#112 - Carl Kaufman: Public Credit Risk Discipline

0:05Carl Kaufman:Welcome to the Insightful Investor Podcast, a weekly series that seeks to share industry, investment, and market insights. We define insights as concepts that are counterintuitive, widely misunderstood, or underappreciated. In other words, unique ideas that you probably won't hear elsewhere. I'm Alex Shahidi, the host of the podcast and co-CIO of Evoke Advisors, a leading investment advisory firm. Learn more about our show at insightfulinvestor.org.

0:38Today's guest is Carl Kaufman, co-president and co-CEO at Osterweiss Capital Management, a boutique investment firm founded in 1983 that manages about$8 billion as of the end of the year. Carl, thank you for joining us today. Thank you for having me. I understand that you majored in music many years ago. Are there any parallels that you draw between music and investing? You know, I do. And I think there's two of them. One is clearly when you practice as a discipline to practice in learning your trade, you learn technique. And that translates to behavioral habits, which, you know, in learning in general.

1:21Second, in musical analysis, especially in say Renaissance or modern music, it requires not only an understanding of the structure of which the music is created, and in the 20th century they didn't write it out. You look at some of these compositions and you have to figure out how it's put together and then figure out the finer points of it. So you have to have a recognition of pattern repetition, motifs, how they change. in Renaissance music where they're hidden. So this translates well when you look at an amorphous landscape like the financial markets, balance sheets, and you recognize patterns, you see them emerge and you see them repeat.

2:07And I think that's very important. As I always tell young people seeking career advice, I say, well, the first thing you want to do is major in music. And they laugh. Of course. So what was it that originally got you fixed on Fixed Inco? Well, it's interesting because I started out in equities. I started out in equity research sales at Merrill Lynch after a two-year internship and had the wonderful opportunity to interact with some of the best industry analysts on Wall Street and having the mindset of learning and learning my student of the markets mindset. I was like a sponge sopping up their accumulated knowledge of what makes each industry tick, how to pick good stocks.

2:53Then I transitioned to convertible bonds, which is a combination, as a combination of elements of both fixed income and equities and options. And that's where I fell in love with fixed income. And it's been a love affair ever since. And what was it that attracted you to that space? Because what got me interested was how fixed income works in a portfolio and how you measure returns and success in fixed income. Because in equities, it's very different. I mean, it's kind of like you get a 10-bagger and you're a winner. In fixed income, you don't get that. You just want to get your money back at an interest rate, which is not too low.

3:37So it has to do with timing and it has to do with credit work, making sure you do get paid back, because that's really what fixed income is. It's fairly simple conceptually, but it's difficult to execute. And I suppose a lot more focus on what can go wrong rather than what can go right. Absolutely. When you look back, what non-obvious experience early in your career most changed how you view fixed income risk? You know, it wasn't fixed income risk per se, but it's one to recognize when groupthink pervades the markets. You know, two moments really stand out early in my career. The first was around 1982 when Volcker was jamming interest rates up to 20%.

4:24And 15-year treasuries were yielding, I think, 15 and three quarters. And there were many professionals in the room who were shaking their heads and saying, that's not enough. I'm not buying. And everybody felt that way. And sometimes you have to take a step back and say, you know, you're never going to top tick or bottom tick the exact market. But when you say 15 % on a U.S. Treasury, that's enough for me to buy. The second was around the same time. I don't know if you remember, you know, if you've been around 150 years like me, you remember these things. but in 1973 we had the oil embargo oil prices spiked they kept going up and then with inflation they kept on spiking so they had increased steadily for about three dollars a barrel to about forty dollars a barrel and i was in a company presentation because i was in equities back then and it was an e &p company that was presenting for a deal they were bringing and the ceo said you know conservatively we can assume 10 annual price increases out into the future, everybody in the room was nodding yes.

