Talk Your Book: Betting on Duration

0:00Today's Animal Spirits Talk Your Book is brought to you by U.S. Benchmark series by FM Investments. You can go to USTreasuryETF.com to learn more about their ETFs that invest directly into treasury bills and treasury bonds. That's USTreasuryETF.com. Welcome 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.

0:37Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:46Welcome to Animal Spirits with Michael and Ben. Michael, one of our sentiment gauges here that's totally internal, we're holding on to it, is our inbox. and in the like the petty 20 late 2020 early 2021 days it was you know these two or three times leveraged tech etfs and trading individual stocks and meme stocks and all this stuff and now the majority of our questions are about boring old bonds and how do i lock and yield and how do i buy t-bills right credit our audience we didn't get a lot of memes like there wasn't a ton of people being like, why aren't you guys investing in AMC? That's true.

1:25There was a few, but not many. People were skeptical. Smart audience. It was more like, why should I not just put all my money into the NASDAQ and that sort of thing? But the bond yield stuff is interesting because I don't think people have had to think about bonds before. If you figure the 30 years from 1980 on, interest rates were falling. It didn't really matter what you invested in. If you invested in something in the fixed income market, you did pretty well because you had a high starting yield and yields were falling. And then when they hit generational lows in 2020, everyone kind of said, well, what am I going to do in bonds anyway?

1:54So I'm just going to go mostly to stocks or I'm going to sit in cash or something. So people haven't really had to be very thoughtful. And now that rates have moved so far so fast, and then the yield curve has been changing from this inverted thing where the T-bill yields were way higher than bond yields, and now bond yields are catching up. People are being forced into thinking about bonds in a more reasonable manner. And for once, it's about yield as well and not just like, what am I going to do? Well, we spent a lot of time on this show with Alex Morris talking about the risks to the long end, the risks to the short end.

2:27But that's the wrong way to think about it. The right way to think about it is there's a lot of ways to win, right? There's a lot of ways that you can successfully implement an approach to fixed income. And it could be a happy medium. It could be whatever it is. There's just a lot of opportunity for the first time in really in our career, which is a wonderful thing. Well, and the thing is about that is you have to kind of define what you're looking for, because some people could say, I'm putting a trade on and I'm betting that rates are going to stay higher for longer, inflation is going to get in control, and I'm sticking away from duration.

3:01Or you could say, I'm going into duration because I think a recession is coming and rates are going to fall. And other people are thinking, no, no, no, I just want something safety. I don't want any volatility. So I'm going to go short. Or you could say, I want to lock in yields for longer. So there's different avenues you could approach depending on how you think about the world in this way, which is interesting. All right. I paused because I thought about a joke that was really bad, so I'm going to spare you. With no further ado, here is Alex Morris from FM Investments. It's good. Fixed income humor doesn't work.

3:29We're joined today by Alex Morris. Alex is the chief investment officer of FM Investments. We're going to start with the long end of the curve today. So we're talking all about fixed income and the benchmark series suite of direct maturities. Is that what do we call it? On the run single maturities. On the run single maturities. Okay. Okay. All right. So the yield curve had been inverted for a long time. I think this is the second longest streak since outside of 2007 of interest rate inversion. And the curve is uninverting and it's happening not because the Fed is cutting rates, obviously that's not happening, but because the long end of the curve has been screaming higher for the past couple of months.

4:15There's been like a lot of debate and I'm sure it's not just one thing. It's probably not even just two things. But in your opinion, why do you think it took so long for the long end of the curve to respond to stronger economic activity? And why do you think it happened so quickly? It's a really good question. I think you're right. It has a lot of myriad answers. I think that the simplest one is that statement of we're going to talk about the long end of the curve, it's something that people hadn't really said for two, three, maybe 10, 12 years, right? There was just no interest. You look at the yield curve, it was a flat line and no one much really worried or cared.

