Talk Your Book: Cash Was Easy… Now What?

0:00Today's Animal Spirits Talk Your Book is brought to you by Federated Hermes. Go to federatedhermes.com, that's H-E-R-M-E-S, federatedhermes.com to learn more about all their income products and strategies. 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 Ritholt's Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:35Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:41Michael Batnick:Before investing, carefully consider the fund's investment objectives, risks, charges, and expenses. Read this and more information in the prospectus or summary prospectus at federatedhermes.com. Federated Securities Corp. is distributor of the Federated Hermes Funds. Investments are subject to risk and may lose value. Views are for informational purposes only and do not constitute tax or investment advice. Welcome to Animal Spirits with Michael and Ben. On today's show, we spoke with Brandon Clark, ETF Business Director at Federated Hermes, about income and how investors are behaving and responding to the shape of the yield curve today.

1:17Michael Batnick:My read on the situation is that investors are thinking too much about income and not enough about what might happen if the economic and market environment shifts. Meaning they're pushing out on the risk curve, essentially? No, the opposite. Okay. They're getting too comfortable with cash because - Oh, they're more on the short-term side of things. Yeah, they're like, oh, I don't want to go out on the curve. Look how much volatility there is, and I'm still getting paid. But that's missing a really key part of the equation. So people have gotten comfortable in a rising rate environment, essentially.

1:57That they're investing like that is going to last much longer than it might, essentially.

2:02Michael Batnick:So not thinking about, well, wait a minute. What happens if Fed fund rates goes down by 50 basis points and I miss the ability to lock in rates for a longer period of time? what happens if the economic environment softens and inflation comes in lower and then the 5 % is now down to 4 % and the bonds are up 3%. I just think they're just hyper-focused on the income component. That's fair. If you would have said six or seven years ago, hey, the 10 years is going to be at 4.7 and the 30 years is going to be at 5.3, would you lock that in now? Yeah, give me all of it. Everyone would have said yes. And now we're there.

2:40People are going, whoa, whoa, whoa. But what if the 30-year goes to six? And what if the 10-year goes to five and a half? People want to catch the top or the bottom in this case, I suppose. Yes, that makes sense. But it is hard to believe that we've gotten to this place where I call it more normalized or just rising or stable yields. And you're right. And no one wants to touch them.

2:59Michael Batnick:So I definitely am not of the opinion, hey, ding-a-ling, take your money out of cash and put it into 30-year bonds. It's not what I'm saying. Right. But I don't think all or nothing is the right approach here. And all of it being in cash is probably not the right approach either. I don't think most people are doing that. But I think there's a lot of money that is very comfortable in cash. Yeah. And to your point, if the Fed does low rates because growth slows and we go into recession or whatever the reason, it doesn't even have to be a recession, really. It could just be inflation slows and the Fed cuts rates because they're worried about AI bubble bursting or whatever it is.

3:37By that point, it's probably too late and you miss the move in bonds.

3:40Michael Batnick:Correct, Ben. Right? And then you're sitting in lower cash and you go, oh, no, what? And the people who are in the option income stuff, that's a different type of risk, obviously. There's equity-related risk there. Right. Anyway, we talked about all these different angles of income. Here's our talk with Brandon Clark, Confederated Hermes.

3:57Michael Batnick:Brandon, welcome to the show. Thanks for having me. All right, so today we're going to be covering all things income-related, not just on the fixed side, but how clients and their advisors are structured in portfolios to deliver income. Before we get into that, I believe that you're the first person we've had on from the firm, Federated Hermes, not to be confused with the luxury brand or maze. Tell us a little bit about the background of the firm. We're a global asset manager focused on active strategies. I'll start there. We've got about$900 billion in assets under management, which puts us in a mutual fund context.

4:37We're inside the top 10. And so we're a large business that's been around for almost 70 years. Our focus, I'd say, primarily has been around money market or where most of our assets are concentrated around money markets. So just given our capabilities around money markets. That being said, I mean, we're largely intermediary or have been intermediary sold. So, you know, I'd say our client base largely knows us from the advisor world, given the fact that that's been our main source of distribution. And really, we focus on trying to help advisors solve problems, right? And so when we think about this, it's like, What can we do to best serve you in a way of creating solutions?

5:24And so a lot of our investment strategies are based around how do we solve certain problems for clients or their clients. That being said, we recently entered the ETF business about five years ago. And that obviously opens up a whole new world for us when it comes to retail, right? So where most firms, I'll say traditional asset managers, have gotten into this business, if they have been intermediary sold. The ETF world is just kind of opens up the entire investable universe in terms of clients. So what are the biggest solutions that you're providing today? Where are people coming to you with?

5:54What are they trying to solve? Yeah, I think it's multifaceted, just given kind of our background. What I would say is, you know, I think right now there's a lot of uncertainty. We can talk all about the uncertainty that's out there, whether it's around the geopolitical climate, whether it's around rates, inflation, you can go through all the different potential issues that are out there that clients and advisors are having to navigate. What they really focus on or where we've been looking or trying to solve solutions, definitely on a fixed income side, kind of two-year and in space, having some attractiveness in terms of your risk return opportunities.

