Talk Your Book: Balancing Risk and Yield

0:00Today's Animal Spirits Talk Your Book is brought to you by J.P.Morgan. Today's show we're talking about the J.P.Morgan Core Plus bond ETF. JCPB. Go to J.P.Morgan. Asset. management to learn more.

0:13Welcome 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.

0:43Welcome to Animal Spirits with Michael and Ben. Michael, we always talk about like the market, quote unquote, trying to predict what's going to happen to the Fed or whatever, you know, like the market thinks there's going to be five rate cuts or the market thinks this, market thinks that. The market is obviously not always right. What? Yeah, shocker. So I think this is the interesting part about thinking in terms of bonds, because there is so much more of a macro component. The macro matters a lot to the stock market too, but I would argue more to the bond market. And so I think what makes the bond market interesting right now is just the fact that thinking through the scenarios of, even if you just think of the two, like the soft landing and the Fed brings rates down to 3.5 % or 3 % or whatever, that seems like a pretty good place for bonds because you get a little kick from lower yields, right?

1:36And you still have decent yields on your products, like not bad, but a hard landing of recession. Here we go. You're starting with higher yields and those rates are going to fall. You're still in a pretty good place. So I think thinking through the different scenario, the other scenario would be rates rise again because inflation picks up or whatever. But thinking through the probabilities of what could happen, fixed income seems like it's in a pretty good place right now. Yeah. Relatively higher for relatively longer? Well, I don't know. More like higher for shorter? Well, relative to where we came from.

2:10Okay, to the past, yeah. And we talk about on this show, the fact that yields in fixed income now are over, they're real, right? They're above the rate of inflation, which was not the case for a long time. You had negative real yields in fixed income. People were just kind of saying, all right, well, I'm not going to get anything in yield, but at least I'm going to be kind of safe here. And yeah, I think you have a much bigger margin of safety now than you had before. The question is, there's so many different products you can invest in and ways you can go on the yield curve, but different types of products and corporate bonds and high yields and securitized debt and asset back debt, all these different things.

2:45So on today's show, we talked to Priya Misra. Priya is a portfolio manager with JP Morgan covering their JP Morgan Core Plus Bond ETF, JCPB. We'll get into all this with her. really interesting talk. We asked her, is fixed income really smart money? She gave a great answer. And so here's more with our talk with Priya Misra from JP Morgan.

3:07We are joined today by Priya Misra. Priya is a portfolio manager covering the JP Morgan Core Plus Bond ETF. Priya, welcome to the show. Hi, thanks for having me. You sent us some background information on yourself. I'm always curious, how did you get into the fixed income world? So fixed income, I started in 2001, straight out of school. I enjoyed economics. I enjoyed thinking about market pricing. And, you know, it sort of made sense. Fixed income was this wonderful place where you had a nice blend of macroeconomics, as well as market pricing. You're trying to find, you know, inefficiencies. Or if you had a view on the macro, which was different from what was pricing.

3:50And that was sort of my interest. And so I actually ended up in research. I thought when I figured it all out, and, you know, 22 years later, I was still figuring it out. So it's just a fascinating market. I did start, I will say, at a time when government bonds were not considered very exciting. Well, not that they're all that exciting now, but, you know, that was a time when we were in a surplus, if that's believable. But in 2000, the budget deficit was negative, meaning we had a budget surplus. And people were saying, well, there may be no government bonds in 10 years time. And here we are, we've got enough government bonds for generations to come.

4:27So the world's changed a lot, but fixed income just was interesting to me from what I enjoyed. And it has stayed interesting. And you never quite know what the day is going to bring about. So that's kept me fascinated all these years. One of the arguments Michael and I have had over the years is that people always say the fixed income is the smart money. Maybe you could expand on that for what that means. And I'm curious if you believe it, because there is this idea that fixed income is the smart money and the stock market is the dumb money, right? I guess in certain ways, maybe you can let us share with us on your thoughts of a theory.