4:52There's one moment we could talk about. We probably should spend a little time talking about, which is the Bank of Japan. And I get they're not the treasury or the Fed, but they probably had more impact on the rate and the material interest or lack thereof in the 10-year, US 10-year, than anyone else has had in a long time, right? Governor Yoshida comes out a few months ago and says, basically, we're going to stop propping up the Japanese bank 10-year. And when they do, the 10-year US becomes unpaid and its yield starts to fall in line with the rest of the yield curve. Because it, for a long while, had bit this sort of second inversion, like a divot, if you looked at it.

5:26On top of that, once that happened, I think folks realized that recession by virtue of the Fed cutting the front end, because that's usually when you see an inverted yield curve, you think recession, but it's not because the yield curve is inverted. It's because the Fed usually reduces rates suddenly, and that creates the actual recession. That didn't happen. And it happened long enough now that folks had an opportunity to trade out of those positions and allow the rest of the curve to really come in line with what I think is a more reasonable long-term expectation. I don't think it was fair to say that the US long-term growth expectations were 100 basis points.

6:00It is a more 400 basis points, 500 basis points operation 30 years out for now. And you should kind of want that kind of return, right? Can we talk the nomenclature here? Is it disinverting, uninverting, steepening? What do you prefer? I like steepening, but that means a lot of things for a lot of people. So I guess normalizing, maybe? Is that fair? So I guess a lot of people, investors, maybe the bond market itself assumed, yeah, that this uninversion steepening would happen because the Fed would be forced to cut rates if and when the economy sold or went into recession, and it's the opposite.

6:31Is there any precedent for this happening, especially this quickly where, I mean, I guess maybe the early 80s or something where the long end sort of did the uninverting here? If you look at the 80s, the long end did some of it, but rates just got so high in the short end, right, and the housing market went so wonky that it was kind of hard to justify that. I think this is truly a wrinkle. And this is where we kind of remember when we're playing with economic or economy-wide global macro things, looking back at history is not often the best answer of what's going to happen this time, right? They tend to be events that we then write books about because they're exogenous.

7:03Like this is when something changed. Every time there's a crisis of some sort, the Fed, the Treasury, and Congress get together and they redistribute their rights. And then all of a sudden, everything they did the last time doesn't matter because they have a different rule set. We got to forget that we regularly forget that. I think this time, though, the big difference, right, because I don't think there's been a time where this has happened as quickly, certainly not on a relative basis, going 5x in the last 12 months on a yield basis, is that folks didn't believe the Fed would actually stick to it.

7:31I think that bet you saw on the long end of the curve was a belief that the Fed would chicken out and that they would just drop rates quickly to go back to the way things were. And they absolutely did not. And they've made very clear they don't intend to give it up anytime soon either. You mentioned the bet on the long end of the curve. We've spoken about this, the chart floating around of the massacre in TLT. It's in a deeper drawdown than the S &P 500 was in the dot-com bubble. That's the sort of carnage we're talking about here. And yet total assets in TLT kept rising, which is very inconsistent with investor behavior.

8:07Usually people run for the exits when they're feeling that level of acute pain. But how much of that rise in assets, I think it's probably impossible to untangle, how much of that rise in total AUM is from short sellers getting involved there? Well, so if you looked at the stats as of yesterday, as it were, so then the last week, I'd call it mid to end of October, about 12 % of the open interest was in short sellers. So there is a lot of creating to short. That's actually not nothing, but not everything. I mean, not even close to everything. Yes, not even close to everything. Now, let's not forget there's a triple X inverse and a triple X long TLT.

8:52Yeah, I tried. I tried to buy one of those things. Did not go well. But credit to me, took a quick loss. Three to 4%, gone. But you know what you're doing. So you got to know that there's some folks who are going to buy that thing and hold onto it, not realizing what's about to happen to them. And I think that the short answer for why folks are interested is maybe folks are doing the right thing, right? All of a sudden, if there is interest from sellers, that's when you want to be buying, right? If folks are getting fearful and getting out, you want to get a little greedy on it. The problem with TLT is it's a great trading vehicle, but it's kind of hard from a theory standpoint because it owns a bunch of stuff greater than 20 years, right?

