Talk Your Book: 3 Reasons to Buy Bonds

0:00Today's Animal Spirits Talk Your Book is brought to you by PIMCO. Check out PIMCO.com to learn more with their flagship product, PIMCO Active Bond ETF. Might've heard of it. Ticker B-O-N-D. I mean, one of the better ETF tickers there is probably. The name's Bond. It's very good. PIMCO.com to learn more.

0:19Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:49Welcome to Animal Spirits with Michael and Ben. Michael, one of the big misnomers, I think, for a lot of civilians when it comes to investing is they think if you're going to invest in fixed income, you have to be able to figure out where interest rates are going, right? You have to guess what growth is going to be, which direction interest rates are going to go, and then you make your bet. I bet interest rates are going to fall, so I'm going to buy this. Interest rates are going to rise, I'm going to stay away from this. And really, I think the right way to think about it is thinking through the risk-reward framework and the setup for where am I being paid to take risk?

1:20And so on today's show, we talked to Dave Braun, who is a managing director and generalist portfolio manager at PIMCO. And he said, listen, the way that we think about the setup of all the different types of bonds we can invest in is what's the better risk reward framework. It's not like we're buying and selling because we think this thing is going to go to zero and this thing is going to go straight up. It's more like this. We're getting paid to take more risk here than we are to take here. And I think that's the right way to think about investing in fixed income. I agree. And where do I go from here?

1:48I don't know. I'm not sure where to go with that, Ben. That was just so well said. I have nothing to add. It is interesting, though. We went from the worst fixed income market for, I don't know, 10, 12, 15 years. It was just awful. No yield. People were reaching everywhere. Then And yields went up forever. And now that we've lived through that - Wait, wait, hold on. Just think about how bad it was. So no yields forever. And then rising yields caused the stock market to crash. And then, of course, because yields were rising, there was no cushion. In fact, it was the opposite. So not only did they get bad returns relative to the stock market, they caused the stock market meltdown, but they kind of did.

2:25So it's been a rough go for bond investors, for bond managers. And I feel comfortable in saying we are now firmly on the other side of that period. I picture Tim Robbins climbing through the pipe in Shawshank and coming out the other side with his hands up in the air. That's fixed income investors. They crawled through a 100-yard sewer pipe. And now you have 4%, 5%, 6 % yields, depending on where you're looking. And things are looking much, much better. And I don't think you have to be a person who decides, I think the Fed's going to do this, or I think rates are going to do this. You have a good margin of safety in a lot of places in fixed income.

3:02That's so true. You remember back, I don't know, 2012, 2013, people were just like buying AT &T and clipping the coupons instead of owning bonds. Like that's how bad it got. Right. Should I own dividend stocks instead of bonds? It's a much better place now for fixed income investors. Bond proxies. Remember that? Oh, yeah. There was a million of them. What do I do in between stocks and bonds? So you don't really have to make those choices anymore. So now you can just own the bonds. Yeah, that's true. So we had a great talk with Dave, total pro. He talked about - A real straight shooter. Yeah, just great.

3:33He talked about PIMCO's thoughts on their baselines for the economy and for rates and for fixed income and what they're seeing in terms of the risk reward to set up. So here's our conversation with Dave Braun from PIMCO.

3:49Dave, welcome to the show. Thank you very much for having me. Excited to be here. So interest rates are easy. The Fed cuts rates and bond yields go up. I feel like to the lay person who's not in the world of finance, this seems like something that doesn't make any sense. Can you make sense of it for us? Yeah. So what you're getting at is the dynamic that back in September, the week before the Fed cut, we had a tremendous rally all the way down to 360 on the 10 year. And since then, the Fed's cut 100 basis points and that 10 year is 100 basis points higher. So that might not make a lot of sense to folks.

4:23But what you have to recognize here is a couple of things are in motion. First, the Fed only controls the front end. And what the belly and longer ends do is kind of their own beast. And right now, that rise in rates has really happened because you've got a couple of things going on. You've got the Trump trade, where animal spirits, no pun intended, and the view that we're going to have greater growth, potentially a little higher inflation, more stubborn inflation has caused that belly to rise. The other thing I'd really want to harp on is what we saw in September. I mean, this happens many times throughout my career.

