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The Case for Cash in a High-Yield Fund

Dan Culloton

Dan Culloton: Hi. I'm Dan Culloton, associate director of fund analysis at Morningstar. I'm here today with Carl Kaufman, manager of the Osterweis Strategic Income fund. Carl, thanks for being here today.

Carl Kaufman: Thank you for having me.

Culloton: Carl, you're technically a go-anywhere bond fund. But over the last several years really almost since the inception of the fund, you have focused on a very narrow slice of the fixed-income market, particularly short-term high yield and convertibles. Why is that?

Kaufman: As a go-anywhere fund, you're always looking for what the market will offer you in terms of opportunity, namely yield. In the last few years there really hasn't been much yield in Treasuries. We like to get paid for our risk, and risk in the bond market is dynamic. It changes. And I think that as we get further into this recession with low interest rates that the risk of rising interest rates becomes greater, whereas companies are flushed with cash, they are operationally about as efficient as they've been, and the fundamentals are actually quite good despite the weak macroeconomic backdrop. So the opportunities we're seeing in high yield are much more attractive than in investment-grade [bonds] at this point. So that led us to sort of focus the fund in high yield.

Within high yield, yields have been coming down overall, especially in the longer paper, and the differential between the front-end of the curve, if you will, and the back-end is not that large anymore. So the risk that you're taking, or the opportunity set of what you're getting paid to take the credit risk or the economic risk, is not that large. We find the sweet spot to be one to three or four years. You're not giving up that much. Plus you have much more visibility one to three years out, than you do five to seven years out. You know five to seven years is a long time. Five years ago, goodness gracious, we were in the heat of 2007. A lot has happened since then.

That's where we're finding opportunity, and occasionally [we look at] converts. We buy converts; we love the asset class first of all. It's a chameleon-like asset class. It can look like a stock. It can look like a bond. It can look like something in between. We typically have bought them as a bond substitute when the yield gets equivalent to non-convertible bonds and occasionally, we will find the stock that we like either by virtue of our equity team having a stock they really like that happens to have a convertible that's priced appropriately. We're on our own, and we'll take a position there which adds an element of return to the fund as well. So, that's pretty much why we focused in on the short-dated high yields for the last few years.

Culloton: So, it's really choosing credit risk over interest-rate risk at this point because interest-rate risk is greater.

Kaufman: Correct.

Culloton: Wouldn't that expose you to credit events or even macro news about a weak economy? Wouldn't that affect purely the corporate high-yield credits that you have in your portfolio?

Kaufman: Yes. As I say risks are dynamic. So, at this point in the cycle as companies, after 2008, got very risk-averse, they just did not spend money. They're still not spending money in the way that you would expect. They're spending on expansion plans, but they're not spending on structures. The capital spending has been very low. They have been managing their cash very conservatively. So, credit risk in terms of the magnitude of credit risk right now is very low. The funding is freely available to them. The capital markets are wide open. They're refinancing their debt at decreasingly low rates.

The risk to the issuer, the default risk, because that's what you're always worried about, is lower than it was, and it almost becomes a self-fulfilling prophecy. If you had a 10% debt burden, and now it's 8% and maybe now 7%, you've taken that risk off the table by virtue of having refinanced that debt at a lower rate. So, I think at this point, credit risk is at the low end of the historical spectrum.

Culloton: By keeping the duration very, very short as you do in addition to avoiding interest-rate risk, you increase the possibility that these companies will survive until they pay you back?

Kaufman: Exactly. Typically, a lot of these companies have cash on the balance sheet--we like to see cash on the balance sheet--or are throwing off free cash flow enough so that we can see us getting paid off without even having to access the capital markets. We take that layer of risk out of the equation or at least try to minimize it as much as we can.

Culloton: Where are you seeing opportunities around in terms individual credits in the market right now. I know you have a lot of cash in the portfolio. Does that mean you're not seeing a lot of opportunities right now?

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Kaufman: Right now, I would say that the market is not exactly forthcoming in very, very fat pitches, if you will. There is not a whole lot of obvious value in the marketplace. I think it's fairly to somewhat richly priced overall. We haven’t had a really good correction since last fall when we had the debt debacle follow-up fall through. We may get some more of that this year, and I'd like to keep some cash on hand because when you do get [those market conditions] we find that cash is king.

You'll find that either people are getting redemptions, or they are finding other opportunities. But they're generally selling, and it’s usually the time when dealers aren’t standing up as much as they would in the normal environment. Having cash on hand to take advantage of that is really important. So, cash does have a strategic value for us.

Culloton: Are there any individual credits that you've added recently that really you think exemplify what you're trying to do?

Kaufman: There are a few. We have added a bond called Heckmann, which is a water-treatment company. They started out, and the man who runs it has built a couple of successful businesses in the past. He built U.S. Filter and K2. So, he has done this before, but he sees an opportunity in water and oil treatment. What half of the company does is it supplies wastewater, complete turnkey solutions to the majors who are drilling for gas. An oil well takes about 7 million gallons of water to drill. In the early part of that drilling when the water comes back up, it does have some petrochemicals in there--some oil and gas liquid residue--which Heckmann separates out and sells the oil. It’s pretty profitable. After that it just becomes very salty water. It has to be disposed of properly, and the majors don’t want to have to deal with that. So they have someone they can trust. The firm has GPS on its trucks, its clients can approve drivers, and so on.

So that business with the price of natural gas right now, people are wondering what happens to that business. You don’t stop drilling for gas or you don’t shut in your wells that you're already drilling because things are pretty fast decline curves. Just because the price is low, you're on contract and you're generally hedged out for a couple of years. So we have a couple of years' leeway there. What really attracted me to the company was not so much that business, but they are acquiring the leading waste-oil-treatment company in the western United States. Companies like Jiffy Lube have to get rid of their waste oil. These guys pick it up under long-term, multiyear contracts; there are predetermined margins. They haul [the waste oil] away and recycle it. It gets used into tar. That’s a very profitable business, and they can grow that business much like they did U.S. Filter by buying a lot of mom-and-pop companies. The mom-and-pops have the roots, but they don't have the treatment facility, so they actually drop of their oil at these guys facilities to be recycled. That to me is a great razor-blade-type business.

This offering happened to come with a double-digit yield on it, about 10%. So it was pretty cheap from our standpoint, and this is a management team that does not like to have debt. Typically his acquisitions have been done with equity. Because he was buying this company from a private equity group, he had to pay cash and come to the debt markets. At U.S. Filter, they did all their acquisitions through equity. I think they will continue doing that, and I can see them deleveraging this company quite quickly with their free cash flow.

So that to us is a type of company that is a special situation, and not everybody feels comfortable with the oil side and the natural gas drilling side of it. But I am very comfortable with the other side of it. Occasionally, you will find companies that make a lot of sense, and it's their first time coming to the market, so they typically are rated a little lower by the rating agencies so a lot of people just will wait to buy them. We are finding opportunities occasionally.