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Osterweis Strategic Income: Decent Yield Without Too Much Risk

The fund keeps maturities short and has a great record of sidestepping defaults.

In the bond market, you have a choice for boosting yield. You can take interest-rate risk by investing in high-quality, longer-term bonds and hoping that rates either decline or stay stable. Or you can increase income by taking “credit risk” — that is, investing in lower-quality bonds, which tend to rise and fall with the economy.

For Osterweis Strategic Income (symbol OSTIX), virtually all the risk is credit risk. The average quality of the bonds it holds is single-B, which means credit raters see significant risks that the issuers of those bonds could default. How risky is a single-B bond? By way of illustration, Standard & Poor's assigns that rating to debt issued by Egypt and Rwanda — hardly paragons of stability.

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Here's the stunner: Since Osterweis's inception in mid 2002, not one of its bonds has gone into default, says Carl Kaufman, 57, who has managed the fund since its launch. “I like to be able to sleep at night,” Kaufman says. “So we do our homework on individual companies, just like an equity manager would.”

Osterweis has been a solid performer. Over the past ten years through June 5, the fund returned an annualized 7.4%. That's an average of 2.3 percentage points per year less than Barclays U.S. Corporate High Yield index. But the fund has earned its stripes in lousy markets. And bonds, in my opinion, are overdue for a prolonged stretch of lousy performance.

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Kaufman says the fund avoided technology and telecommunications bonds before the 2000-02 tech wreck. He also presciently steered clear of homebuilders and most financial companies before the 2008 financial crisis. As a result of such careful risk management, Osterweis has never lost more than 5.5% in a calendar year, and that decline came during the 2008 disaster. By comparison, the Barclays High Yield index fell 26.2% that year.

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How did the fund manage to avoid those potholes? “When you get a spike in defaults, it's generally in the most over-capitalized sectors,” Kaufman says. So, staying away from sectors that had issued tons of debt kept Osterweis shareholders safe. (In a typical year, 2% to 3% of junk-rated bonds go into default; the higher yields that junk bonds pay are designed to compensate investors for the risk that those bonds might go bust.)

Osterweis invests mainly in shorter-term junk bonds, and that reduces the fund's exposure to rising interest rates (bond prices move in the opposite direction of rates). The fund would likely lose only 2% of its value if interest rates were to rise by one percentage point. Given that the fund yields 3.7%, you'd still wind up in the black if rates climbed by that amount.

The low sensitivity to rising rates — and rates will inevitably rise, perhaps by a large amount — along with terrific bear-market returns and a decent yield have me sold on the fund. (It's also a member of the Kiplinger 25.)

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Kaufman and co-managers Simon Lee, who joined in 2008, and Bradley Kane, a recent addition, look for well-managed companies that generate more than enough cash flow to service their debts. The fund has 77% of its assets in junk bonds. Waiting for better buying opportunities, the managers currently have about 17% of assets in cash and in bonds maturing in less than a year. The fund also has about 6% of assets in convertibles--hybrid securities that are part bond and part stock.

One longtime favorite is Hertz bonds. The company doesn't have a ton of cash, Kaufman explains. But when times are tough and fewer people are renting cars, Hertz sells some of its fleet to raise cash to pay bondholders. When good times return, Hertz rebuilds its fleet.

Osterweis has a couple of shortcomings. For starters, the fund isn't cheap. Its annual expense ratio is 0.92%, high for a bond fund (especially in today's low-yield environment). Moreover, the fund's success has hardly gone unnoticed. Osterweis has $3.4 billion in assets — more than ten times what it had as recently as the end of 2008. Returns show no signs of falling off so far, but the fund's growth makes me a little nervous.

Because of the junk bond focus, you wouldn't want to make Osterweis a core holding. But I think this fund is suitable for virtually any well-diversified portfolio. It's a great fund to own at a time when the bond market offers no screaming buys.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.

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