4:57Preferably buy the rumor, sell the truth. Everybody knew the Fed was going to cut. There was some debate was going to be 50 or 25. And all of a sudden, everybody rushed to get bonds. All the Johnny come lately's and everybody wanted to get bonds. That caused, in our mind, rates to overshoot on the low end from where we thought fair value was, created a tremendous trading opportunity for an active manager like ourselves to lean against that and reposition. And now rates are much more attractively priced than they were in September. So very perverse logic. But if you look at history, and we wrote a nice paper on this on our website, that actually happens more often than you would expect, that the start of the cutting cycle, the market's trying to figure out which way we're going.

5:33And the move of the Fed funds might not be in the same direction as the move of the kind of belly of the curve or the 10-year of the curve. The bigger point I want to emphasize is, look, we think overall rates are very attractive right now, right? We went through a once in 40 year inflation fight, right? We had not had an inflation fight in the United States since the 80s. It was sparked by the COVID inflation, supply chains, pent up aggregate demand, and that revenge spending that was unleashed. And boom, we get a once in 40 year inflation fight that caused a generational reset in yields. Literally, the ag is yielding around 5 % now.

6:07That's the best it's been in almost 20 years. So you're getting meaningful real yields on bonds that we haven't seen in decades. This creates a tremendously attractive opportunity for investors to step into bonds. Dave, one of the theories for why rates have snapped back as violently as they did is because people were bracing for a recession that never came. And so they were offsides and they need to unwind that trade and get neutral or whatever. And I bought that for the first leg up of the move, leg higher of the move in the 10-year. But the recent price action in yields, I think it's telling a different story and I'm not quite sure what, and it's never just one thing, but if it were structural fears around maybe the deficit or the debt, the dollar wouldn't be so strong.

6:51So I think we could eliminate that as a potential. Is it because of a stronger economy, the catch-all term premium? What do you think is moving the 10-year higher today? Yeah. So let's take a step back. So our bigger view is, look, we're on the precipice of the Fed pulling off a soft landing, right? Sad, but true. We're consensus on that view. A lot of people have that view. Why sad? Why sad? Well, we would much prefer to be non-consensus, right? As an investment manager, you love it when your view is non-consensus. You can make some more money that way, but we're not going to force a contrarian view if we don't believe it.

7:30So our base case is the Fed's going to pull the rabbit out of the hat and get the soft landing. And that's historically the exception, not the norm, right? Normally when you have to an inflation fight and a central bank has to fight inflation by hiking rates this high, that usually ends in tears by causing a recession. But we see that - They did. And that was the narrative a couple of years ago, as you just mentioned. So now we're at the point where everything's growth this long. Our view is next year, we're going to grow like 1.8. That's a far cry from 2023. We're going to grow at 3%. And 2024 is probably going to be closer to 3 % as well.

8:02But we're growing slowly next year. And our base case is only as good as the paper it's written on. You have to be humble in this profession and realize that's only one outcome. We live in a probability-based world. And right now, we think the wings of the U.S. distribution, the scenario, are pretty wide. We could paint an easy scenario where we're wrong on the downside and growth comes a lot better. Think of all the pro-growth stuff Trump's trying to do, deregulation, tax cuts. That could auger up growth and we could be wrong on the downside. We could also be wrong on the upside, meaning we're too high and we could have a recession next year.

8:36Think about that path. You make a mistake with the aggressive tariffs and protectionism. You make a mistake on some of the fiscal contraction that we're trying to do. You make a mistake on the fiscal. You make a mistake on the tariffs. And all of a sudden, and the immigration is the one I was thinking about. And then all of a sudden, you've got risk to the system where we could grow negative next year. And what we're trying to figure out is when you balance all the risks and look at your base case, what's priced in? Where are you getting safety margin? And right now, when we look at the forwards, we think the forward curve, say the 10 years at 460.