5:32All these 40, 50 portfolio managers were nodding yes in agreement. I'm looking around and saying, wait a minute, you can't just assume that. Needless to say, that was the peak in the oil market until we hit the Kuwaiti invasion in 1990, it got back to 40. So when everybody believes the same thing, it's good to take a step back and sort of get perspective. You just don't want to be with the crowd all the time. Works for a period of time, but not always. Particularly at the extremes, when a lot of those perspectives find their way into the price. So you're actually paying for that outlook. Exactly.

6:13So when you look back and you think about the core principles that guide your approach, which do you feel have meaningfully evolved over the years and which have stayed exactly the same? You know, as we age, we go from youthful exuberance, high risk tolerances, to more patience, perspective, and caution. I'm no different, I think any of us are. What has stayed the same is the ability to stand back and look at markets and ask hard questions. I remember back in 1999, you know, we had the four horsemen back then, Cisco, Dell, Microsoft, and Intel. They were like the Mag-7 were today. If you didn't have those stocks, you were probably lagging.

6:56And I took a look at their market caps in 1999. I was at Robertson Stevens at the time, which was a very focused firm on the internet and new technologies. And I assumed the torrid pace of growth that they had had for the last five years continues for the next five years. And it showed that their market caps would be larger than U.S. GDP. cisco has taken over 25 years before it finally reached the peak that it got to in 1999 despite growing through the last 25 years so that goes to show how overvalued it was at that time we did a similar exercise at the end of last year with the mag 7 and pretty much found the same thing i mean taking a company from 4 trillion market cap to 8 trillion market cap even if it takes 10 years that's a seven and a half percent return so you can expect slower growth going forward from those stocks i don't think you're going to see the same toward pace so always take that step back get rational look at the numbers and don't call that get caught up in the fomo of the moment and obviously that is much easier said than done because it's not just you internally but it's the people on your team that are surrounding you.

8:16It's your clients. It's what you read about and what you hear about. So it's constantly in your face. When you think about how you manage fixed income, how do you feel you fundamentally differ from a typical, if there's such a thing, fixed income manager? And then what important trade-offs do you knowingly accept as a result of that? Sure. Well, first of all, most fixed income managers are benchmark driven. We are benchmark agnostic so we have what we call a high conviction buy and hold strategy so we don't need to buy every deal that comes down because it's going to be in the benchmark as most of these guys do they know they're paid to give investors access to a benchmark and and they a lot of times they buy deals that they don't really like the companies yeah what we do is we can be patient be more focused and that helps us avoid the losers as you mentioned you know you try to avoid losses in fixed income we've had no defaults in the last five six years and since inception our default rate has been equivalent to investment grade i think it's around 32 basis points uh cumulatively second we have deep expertise in convertibles we have the flexibility to go across the fixed income spectrum which most benchmark oriented high yield funds or investment grade funds they don't buy convertibles we can find value there in both short-term busted issues which means the stock has come down and they're trading more like bonds and we can also buy equity sensitive names which will act more like equities and we do that typically at the bottom of markets when markets have traded off a lot and there's you know you get pretty decent yields and you get some upside for free the third is structural we have four season pros on the team i think the the most junior guy has about 30 years experience we all look at each name together so we follow each name together so we're all on the earnings calls we're all in company management meetings when we have them versus the traditional model of a fund, which is a portfolio manager at the top, relying on a team of industry analysts recommending names to include in the portfolio.

10:38We can get to know our companies very well. So that's, I think, the main differences that we bring to the marketplace. And we do have the flexibility to raise cash and play defense. So is one of the potential trade-offs of that approach relative to the way many others do it is that you introduce more, some people call it tracking error, but deviation from the benchmark, which could also introduce business risk as well. Well, I will tell you, in the earlier years, when we were, I think, one of the few sort of flexible funds or go-anywhere funds, there weren't many around, it was really hard to market.

11:23Because they'd always ask, what box do I put you in? And then after 08, they realized that, you know, maybe I should be looking at more flexible mandates. Because they can play defense. And I think we've gained a reasonable following, and there's certainly a lot more flexible funds out there now that we compete with, and everybody does it differently. If you look at a scatter chart, they're all over the map. But we are way over on the left in terms of volatility, and our returns are towards the higher end of those. And I guess there is a difference between being flexible and focusing on downside protection versus swinging for the fences, which is a different orientation.