9:27It really has a long end of the curve of which the government only issues 20 years and 30 years every quarter. So there's not that much to go around. There's some zeros in there that help keep the duration really long. But you're not talking about things that have a duration that's north of 10, 15 years. That's like a 15x leverage impact, right? If you look at that, you're buying into that idea. And if you're going to buy a 5 % 30-year as a cash bond and hold onto it and just know that at the end of 30 years, you're going to get all your money back in 5 % a year, that's a great idea. But buying as an ETF and now being in there with a bunch of other low coupon items, you're not going to get what you expect.

10:03Most folks at Bank of Looking at that, and at the 20 and the 30, yielding about 4.7 to 4.9 today, somewhere in that range, and thinking, oh, wow, I'm going to get that kind of yield. What they get is 3.5 % or less, because the embedded coupon rates from those bonds is just so low. And so they don't get the experience they want. That's a good point, because right now, a lot of people are saying, like, okay, rates are higher, I want to lock them in. So maybe, yeah, maybe just sort of compare and contrast that like buying an actual bond with buying one of these ETFs that has a constant maturity profile or duration or whatever it is.

10:34Yeah. So let's take the multi-bond funds, which are, we've been around for a long time, right? And why we built the benchmark series, which is just one thing and why it was important to be very different. So if you're buying something that's 10 to 20 years or 10 to 30 years, you're going to have to buy a lot of bonds. And there's no, that diversification doesn't earn you any credit diversification, right? It's the same issuer, it's the government. All the bonds are the same. The theory that if one bond crashes, the other ones won't, doesn't make any sense. If the government defaults on one debt, it's going to default on all of the debt, in theory.

11:03So you're not giving the diversification you might hope. What you are getting is a difference in liquidity profile, right? The further away from all the run you go, the less liquid, so the greater the spread to buy or sell the thing. And you are picking up coupon differentiation. So if you have the same issuer risk, you might as well just try to maximize your yield or optimize for liquidity. And that's why we built the benchmark series. We didn't inherently want to build and launch a single treasury ETFs who thought it'd be fun for the marketing. We did it because the other tools weren't precise enough.

11:31And as we tried to buy a, say, three to seven year, because we wanted an average of five, we found that some days we got seven, some days we got three, and we spent a lot of time fighting where that index was going. And it kind of makes sense, right? If you think about why those indices were originally built, they were built around accounting principles of the government and how the government issues debt. And with all due respects to all of us as taxpayers, none of us really go to the government for our investing criteria, right? And how they want to do their accounting is their problem, but it shouldn't be my investment thesis.

12:03So we built the benchmark to give you that liquidity because the on-the-runs are just more liquid. They tend to always be more liquid. And then separately, if you had a point on the curve you wanted to access, you should get that point. So when rates go up, you're constantly reinvesting that accrued income and do a higher coupon, which is what you want to be doing. And the rates go down, you're constantly reinvesting in longer duration, taking advantage of that price move, again, which is the exact move you want to do. And that point moves on the curve up and down pretty readily. If you start looking at, say, three to seven years or 10 to 30, that's a pretty wide swap.

12:37And if we go back to high school calculus, there's a lot more action that happens and a lot of things you don't expect. And bond math is hard enough as it is, start putting that over multiple issuances. We're going to talk about bond math in a second, but let me ask you a dumb question. So if I want to buy the 10-year today and lock in close to 5%, you could do that, right? You could buy a 10-year treasury in various places. But if I'm buying the benchmark one, how does that work? So am I really lock hitting the 5 %? In other words, is there an interest rate risk to the downside? What if the 10-year goes down to 3 %?