9:07Most of the forward curves are around that. And we think eventually, once we're done with this inflation fight and the world settles out, Fed funds will be more with a three handle on it, right? Fed funds is currently at 450. Maybe they pull off another 50 basic points of cuts next year as growth slows and inflation comes down. But at the end of the day, eventually, two, three years from now, we believe Fed funds neutral will be somewhere around three or three, a little bit of three. That means right now, if you're willing to take a long-term view, tremendous value out the curve in fixed income.

9:36So we always like to say that the stock market is not the economy. And obviously, a good economy is typically good for the stock market, but they can diverge. It seems to me that the macro is way more important when it comes to bonds. Because to your point, if we do get a situation where growth slows and rates fall, the types of bonds that you're in are going to matter. And the other good news is that there is a margin of safety now, right? In 2020, 2021, when rates were on the floor, there was no margin of safety for rates going up at all. I don't think anyone predicted that they'd go to 5%, really.

10:08But there's now just a much higher margin of safety. If inflation comes back, rates are already at 4 % or 5%. If a recession risk hits, yields go down. But there are obviously going to be better bonds for a recession-type scenario. So how do you try to play these different ranges of outcomes that rely around your baseline, I guess? Yeah, we try to be an active manager, right? People are willingly joining this call with a PIMCO portfolio manager. You should expect us to endorse active management. And in this environment, it's perfect for an active manager. We've got tremendous uncertainty in the path forward on the U.S.

10:41economy and global economy, right? Some of the things we already talked about. We've got a tremendous amount of volatility in the rates market. And then we also got quite a bit of dispersion in both the bond market, meaning some things are priced incredibly rich, some things are attractive, but also globally, the global path of rates, right? We've got some countries that are way ahead of the US in the cutting cycle, some countries like Japan that are still tightening policy. So uncertainty, volatility, dispersion is an active manager's dream because it creates an opportunity to generate alpha.

11:10And what you have to do is you have to get more of your investment calls right than you get wrong. That's the first thing you have to do. And second thing you have to do is be willing to trade against the market. And just look at the past couple of years. We've seen the 10-year go up to 5 % when everyone thought, what was that summer? of, or actually October of 2023, when we thought Powell had to go to 6 % on Fed funds and inflation wasn't whipped. Then we had rates go to 340 when we had the mini banking crisis. Then we had rates go up to 470. Then we had rates go down to 340 or 350 when the Fed started cutting.

11:41Now we're currently at 460. That is what we need as an active manager. But you have to have a process that anchors a forward-looking view. So at PIMCO, we focus on anchoring a one-year view and a five-year view called our cyclical and our secular. And then what we do is we try to figure out where we think appropriate range for the 10-year, let's say, is, or any part of the curve, and then we'll trade against the market. We're in a market, I don't want to say rudderless, but the market really likes to romance the narrative of the day. Think of the narrative that was being romanced back in September when the 10-year went to 360, right?

12:12The Fed hadn't even cut yet, and it was like, oh, inflation's whipped. The Fed's way behind the curve. They got to get cutting. That's gone right now, right? No one thinks that. There's only two more cuts priced in for the next 12 months. Now everyone's romancing the Trump trade, how great this is going to be for growth, how we might have inflation come back, and therefore the Fed might have to go the other way. We think you got to take a long-term view, have that true north, and lean against the market. And like I said, we expect this environment to continue for the next couple of years. I don't think anyone thinks that what we have on the docket, that uncertainty and volatility are going to go down.

12:45They're probably going to go up. And that's what we need as an active manager. So, Shredemar Gavin said to Happy Gilmore, you have to play the field as it lies. And the field that I'm talking about are credit spreads. Whatever spreads you're looking at, they're painting a pretty rosy scenario. There's not a lot. Now, the absolute level of yields is great, but the relative level is not, and the margin of safety isn't there. So, how do you navigate a world in which you're getting a lot of rate from the government and not a lot of excess rate from riskier parts of the bond market. Yeah, that's a great point.

