Put a Little Junk in the Trunk

"Buy high yield when the stimulus ends."

It's not exactly "shoot when you see the whites of their eyes," but it is certainly a strategy that has worked well for Carl Kaufman, portfolio manager for the $156 million (OSTIX Quote) Osterweis Strategic Income fund. The go-anywhere bond fund, which concentrates on high-yield and convertible debt, has returned 5.44% annually over the past three years, 40 basis points better than the Lehman Aggregate Bond index.

"There is no surprise that the outlook for corporate debt is weaker considering the economy and the stresses on the consumer," says Kaufman. "Coverage ratios will drop. Cash flows will drop, and so will bond prices. In fact, they already have; the questions are: how much more and for how much longer?"

Kaufman admits there are no easy answers. In the meantime, he raised his cash and Treasury stakes to nearly a quarter of his assets as he waits for opportunities to arise, all the while watching what he calls the "interest rate cycle" and the "credit cycle." Right now, he says, we are very much at the start of an interest rate cycle, with the Fed cutting rates and showing no signs of stopping.

"When the Fed cuts rate, investment-grade bonds go up," says Kaufman. "During these times you play defense in high yield, because defaults are expected to rise."

Conversely, the credit cycle has reached its peak, according to Kaufman, and will decline over the course of 2008. Under this scenario, prices for high-yield bonds fall as GDP growth slows, defaults increase and the fortunes of the individual issuers become more important than changes in interest rates.

Kaufman expects the most recently completed high-yield deals to collapse the soonest.

"Like mortgages, the pressure will be on the most recent vintages," says Kaufman. "Defaults will rise on most recent deals when EBITDA was at a peak and the buyer paid a peak multiple."

Although the fund manager remains cautious, he is still looking for high-yield and convertible opportunities, especially in technology companies, "because they tend to run with high cash balances."

Perhaps surprisingly, the fund owns bonds issued by homebuilder KB Homes(KBH Quote) that are due in December. Kaufman, however, says it's not as risky as it sounds, despite the housing market mess.

"The company has been around for 50 years and has $1.3 billion in cash," says Kaufman. "It pays an 8.625% coupon -- far more than Treasuries -- and it's trading barely below par. They'll pay it off."