that's going to be inflationary. So the 10, 20 and 30 year rates shot up to 5%. So a little bit of that has happened here. I mean when they cut last, last time, the 10 year rally to 395 but then immediately bounced back to, you know, 415, 420. I mean they had an auction auctions today, so see where those settle out. But I think, I mean we used to have what we used to call bond vigilantes which would keep, you know, tight hand on the Fed by, by manipulating, not manipulating, but you know, expressing their views via the bond market may come back. We've got large buyers of Treasuries that are no longer there. China's no longer buying our Treasuries. Right. They've got their own problems. They have a huge deflationary problem that they have to deal with. So they're going to be spending money on stimulus, not buying our bonds. We are running huge deficits so we're going to have to finance a lot. And while the White House would like to see lower interest rates to finance into that, you know, we've stopped immigration. So population growth is much slower. You don't need to create as many jobs today as you did when population was growing. So the fact that the number of jobs being created is lower is not necessarily showing weakness in the economy. It's actually probably normal between 0 and 50,000 is what I'm hearing from people. So and all the layoffs you've seen in tech, they don't add up to a big new, you know, 10,000 here, 15,000 there, 20,000 here. Just like, you know, if you have 100,000 in layoffs, a bad month. But it's not the end of the world. When you get to the millions, then There will talk, but. So the Fed has been focused on employment initially and they don't know whether it's weak or strong because A, they had a shutdown so they didn't have the people to do the surveys. So keep your eye on the revisions. They're going to be huge once they get the initial numbers out and then they get the, do the catch up work and get the real numbers. Probably have some pretty big revisions. Most people don't pay attention to those. But I think we shift this time. And if the Fed cuts again with M2 at an all time high still, that's inflationary so that plays, they're playing against themselves.
- [54:41]
Excess Returns Host
This has been a really solid discussion because I think it, you know, setting up how we did at the beginning, just your ability to explain this to our audience has been really, really good. And I think it's like an economy, you know, a lot of like just common sense thoughts here. So we really appreciate that for sure. And I think what you're, you know, our audience should also understand is that, you know, you're hearing from someone that has an outstanding long term track record over, you know, multiple market cycles. So there's tons of, of wisdom and knowledge in here that Carl, you, you share with us today. And yeah, we have two standard closing questions we like to ask all of our guests if we could have you just for a few more minutes. The first one is what's the one thing you believe about investing that most of your peers would disagree with you on?
- [55:37]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Well, I still think it's about providing a low volatility, reasonable return to investors. Whereas I think some of my peers might think it's about, you know, going for broke when you know the time is right and then letting the cards fall where they may when they're not. I mean, we don't believe in taking excess risk at any time. But you see a lot of these funds, you look at their positioning, we would not buy half of those names. But you know, that's what they do. They go for broke, that's one thing.
- [56:22]
Excess Returns Host
And the final question is, based on your experience in the markets, what's the one lesson you would teach your average investor?
- [56:29]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Be patient, don't fear missing out, always get another chance. And I think, you know, only invest what you can afford to lose in most cases and be able to sleep at night with your investors. As a former partner here, he used to say, Carl needs his beauty sleep more than anybody. Just look at him.
- [57:00]
Excess Returns Host
Nice.
- [57:00]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Well, you're still here.
- [57:03]
Excess Returns Host
Nice. And you're still getting your beauty sleep, so something's working.
- [57:05]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
True.
- [57:07]
Excess Returns Host
All right, thank you very much, Carl. We really appreciate it.
- [57:09]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Thank you very much.
- [57:10]
Excess Returns Host
Thank you for tuning in to this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the Excess returns network@xcessreturnspod.com. if you have any feedback or questions, you can contact us@xsreturnspodmail.com no information on.
- [57:30]
Interviewer/Co-host
This podcast should be construed as an individual investment advice.
- [57:33]
Podcast Host (Ad Reader)
Securities discussed in the podcast may be.
- [57:35]
Carl (Guest, Co-President and Co-CIO of Osperweiss Capital Management)
Holdings of the firms of the host.
- [57:37]
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