13:11There is interest rate risk in general on that product. The good news is if rates go down to 3%, your principal value has gone up. And we've constantly reinvested in that. So you'll pick up that immediate price appreciation. You won't have to stick around for 10 years to actually recognize that total value. And if rates go, even if rates ticked a little higher now, because the coupon rate and just the yield of it is so high, we're actually not going to lose very much. And your total return will still be net positive. So on that long end, up to the 10-year, you shouldn't be interested in doing the roll.

13:42And then at some point in the future, if you say, okay, I think rates are now going to be static forever and I really like what I've got, that's when you should lock in. And if you bought, say, U10 today and then in three years decided that's the rate you wanted to lock in, you would do so with a fairly sizable increase in value, some more principle for you to invest and lock into. So just to be very clear on that point, so I'm not misunderstanding, buying something like U10, you're not locking in rates, right? You're really just getting exposure to that part of the curve for better and for worse.

14:14Correct. Right. Yes. So his point is that, yeah, if rates go down, you'll get the price bump. But yeah, the yield will change too. So your yield will go down. But between five and three, right, with the duration on 10-year, which is somewhere around seven and a half, you're going to be really happy with the price appreciation you get. And because of the ETF, you're going to get a capital gains tax-free other than it being in UTEP. And if you've been a U10 holder for 365 days, you will have converted that short-term capital gain in the underlying bond to a long-term capital gain for your portfolio, which is the trade you want to make.

14:49Good segue to the interest rate scenario analysis that your team sent to us here. And it shows the different parts of the curve from the two-year up to the 30-year and what happens if we have different interest rate moves, right? Interest rates rise 50 basis points or fall. If they rise 100, fall 100. And it looks now like we have a situation where if rates fall, bond prices are going to go up more than if rates rise and bond prices would fall, which I assume was probably the opposite in like 2020, right? So back in 2020, when yields were so low, you had the opposite situation where if rates rose, you were going to lose way more money than you would have made if rates would have fallen.

15:25Correct. So looking at these different scenarios, obviously, we're not going to have a situation where rates rise 100 basis points or fall 100 basis points for every bond, right? They move differently at different times. But what is the sweet spot these days in terms of more bang for your buck if rates fall? So looking at the heat map that we shared, right now, that's the seven-year. And so the seven-year is pretty well traded. The five and the 10 are substantially better traded. They're just much more common for risk hedging across industry. So if you really like that, I'd probably split things between the five-year and the seven-year.

16:00Sorry, the five-year and the 10-year. So UFIV and UTEN, which is where you'll really get that same affected duration as the seven-year, but in two very highly liquid items that are well-traded, well-regarded, and well-talked about. So you're going to be really tuned into what's going on there. Aaron Powell, Michael and I were talking about the convexity piece here, which is kind of like a CFA thing we learned. And we're curious because, correct me if I'm wrong, the basic idea here is that typically when interest rates fall, you're going to get a greater rise in price than the opposite, where if interest rates rise, then you'd see a small.

16:36Does it work like that, where you get a little bit of a bigger bump on the upside than the downside? That's exactly what's happening. And you're also earning that coupon rate, right? So you care also about how quickly you're paying, how much you pay. And you're paid so much now sufficiently quickly that your reinvestment of that earns you way more. And if frights fall, you bought even more of that bond, right? So you're doing the exact right thing by reinvesting in an asset that's about to become a lot more profitable for you. And even while you're doing that, you're reinvesting at a higher rate of return than you were initially.

17:06So you're in that spot where it makes sense to be. And when you think about timing trades, which we always talk about, shouldn't be a market timer. You always fail at it. But this is one of those trades where you don't need to be day precise. It turns out that if you come in a little too soon on the S &P 500, it could be very painful. You come in a few months too early on some of these duration trades, and it doesn't hurt as much. If you come in a month or two early, you actually make more than if you timed it just right, given how quickly assets and cash starts to move into these securities, where you get tighter spreads and you can sort of shop around for a deal at that point.