12:09Something that has kind of emerged called the time horizon mismatch. Would you talk about that and how you think about that in terms of how you manage portfolios? Sure. Because we can and do flex our defensive muscles by shortening duration, building cash, going up in quality, we can defend against the worst market sell-offs, which are part of the normal part of the cycle. Since inception 24 years ago, we've never had a period where we were down 10%, nor have we ever needed to sell a position to meet redemptions, which usually spike when markets collapse. so that's typically when we have let our cash build to the highest levels of the cycle so what you'll see is if you were to think of us as as a boat in a storm we're very calm whereas the other players are bobbing up and down much more they play more in sync with the cycle whereas we are oftentimes out of sync with the cycle in a good way and and what we give up with that is when you have an extended rally like we're having now for example when people say when does this thing end reading new all-time highs every day we do tend to lag so you have to have the patience and the stomach to put up with that because the rewards of of lagging by a couple 300 basis points for a year or two, more than make up when the market trades off 20, 25%.

13:43And I guess part of that is emphasizing measuring performance over a full market cycle, rather than focusing too much on short-term returns. Would you share a moment when staying long cycle focused felt uncomfortable in the short run, but proved right over time? Sure. As you said, we typically lag during extended bull market cycles. And if you look at, for instance, 2002, perfectly when we started the fund, just to show how we look at the markets. We had been two years into the recession post the dot-com crash. There was the treatise all over the place. And, you know, we started looking at the markets de novo because we didn't, we just started the fund.

14:28The facts were we were still in a recession. most high yield was at this point very highly leveraged given the declines in profits that had happened over the previous two years interest rates were low so we figured the next move would be up so you don't want to buy investment grade but there were a number of companies that had issued convertibles during the boom and kept the cash on the balance sheet those were yielding 15 16 percent for one to three year maturities versus 20 plus percent yields on high yield for companies that were four or five years out so we decided that it would be better to buy a portfolio of those companies with some you know high yield than just sort of make a bet on high yield in general now come 2003 the economy recovers you know high yields took off we were up 16 percent high yield did better but took a lot more risk getting there and uh you know so we we were happy with our return because we took a lot less risk getting there our bonds were basically deceased more cash than debt they're going to pay you off the second was in 2008 we had pulled our risk back starting in mid-07, and we had bought treasuries because that was when our Secretary of the Treasury said we're going to bring out the big bazooka.

15:56So we had a barbell basically with treasuries and very short-dated high coupon, high yield on the other side. We had lagged a bit in 07, but in 08, we were actually positive for the first three quarters. And then in September, after Lehman, Fannie Freddie, AIG, all those troubles, we figured, okay, rates are near zero. It's time to buy some high yield. So we bought, started buying it. We sold our treasuries, bought high yield two months too early. We were down 5 % in 08. Great year. 2009 hits, market takes off we're in recovery we're lengthening our our duration at that point but we lag severely so did it feel uncomfortable no nine yeah but because we had done so well in 08 the two-year return was was better i suppose it can be in some ways more painful if you stretch it out over a longer period of time where you have a you know a downswing that maybe lasts a few years rather than over a short period of time.

17:02And then the recovery that is stretched out and lasts three, four, five years. Because time oftentimes becomes the enemy. Right. I think that these up cycles, trees don't grow to the sky. And we participate in the upside. We just lag a little bit because we tend to be increasingly cautious as time goes on. So we will let cash build as time goes on. And that served us well in 2020. When in 2018-19, the market got extended. Rates were zero. High-yield companies were coming with 4 % and 5 % coupons. Ball Corp came with a 10-year deal at 2 and 7-8, not investment grade. We said, okay, this is ridiculous.