5:05So as much as my ego would like to think that as a person who's been in fixed income that it's smart money, you know, I struggle with that. But I do think all of us look at the same data. The market's looking at economic data, Fed speak, global macro developments, company fundamentals. We're all looking at the same data. How you interpret that data and how you think about flows, that's going to drive what happens to market pricing. I do think in fixed income, there is this macro element, which I think maybe is a little less in the equity market. I think that's one difference. I think the macro component, so for example, when I say macro, what do I mean?

5:44I mean, interest rates, FX, and interest rates, you've got interest rates from overnight rates, which the Fed controls, all the way out to third tier. Or if you're out of the US, you have 100-year bonds. So there's an element of where are interest rates today? Where will they be over time? I think there's a bigger macro component within fixed income, because ultimately everything is really benchmarked off the treasury curve. So you kind of have to have that sense, which I think in equities, it tends to be, there's one equity risk premium component. And then after that, it's very much the sector or the company that you're looking at.

6:21We have all of that in fixed income, but then you also have this macro component of where will 20-year interest rates be, or 10-year interest rates. And then we benchmark how much more should I be paid to take on a corporate risk. So I don't know about smart or dumb. I do think it requires a lot of work and it's humbling in the market, in any market. We do tend to focus on slightly different things. So that's where I think I find it interesting to look at both markets, if I just think about it, fixed income and equity to see, is there an asymmetry there? I think we may be at that point right now where the equity market may be a little more excited about Fed eases, and the fixed-income market may be saying, well, there are lags.

7:07We just lived through lags. So it's not clear that if the economy is slowing, Fed eases will be enough. So there may be some differences in terms of how the risks are being perceived, but ultimately, we're all looking at the same data and taking a view. For the last two-plus years, the shape of the yield curve has been inverted, meaning that the short-end rates have been higher than the long-end rates. And ostensibly, that's going to uninvert or disinvert in the next couple of months as the Fed does start to finally ease. As a portfolio manager, how do you think about the dynamics of the yield curve?

7:43Sure. Great question. There's a lot of hand-wringing done around the yield curve because historically, an inverted yield curve is actually, you would argue, the single best market indicator of a recession. And here we are, two years later, we're not in a recession right now. So what's different? So I think there's a couple of differences and we have to incorporate the entire macro environment. And why I say this is one of the reasons why the yield curve is inverted is that the Fed owns a large number of treasuries and mortgages. So duration risk, a large part of that duration risk has been taken by the Fed.

8:21The market, you and I, investors don't have to own it. So to some extent, that's artificially depressing, or I shouldn't say artificial, but it's a price sensitive buyer, the Federal Reserve, that's bought these bonds. So that's a structural reason why the curve should be flatter. Should it be that inverted? I think that's the market telling you that the Fed has taken rates into restrictive territory. We're seeing it in the data. We've heard the Fed say that it is restrictive. And so to your point on, is it disinverting? Yes, as the Fed reduces the level of restrictiveness, which they're indicating.

8:55I think the debate is not whether they will reduce, it's how quickly, is it a 50 basis points in September or not? How, where's, what's that end point? But as they reduce the level of restrictiveness, that front end is going to get to either some level of normal. If we stay in a soft landing, we could get to, let's say, 3 % is the Fed's estimate of neutral. I think it's a fair level. If we head into a recession, that front end is going below that because at that point, the Fed will want to decrease into accommodative territory. The long end is less impacted by that. So that's when that curve disinverts.

9:31So you sent us some notes on some of your thinking about the fixed income market. And you said, and it's interesting because this is something Michael and I have been talking about a lot. You said once the Fed starts to cut, I think money that has been in money market funds will leave due to reinvestment risk and will go into bonds and stocks. Now, the amount that leaves maybe will, it might depend on which scenario happens from you. You said like, does it get to the neutral rate of three? Does it go even lower than that because we go into some sort of recession. Do you have a feeling, because there's, I don't know, six or$7 trillion in money markets.