13:22So a lot of folks just chase yield and the all-in yields are attractive, like I mentioned. But a sophisticated investor should bifurcate the two. How much am I getting from the risk-free rate? How much am I getting for the credit spread? And when you do that, you're looking at generic investment grade corporate credit and generic high-yield credit are literally the richest they've been since the tech bubble. I mean, the spreads are the lowest they've been since the tech bubble, right? Now, it was another world where we're hearing the narrative of a new paradigm. The internet and fiber optics want to change the world.

13:50Now, we're hearing the Trump trade and this manufacturing renaissance here in the U.S. is going to change everything. You got to be very careful because, like you said, there's zero safety margin. There's a tremendous amount of complacency and credit spreads. And you may be right. And in our base case, that credit probably does fine and you don't get hurt. But again, we don't live in a world where the path is guaranteed and you have zero safety margin. And if you look at the distribution of risk, probably much more density in the chance that spreads widened from here rather than they continue to grind tighter.

14:21Certainly feels skewed in our mind. And that's analogous to the stock market. That's almost seeming, in our mind, priced to perfection. So what we try to do at PIMCO is, you know, this is where style matters, right? Like hopefully folks are interested in active funds. You got to figure out what your active manager style is. A lot of active managers can just beat the ag by adding more investment grade credit and high yield. And if you do that on a steady state, over a 10-year period, you're probably going to beat the ag because more of your credit spread that you're getting is above and beyond the true default risk.

14:52So if you just do that and hold it, it's going to be great. Problem with that strategy is twofold. One, we're starting at the richest levels in 20 years on spreads, so I don't know if that'll work. And second, even if it does work, they haven't repealed the business cycle. And when we get a recession and perhaps a default cycle, you're going to have to apologize to your clients because your bond fund did not behave like a bond fund. So this is where style matters. So what we're doing at Pimpco is exactly what you alluded to. If spreads are rich, don't buy them. Go buy something else. And we're finding great value in non-generic corporates, meaning go outside of corporates.

15:26Agency mortgages, not the most exotic thing, Fannie, Freddie, Ginnie mortgages, we think are very attractive versus corporates. They're basically, you know, the cheapest they've been in years. And they're actually counter-cyclical, meaning their spreads usually tighten in fall when high-yield investor grade spreads are winding. So it's got nice counter-cyclical dynamics. Is the screwiness that's going on in the housing market making those bonds more attractive today? Like, what's causing the fact that those bonds are more attractive? Yeah, so I think it's a couple of things. Rates are high and potentially, and volatility is high in rates, and people are a little averse to owning a negatively convex asset like mortgages.

16:03I don't want to get too nerdy. There's also questions of, well, if the Fed's not buying and the Fed's doing QT, is that going to be a bad technical? And we factor all those in. But we still think when we model them and properly adjust for the negative convexity, they're incredibly attractive. It's an up in quality trade, up in liquidity trade that barely gives up any yield versus investment grade corporates. Why would you not do that in a scenario like this where growth is slowing and credit seems frothy? So Mike, sorry to cut you off. Michael and I have talked about this a lot, this huge spread in mortgages over treasuries compared to history.

16:34And I guess part of the reason for that is I guess investors don't want to own them because the duration is increased. People aren't refinancing as much, right? Because mortgages are so, is that part of the deal? Oh yeah. So look, the duration of the mortgage index is six years or so now used to be, you know, a couple of years lower than that a few years ago, but, but that's okay. Like as an active manager, like I don't need to manage duration asset class by asset class. I can manage it holistically, right? So I could forego buying a bunch of overvalued corporates, buy the mortgages and manage my duration elsewhere.

17:07So again, just like I said before, people got to bifurcate the risk-free rate from the credit spread. You got to separate where you're getting your spread and where you're getting your duration from. It doesn't have to be just in one asset class. Another thing I'd mention is a lot of the non-agency securitized product is also very attractive, right? When you think about it, like, I don't know, the more accessible an asset class is in the bond market, the more generic it becomes benchmark eligible, gets a tremendous halo effect once it's benchmark eligible, right? If you're a corporate who's in the Barclays corporate ag or Bloomberg corporate ag, you know, people have to buy your bonds.