17:48So we let cash build. Then COVID hit. We didn't know COVID was going to hit. But we were in a great position to do some buying. And we can shift fairly quickly. So when the market did tank, we went from almost having no weighting in over five duration paper to 25%. We did that in a month. Unfortunately, these downdrafts don't tend to last very long anymore because the Fed has a bad habit of coming riding in and saving the markets. So you have to have the cash to buy when those hit because they're quicker. I think the bull markets seem to be taking forever, and that's because there's too much liquidity in the system.

18:34We just can't seem to get rid of it. We did QT for a while, but then they stopped. So we'll see what happens. I know you've emphasized knowing where we are in the cycle. What sign most often tells you your REIT might be wrong and needs to be re-underwritten? Well, that's interesting. We've never been wrong about where we are in the cycle, but we have been wrong about timing of certain phases, clearly. They take longer to play out, or they don't last as long on the downside. Today, we know we are closer to a top than a bottom. It's pretty obvious to everybody, but it's taking a while to play out.

19:15And that's mostly due to the excess liquidity that's just stubbornly staying in the system. We've seen some rolling weaknesses in certain sectors. We saw it in software recently. You know, everybody's trade AI is going to wipe out software. Today, there seems to be weakness in the insurance brokers. AI is going to take those apart. I don't think this is going to come to pass quite as draconianly as the market is setting out, but there is some uneasiness starting to filter into the market. So keep our fingers crossed. So you've talked about balancing offense and defense, because you obviously want to protect on the downside, but you don't want to give up all the upside.

19:58In my experience, few truly manage to prioritize downside protection and long-term compounding at the same time. What would you say is the hardest part of actually living that philosophy in real time? It's patience. Most investors being benchmark driven don't really focus on beating the bench in up and down markets. They buy bonds in companies. They may not like because they're in the benchmark. Everybody says they do the fundamental work, but in frothy markets, I think those standards may slip a bit as they hold their nose and buy deals that may be PE-backed LBO, highly leveraged, poor covenants, low coupons, and complacency sets in.

20:38We don't let that fear of missing out get to us. It's really hard to stand your ground. We do have the luxury of avoiding those bad deals, and we do have the patience to wait for fatter pitches. Now, it doesn't mean that we just stand on the sidelines and watch. I mean, we're buying things every day, either adding to positions on a little bit of weakness here and there, finding opportunities that maybe two, three years out, or if we just hold them and we know we're going to get paid back, they're going to be decent returns above our long-term average returns. But it is hard. It's hard to be patient.

21:16You talked about being benchmark agnostic. How do you think about fixed income indices relative to equity indices? That's a really good question, and we've actually written about this topic. Equity indexes, as you know, reward the most successful companies with the biggest market caps. They get the highest weightings. Those with the largest weightings in the index, the MAG-7, for example, that can lead to high levels of concentration where everyone must own those names or lag the index. In fixed income, the opposite is true. The largest weightings accrue to those companies with the largest amounts of debt outstanding.

21:54Those are not necessarily the most successful companies. As a matter of fact, I think if you look at the top 10 weightings in high yield, preponderance of them are rated CCC. So the heavy weightings tend to be in the most indebted companies. Which I guess if your focus is on minimizing risk or making sure you get paid back, you don't necessarily want to overweight the ones that have borrowed the most. It seems in some ways it's a little counterintuitive in that way. Exactly. I think we only own one of the 10. So I guess the way to kind of tie that all together is if your approach is to focus on the benchmark, then, and we know the benchmark overweights the most indebted companies and, I guess, countries, depending on your index, then implicitly in your strategy, you're going to be lending to those if you are benchmark focused.

22:45You are. So you talked about cash in your strategy. Would you just tell us a little bit more about how you think about using cash? Cash is, first off, a defensive tool against market volatility. We've raised cash in periods where we got paid nothing on it. And we've raised cash in periods like recently where we got paid a lot when the real curve was inverted. So that's the first use of cash is as a buffer against volatility. The second is a source of liquidity because it allows us to step in and buy when most everybody else is selling in market downdrafts. And over the past 20 years, this has helped us achieve high yield like returns with ag like volatility.