9:58I think if you add CDs in there, that's another couple trillion dollars or something. Do you have a sense of that money, how sticky it is? And then if you think more will go into just bonds, if that's sort of money markets or a bond substitute, I'm curious your thoughts on that. Because we've been trying to figure this out too. And it's interesting to think through. Yeah. It feels like every investor is salivating at that thought of about$6 or$7 trillion and where it's going to end up. So a couple of points on that. Number one, some part of that is going to be sticky. People need cash for cash management reasons, for liquidity reasons.

10:31And so a large part of that, I mean, you go back to when interest rates were zero and there was a certain amount that was lying there where, you know, and we were not talking about a recession. So is it$3,$4 trillion that's going to stay there? And remember, that number should move in line with nominal GDP. So it should not be a static number. As the economy grows, as markets grow, that number that's the actual demand for cash should also grow. Maybe that's three or four trillion right now. We still have a few other trillion. Where does that go? Historically, so if I go back multiple cycles, you actually find that the Fed cuts in a recession, right?

11:11Soft landing cuts, what we're actually contemplating right now, are very rare. It's happened only once, really, in the post-war history, which is in 1995. But normally what happens is the economy goes into a recession, the Fed starts to cut rates, interest rates fall dramatically. So actually, money, when it leaves, and equities fall. Typically, money leaves money market funds at that point and actually goes into the equity market because equity valuations have reset. The reason this time could be a little different, I'm nervous saying this time is different. I don't like saying it, but there are some different factors this time around, which is, number one, equities are, they have not really reset lower.

11:52They are near their highs. They are at their highs. So it's hard to argue that, you know, there's a lot of value there unless you see some growth sector. the Fed is going to cut rates and the money that's sitting in that you know five and a half percent overnight cash there's going to be some reinvestment risk there because that number is going to go down so I actually think in a soft landing so let's say the economy stays one and a half to two percent GDP current level inflation slowly gets close to that two percent level Fed cuts to neutral rate In that scenario, I think that non-sticky cash will go into really every asset class out there.

12:32There's going to be some in bonds. You're getting real returns in bonds. Actually, for the first time in decades, you're getting real return, meaning you're getting returns above inflation. Some of it is going to go into equities because the economy looks strong. Some of it is going to go into alternatives. In a hard landing, it starts to look a lot different. So if the economy is slowing down much faster, I think actually more will go into bonds because at that point, you know, you can get really nervous about equity valuations. And the fact that we've not really had any decline in equities, I think then more can go into bonds, especially high quality, high grade or government bonds, because the concern will be, I want the yield, but I want the safety of that money.

13:13So I think depending on the economic environment, that money moves. But yeah, you're looking at a couple of trillion that is going to start to get nervous when that overnight yield. And it may not happen in one go. I think the first rate cut actually doesn't matter. It's when you've had three or four rate cuts. And, you know, I was getting five and a half in my money market fund and now I'm getting four. And when I talked to my financial advisor, I realized, oh, I'm going to get three if the Fed continues to cut risk. I think that's when it really snowballs because you start to realize that five, four, these numbers look unreal.

13:48I mean, they're unreasonable as you're looking ahead. That's when that money starts to move out. Can you talk about the dynamic of how a lot of corporations gorged on bonds, borrowed a ton of money in 2020, 2021, where interest rates were ultra low? How much did that insulate them from needing to borrow in later years as rates went up? Obviously, small cap stocks are much more sensitive and their debt tends to be floating. But for larger corporations that were able to lock in rates, what sort of impact did that have on market dynamics? Yeah, I'm glad you bring that up because I think that's the single biggest reason why the economy has been so resilient.