17:42If you look at the assets under management in some of your ETFs, T-bill, which is the three-month one, has$2.5 billion. X-bill, which is a six-month, has$500 million. But then as you extend your duration, the assets drop dramatically. I wonder if this is probably the same story across other asset managers, just investors' preference for either ultra-short or short duration, given that they have the mindset instead of, well, why would I ever bother with all the headache and volatility of the 10-year plus when I can get the same rate and have effectively zero volatility at the short end? Does that make sense to you?

18:24And do you think investors might be taking that too far? So it does make sense. And advisors and investors who've reached out tell us, why would I not take what was a material yield in the short end over just about anything else? And why would I take risk in the middle of the curve, particularly when the middle of the curve was still trading in the threes, right? It looked like if you believe that long-term, 3 % was probably too low for long-term expectations for the US with a more normal rate policy, then it didn't make sense to jump in yet. Now, I think we've seen that, particularly if you look at the 10-year, every time the 10-year touches above 5 % for even a tick, it immediately gets bought up and goes back down.

19:05So we're starting to see kind of a natural ceiling for the market. But I should mention that that posture for investors staying either short or short has actually been the right trade. It has been. And they've also kind of made it the right trade, right? Assets leaving some of the other bits of the trade and coming to the short end has let bond prices decrease. And if you look at just the general selling pressure and the longing of the curve, there have been more sellers than buyers, right? Some of those sellers have been other governments and whatnot who moved way more than individual investors.

19:34But that's been the case. And it's been a good trade. It was theoretically, mathematically, CFA-wise, the right trade to make. And then the market moved in such a way that it guaranteed it was the right trade to make. So you think there is some sort of line in the sand, or at least that's how investors are acting at like 5%, which is hilarious to me because investment people just love round numbers. Like if you get 4.95%, you probably shouldn't bat an eye versus five. But there's something to be. So you're seeing some activity there when it hits 5%. Like that's when people are stepping in. Yeah.

20:04Every time that it's flirted with that, all of a sudden buyers come back, right? Otherwise, it couldn't, in theory, go higher. And it just hasn't. We'll see what happens later this week when the treasury does its reallocation because it's trying, right now, the treasury is about 25%. So one in four bonds is a bill. And it's trying to get down to one in five, which is kind of a tricky thing for it to do because it's got a lot of debt it needs to finance on the longer end of the curve, which is ever so slightly cheaper because it's inverted now. But it's a good thing for it to do. The one thing that it gives up is flexibility.

20:36If every few years or every few months it feels like now Congress is going to have a debt ceiling debate, the one thing you want the Treasury to do is be fluid, right? More on the short end. When it makes the commitment to the long end, it now runs into some other issues. But it's actively trying to do that. And what it's about to do then is add more 10, 20, 30-year to the market. We'll see if that allows it to break through that sort of technical level. And I'm not a chartist or a technician. I generally don't follow that, but I do know enough of the market does. And if they move their assets like they do, then it tends to make itself right.

21:08So we're going to see what happens if supply goes way, way up. Can it break through five? And if it does, does it have a natural stopping point at the next fraction? And I don't know. There's no fundamental reason why it does other than long-term expectations will kind of need to hold it in check, right? If we look at some other banks, like let's look at the lending rate out in Argentina, It's 118%, which is just kind of fun to think about. What does that mean? Well, it means that they have to offer a very high level of return to get folks to overcome this very material level of inflation. So it's a very different story than us, but it goes to show you there's a lot happening in the world.

21:47The question would be, though, what would happen if we get through five? And in theory, Ben, you're right. The answer is five, five, one, five, two. What does it matter? but practically speaking, certain buyers, they become more attracted at a certain rate and they have long-term liabilities they need to manage. So a lot of the folks who are going to buy the long end, they're going to buy that bond. They're going to stick it away and they're never going to see it again until it hits maturity. To me, the risk is, I don't know if it's asymmetric, it's too strong of a word, but I think that's how I feel.