23:29As a matter of fact, in the last five years, I think we've achieved high yield like returns with lower volatility than the ag. And that's mostly due to the cash that we have let build, which has lowered our volatility. And obviously, if you have some average exposure to cash that's above zero or an index, then over time that can introduce a drag on returns because the yield is probably lower than anything else you would buy but is it fair to conclude that you have found that benefits of holding cash over time outweigh that drag we have i mean they will they will hurt you for short periods of time but they really help you over time because it's just math if you can lose less you'll learn more over time because if you're down 50 you got to be up 100 to get back to zero and we don't like to see that.

24:21And I suppose you will increase your cash when you don't feel like you're being compensated enough to take the risk in higher yielding investments. Absolutely. Right. As opposed to having a macro perspective of, okay, the economy is going to turn soon, so we need to cut risk. Is it more focused on the yield that you're receiving for the risk that you're taking? Yeah, it's mostly the opportunity set. We're looking at the market as we do every day. We're not finding anything that we like from a risk perspective based on where we think we are in the cycle. We're just going to buy short-term paper.

24:53And cash consists of many things. It can be, you know, we have treasury money market funds that we use for, you know, daily cash. That's a smaller portion. We buy commercial paper, which has higher yield. That's generally 20 to 30-day paper. And then we buy bonds that mature under a year and generally hire quality companies. So that's what we consider cash. It's not just cash. It's always changing because it's always rolling over. So we talked about this a little bit, but in a world where bonds don't 5x, right, you're focused on the downside. What does conviction look like if we can't see it in outsized position weights?

25:32I'd say look at turnover. We buy every position with the intent to hold it to maturity or redemption. We don't have to trade a lot to execute this strategy and reinvent the wheel by trying to be more tactical. So that is how we measure conviction. If you can buy a portfolio and hold it, then you have high conviction in that portfolio. If you see a lot of turnover in portfolios, those guys may have short-term conviction, but not long-term conviction. One interesting item you've noted is that high yield quality seems to be improving and investment grade quality generally deteriorating over time.

26:12What is the mispricing that this creates that you believe may be obvious in hindsight? You must be reading our blogs. The composition of the index has changed for the better in high yield last 20, 25 years. Double Bs are now 58 % of the high yield index, and triple Cs are slightly below 10%. I mean, this compares to 2007 when double Bs were 40 % and triple Cs were 18%. As you say, the opposite has happened in IG, where BBBs, or BBBs rather, the lowest quality rating and investment grade has moved from 35 % to 45 % of the index. And that means that if you're comparing spreads over time, and you don't adjust for that quality, you're going to be misled into thinking that, for instance, in today's market where spreads are fairly tight, they're actually not as tight as it seems compared to the composition if you were to adjust for quality the spreads are actually much larger today much wider today than they were in 07 based on the same quality or they were a lot tighter back then you know if you adjust for today's weightings so you have to always be aware of that and i think we quantified it spreads today are about 50 basis points wider than the tights reached NL7 if you adjust for quality.

27:44The market is not as rich as it looks today. So you don't want to get fooled into that and just, you know, oh, I'm not buying it because spreads are too tight. Spreads are only one part of the solution. The other is the actual yield. Yields around 7 % are not terrible. Yields have been a lot lower in high yield. Back before COVID, they were as low as 5.5%. I think in 23, they had 5.5%. That's too low in absolute yield to get really excited. And that's why we started raising cash. And what you just described goes back to where we started the conversation, which is what is the return you expect for the risk that you're taking?

28:28And the yield and the spread only give you maybe half of that. And so you have to look at the quality and that is reasonably insightful because you rarely hear the quality and the risk side of the equation, but you always hear about the yields and the spreads. It's like PEs and stocks. You can't just look at PEs when you're investing in stocks. Because if you're buying a cyclical and you buy at the low PE, you're buying at the top of the cycle. Then the E falls out and your PE goes sky high. And that's when you should be buying when PEs are sky high in cyclicals for just as an example. I've heard you frame fixed income as four discrete tiers today, not the old two-tier world.