14:24And I would expand. I know you asked about corporates and I'll get to it, but households. I think everyone was a smart CFO. If you're a household, you've got a mortgage, you refinance at a 2%, 2.5. And that's why you're noticing the housing market, I would argue is frozen. and I'm not even sure a few cuts or 100 basis points of cuts is going to do a whole lot because the effective mortgage rate is a little below four percent and current mortgage rate as of last week six and a half so you need a significant decline in rates for refinancing to pick up but corporates did the same thing what they did was a couple of things they certainly what they had to issue they issued they if they had an a bond maturing they extended out so that they were locking in that funding for a longer period of time.

15:13It was very low. And remember, this was an environment where the Fed had cut to zero and they were doing significant QE. So they were actually impacting long end rates and corporates extended. The other thing corporates did was they pre-funded. And so, and this is why we've heard, you know, this year there's been a lot of corporate issuance. Look at net corporate issuance. It has not been that high because companies pre-funded. if I had a bond maturing in 24, 25, I issued it in 2020. Now, it'll only last that long, which is why the lags exist of monetary policy. If the Fed doesn't cut rates, and I feel very strongly, we're in a soft landing, all markets love it.

15:52But in order for this soft landing to remain, the Fed has to start to cut rates because that effect lasts for three years, five years. The average corporate bond issuance is seven years. If they manage to extend all the way to 10 years, not all of them issued in 10 years. I would say the average is five to seven years. Within five to seven years, that lock-in effect goes away. And even on the household side, you know, you move, you have more kids or you downsize, there are life changes happen. People move because of jobs. That could take a while as well. But at some point when you move, that interest rate shock will hit you.

16:31So, which is why I think the Fed's very smart. They are trying to start to reduce that restrictiveness now so that companies that had done that lock-in, as one of the reasons why corporate balance sheets look strong, because interest cost is not high, because to your point, most of it is fixed rate. It lasts and it's helped them, it's insulated them, but not forever. And so if interest rates don't fall, I think we'll be talking about a different scenario two years from now. But I think the hope is that two years from now, Fed funds will be lower, the 10-year will be lower. And when they have to go out and refinance, it's not going to be current level of rates.

17:06It's going to be lower. So the bond fund that you run is Core Plus, which I assume means the Bloomberg aggregate. And then you kind of can go a little further out on the risk spectrum. I'm curious how you think about it, because you mentioned the inverted yield curve being what some people thought was this, you know, this thing that was never wrong. The interesting part of that is that spreads never blew out for corporate or high yield bonds, really. So I'm curious how you look at the landscape today of fixed income, because the fact is that spreads are still pretty tight historically. So I'm curious how you think through that landscape of treasuries versus corporates and high yields when the spreads are still pretty low.

17:42Sure. So, you know, you're right. Spreads are tight on a historical standpoint, but I would argue that they are tight for good reason. If I look at corporate bonds, look at corporate fundamentals, they're extremely strong, whether I look at earnings or margins or debt levels or interest coverage ratio, various metrics that we look at in the corporate sector, the risk is lower. And so that reflects why those spreads are tighter. Let's look at the mortgage sector. If I think of the broad fixed income indices, you really got the securitized and the credit. So let's look at securitize. Interest rate wall is lower.

18:19A year ago, so in the fall of 23, we were talking about potentially the Fed hiking once more, or maybe cutting a lot because we were heading into a recession. So interest rate levels of wall are much lower now. We're not talking about rate hikes. We're talking about cuts, and the Fed is sort of telegraphing these rate cuts. So I do agree spreads are tight, but for good reason. All in yields are extremely attractive. And I think that's what's attracting flows, whether it's out of cash, out of other asset classes into fixed income, because you're looking at all in yields of five and a half, 6 % for high quality spread product.

18:55But in terms of your question of relative attractiveness, I would say we think of different levels. In terms of credit risk, I like securitized credit. There's aspects of the securitized credit market where you can pick up yield over investment rate corporate market, giving up some in liquidity, but you are picking up for the same credit risk, you're picking up more spread. So I would say parts of securitized credit make a lot of sense to us. The agency CMBS market gives you positive convexity. So it's almost like it is a mortgage product with positive convexity. So there's value there. High quality, high yield.