17:40All those replicators, passive folks, all those low active share active managers buy it. Your spreads are usually lower. What we try to do is go where the opportunity is, not where the comfort of a herd is. And right now we're finding that if you go out of the most generic stuff, you're getting decent spreads. They're not great. They're not as good as they were in, let's say, the depths of COVID or in early 2022 when the Fed started hiking, but they're not at zero percentile or richest in 20 years. So things like non-agency mortgages where there's no Fannie Freddie guarantee, things like consumer ABS, things like even CMBS, which has such a taint right now with what's going on in the office sector.

18:16You know, those spreads are nowhere near their historic tights, whereas corporates and investment and high yield are. Are you at all worried about the consumer? One of the things that people have mentioned are credit card defaults picking up. Is that something that concerns you at all? Yeah. So look, we're definitely keeping a keen eye on it, right? The glory days for the consumer during COVID when, what, we had like six, seven excess savings deposits because everyone was getting stimulus checks and moratoriums on their rent and mortgage and student loans. And plus, you couldn't consume anything because the economy was closed.

18:46That was when the consumer was its strongest, right? And all of that excess liquidity has largely been spent down. But we look at the consumer, you know, unemployment has risen, but it's still very low and 4.2 % or so. Average hourly earnings is pretty decent right now. And household leverage is very light, like the average LTV on a mortgage is in the mid 60s. And over 90 % of those mortgages are 30 year fixed. And the bulk of those are refinanced at low rates. So the consumer by and large is in very good shape in our mind. This is not like your grandfather's consumer who at this point in the cycle is doing crazy things.

19:21over levered, overspending based on what they think they're going to earn or what they think their paper wealth is. This consumer has been pretty much in check. Now, look, the bottom part of the consumer market is going to have a tough go at it when growth slows to like we're hypothesizing below two. So you just got to be careful on which part of the consumer market you're accessing. And even more importantly, when we do the securitized product, what part of the capital structure you are. Like, you know, avoid the mezzanine parts of the capital structure, because if you do get a bad cycle, an economic cycle, and the consumer gets in trouble, some of those tranches are going to take impairments, stay up in quality, top part of the capital structure, cleanly underwritten deals, and you're getting more paid for a complexity illiquidity premium rather than a credit risk premium.

20:05Michael and I were talking today about the, we're looking at the ag returns. And I think over the last 10 years, the ag is up a little more than 1 % per year. Over the last five years, it's gone nowhere. And we know why, because rates went from 0 % to 5 % in a hurry for the Fed funds. in a fashion they've never really gone, especially from that level. Has this been the worst fixed income environment we've ever lived through in modern times? Yeah, I began my career in 93 and those guys all told me about the 80s. But yeah, they said, you missed it. The Fed's got the market under control. And all of a sudden in 2022, we saw, 2022 was a perfect confluence of events, right?

20:39We started off at almost no yields, right? August 2020, the 10-year treasury bottomed at 50 basis points, which actually seemed attractive versus the trillions of dollars abroad that were at negative yields. And then all of a sudden in 2022, you get everybody off sides with inflation is not transitory, it's real, and the Fed's got to get hiking. You start that year with the minimus yield on the ag. I think the ag was yielding barely above 1.5%, and the Fed had to hike from zero all the way up to eventually 550. That is a perfect cocktail for the worst year in bonds, and that's what we had. That was worse than any year in the 80s because back in the 80s, a couple of things, one, rates were higher, So you had that for momentum.

21:17And two, the ag was lower duration then. So, you know, ag was six years or so. You had to hike 400 or 500 basis points. That's pain. We think right now, think about why people buy bonds. Throughout my 31, 32 year career, you know, income, you buy bonds for three reasons. Capital preservation, income and hedge versus your risky assets. Let's hit each of those. All three of them haven't worked well in the last five years, to your point with the data, but we think we're in the process of them working incredibly well for the next several years. Let's talk about capital preservation. I get thrown in my face.