29:12Would you walk us through that and how you think about managing portfolios with that insight? Sure. I mean, when I started in the business a hundred years ago, you had investment grade and high yield. Banks lent directly to corporations and that was you know referred to as cni loans that people covered commercial and industrial loans and they kept those loans on their balance sheet with the advent of securitization in the you know 90s and 2000s we saw a rise in loan securitization where banks wanted to get some of those loans off their books and this really accelerated follow following the 2008 great financial crisis as banks were not allowed to lend to highly leveraged enterprises and you Elizabeth Warren fought through these regulations so we wouldn't have to bail them out again so they were mostly dominated by large private equity-backed lbo deals funded with loans the clo market is now very large and banks uh you know they still make loans but most they found that it's much easier just to syndicate the loan, take a fee, and move on.

30:19It's much more efficient use of capital. And in the past five years, we have also seen very rapid growth in private credit, which I'm sure you've all heard about. Traditionally, this was smaller loans to smaller mid-sized businesses that were mostly ignored by banks and done by companies like Aries and Blackstone that dominated that market. it was a good business well done you do your credit rate research you know your who you're lending to unfortunately with wall street people never know when to stop and there's been a huge rush of new entrance in the market because the returns are pretty good in that business have done correctly and they've raised a ton of money which needs to be put to work and this has led to the quality of loans being made, quality has really suffered.

31:12And we are seeing higher defaults there. For example, Tricolor and First Brands recently. So in sum, you're seeing much lower quality lending going on in private credit than you are in high yield. Those companies that are borrowing in the private credit space have gotten bigger. and they just can't borrow efficiently in the high yield market because of the higher quality of that market and expectations there. So you'd have four sectors now. You've got investment grade, high yield, leveraged loans, and private credit, and that is in declining credit quality. So high yield is now the second highest quality sort of tier, if you will, and then leveraged loans and private credit below.

32:01I'd like to ask you a few questions about your outlook. What do you see with respect to growth, inflation, and interest rates over time? So far, corporate profits have held up very well. I think that's partly due to companies are mostly taking price increases. So that's flowing to profits, and they take it whether they need it or not. We're not yet seeing a shift to battling for market share, so that's something we're watching for. As a result, inflation has been fairly sticky. sticker prices remain high and that's what consumers watch they don't really care about the rate of increase they care about the sticker price versus what they remember you know said five years ago and while price increases from here may be smaller consumers will still focus on that price interest rates i think are under extreme pressure at the short end to go lower by this administration, but longer rates remain stubbornly high.

32:58As a matter of fact, you know, after every cut they've had last year, long rates have actually ticked higher. So they're stubbornly high due to concerns about deficits, debt levels, and the dollar weakness, and all the other worries that we have. And I don't think that's going to change much. you may see you know higher higher spreads which help the banks and also help mortgage borrowers maybe but i doubt it if you were to get long-term rates down the banks would not like that because you'd see an avalanche of mortgage refinancing which would help the consumer so that could prolong the economic recovery but we'll have to see you just mentioned something in terms of the Fed cutting rates and then long rates go up.

33:47Is your sense that the market, after a long time of running massive deficits, growing debt, is the market starting to push back a little bit on that continuing? They are. The market is pushing back, and it's doing rightfully so. I mean, let's take a step back. For 2 ,000 years, interest rates have been between 4 % and 6%. that's a normal range the 1970s and early 80s were a clear aberration when they spiked up the following 08 to 2000 call it 22 that was an aberration of 0 % interest rates and negative rates in Europe so those two are sort of large aberrations in the long term trend of interest rates right now interest rates are kind of normal where they should be.

34:43And people have anchoring biases where they want to relive the most recent past. And that's not often the right way to go. I think the long end of the market gets that. They want to get paid for that long-term exposure. Right. And also, at least I've noticed, more complaints and narratives around this, you know, the debt path and the fiscal deficit path that are unsustainable. And so you're starting to hear some pushback just through the narrative and the discussions, but it also seems like the market is fighting back as well. And it just makes me wonder how long this can continue. Well, you can look at Japan for an example.