19:33The high yield market today is not the high yield market from 20 years ago. I think the private credit market has reinsured the high yield market. So there's a lot of value in these high quality high yield. I think triple C's become a lot more idiosyncratic. There's a lot of liability. Sorry to cut you off. So you think high yield is much more high quality these days, or at least certain parts of it? Yes, exactly. I think the double B, single B high yield is higher quality than before. You've had a lot of the rising stars where these double Bs are getting upgraded into the triple B. We've had a larger percentage of these upgrades happen.

20:11Part of it is because they've been helped either by fiscal stimulus or they did the lock-in effect that we were talking about earlier, that they actually managed their liability stream well. So, you know, there's a lot more rising stars than fallen angels. But I would say we found high quality high yield and high quality IG actually gives you better risk reward than the BBB sector. You mentioned something about private credit de-risking high yield, making it more high quality. Can you say more about that? Sure. So I think the fact, the advent of the private credit market, I think there was a lot of trepidation, concern.

20:49What it's doing is it's providing credit to a part of the market that was either provided credit by the banking system, and that changed with regulation with what happened last year with the so there was a reduction in availability of credit there or it was provided from the high yield market and the advent of this new private credit market with I guess money that was you know not looking for instant liquidity most private credit money is sort of in there for the long haul ends up then being invested in sectors that then don't end up in the high yield market. And as a result, what's left for the high yield market ends up being higher quality.

21:33So I view the private credit market, I mean, broadly from a macro standpoint, as almost reinsuring the high yield market. And it can explain one of the reasons why you're seeing a lot of upgrades or these rising stars may be the fact that the higher quality players ended up in the public high-yield market, and their quality effectively is getting upgraded relative to where double Bs were considered 10 years ago. So I think it's got good macro development. I wonder if that's part of the reason, maybe this is a stretch, but maybe part of the reason why spreads never blew out in high yield, or interest coverage ratios, for example, maybe higher for the current makeup of the index than it was, say, 10, 15 years ago?

22:22Yeah, I think that's fair. I mean, there are lots of things. I mean, did spreads not blow up because default rates? Okay, let's look at default rates in the high yield market. Historically, three to 4 % in a recession, they spike. We're running at one and a half to 2%. Now, is that because the economy has been resilient? There was a lot of fiscal stimulus. There was savings in the household sector. So the consumer was much stronger. The supply side helped. Tons of labor supply, supply chains improved. So I think there were macro reasons for the strength of the economy. And then I think at the marginal player where defaults might have gone up, might have ended up in the private credit market.

23:05So I think there was a factor. I don't know if it was the largest factor, but I do think that, you know, and there have been. There have been the defaults, the concerns have happened. You see it more in the distressed part of the high yield market. The high yield market, I should clarify, is bifurcated much more now than it was 10 years ago, where you're seeing the high quality high yield is really trading like investment grade in my mind. And then you've got the distressed sector where, you know, that's where the problems are. So you see the 200, 300 basis points spread in the high quality sector.

23:39And then you have the thousand basis points spread in the distressed sector. And that's where it's idiosyncratic. And now that might be more similar to private credit. It's actually not an area we traffic in. I don't think it gives you the best risk to what you really need to be. You need to have a seat at the table to know which companies to own within that distressed world. When you're creating a portfolio, how do you balance this desire for going a little further on the risk curve so you can increase your yield versus the worry that, well, what if the Fed does accidentally cause a hard landing and this is not good for a certain type of bonds?

24:15How do you tow that line? Yeah, we stress about it a lot. We don't sleep well. But it is something we think we spend a lot of time thinking about portfolio construction. So let me summarize quickly, and I'm going to simplify what we do, but it's some version of this. So we think about where are we business cycle-wise? And I think right now we would say we're in a soft landing. But in my mind, soft landing is about risk management and then which is a bigger risk. And right now, the bigger risk would be that the Fed doesn't cut enough or early enough or quickly enough, and we might end up in a hard landing.