6:33And so we're having a lot of conversational advisors around how to best manage, we'll say that income sleeve for portfolios.

6:41Michael Batnick:Brandon, you mentioned the short term. There was an article in the Wall Street Journal talking about how individual investors don't want to get off cash. There's$3 trillion in money market funds, and they don't find the opportunity set attractive in bonds. I think a lot of that is PTSD from 2022. You mentioned uncertainty. I would say the number one area in the market right now, or at least top five, I don't know if number one is fair, area of the market that I see uncertainty is in long-dated treasuries. So we're recording this on Monday, August 17th, and the 30-year is breaking out to new highs.

7:21Michael Batnick:We haven't been at 5.295 % since June, 2007. So it has been a long, long time. I do find it interesting that the income on long dated bonds, as I just mentioned, is at the highest level. It's been in a long, long time and nobody seems to want any part of it. Now I understand that you could have said this for the last year, last five years, and there's been negative returns, all volatility and no upside. At some point, do they become attractive? Because I know we're going to talk about income, but I feel like the potential price appreciation on bonds is something that I'm not hearing anybody talk about.

8:01Michael Batnick:Recessions do exist. It's possible that you get a boost from bonds if the economy softens. What's your take on where we are short, long, and the opportunities in between? Again, going back to it, there's a lot of uncertainty. I'll echo your PTSD from this last four or five years here where we saw what was a traditional 60-40 portfolio working for most. And then 2022 happens and we saw rates obviously go up and it really hurt the overall. There was a lot of challenges on the fixed income size in terms of negative returns. To your point around the Wall Street Journal, money and money markets, obviously we are a benefactor of that.

8:44So it's not necessarily the worst thing in the world for us. But what I would say is at some point, you know, the challenge I always think about when we talk to advisors and when we talk about clients is I think the challenge at some point is you've got to move. You're not going to be able to necessarily catch the bottom on a lot of this stuff. So it's where we start to see that risk reward trade-off out, call it a little bit further out in the curve, call it two years and in. Starting to try to find ways to capture some of that yield and lock it in for longer is definitely, I think, some benefit.

9:19I think the challenge is there's just so much volatility on a long end of the curve right now, right? And so advisors have the challenge of trying to have their clients stay the course. And so there's a lot of behavioral finance in that when it comes to managing clients' expectations on the go-forward side of this. I think the question becomes, out on that far end of the curve, are we there yet? Is it something that we want to be moving clients out into or do advisors, do some clients want to move their clients out there only to have rates go up again like we saw here over the last couple weeks?

9:52And then the next thing you know, they're wanting to go back into money market, go back into cash. So that makes sense to me because it's a long-term asset. It's going to be more volatile. If people want income, they're looking for more stability. Is that what you're trying to provide with your products? Are you looking more from stability? Are people looking for, no, I want the income piece of the pie to grow and go up with inflation or beat inflation? I want higher yields. What exactly are people looking for in terms of income these days? So I think in terms of income, there's a couple different approaches.

10:22And we're really seeing it in terms of, I'll say broadly in the ETF industry, broadly in terms of flows. I think folks are looking for income. How they're getting there, as we just discussed, the long end of the curve may not be, that might be a bit challenging for people to move all the way out there and lock those in. But these shorter duration products, that's definitely of interest for clients. So we see people looking at that shorter end, again, inside of two years. We also see a lot of people, and we've seen this in the industry, we see a lot of people looking at this covered call derivative income category.

11:01And folks looking at that category as a new bucket or a new way to generate income and taking that from potentially their fixed income and or equity portfolio, how do we best build a portfolio on a risk-adjusted basis that generates income, keeps my client invested, and solve all the challenges that normal portfolio construction poses for advisors?

11:25Michael Batnick:Brandon, before we get into that category, it's worth mentioning, and I know we're talking about an income, but investors, a certain cohort of investors, obviously on the older side of clients, they love income. And I totally understand why. I mean, you don't have to scratch your head and figure out what's going on here. I don't know what the level is where people stop thinking in real terms. But I found that people think about income nominally. They don't think like, oh, man, my cash has given me 3.25%, but inflation is still running at three or whatever it is. I'm only actually getting 25 basis points above inflation.

12:07Michael Batnick:They never think like that. And I'm not saying that's wrong or anything. It's a fact. You might not like it. You might say it's not rational. It doesn't matter. People love nominal income. I agree. And I think we see that in a lot of these covered call strategies, that derivative income space. You can divide that bucket into different strategy types. We've seen the single stocks, which have these mind-boggling distribution payouts. Yeah, 80 % income. Which, by the way, when you think about it on a total return basis, I mean, from my perspective, I always think about in total return because you can generate a lot of distribution yield, but you're still exposed to the equity.

12:50Right. So you've got that cohort and those those types of products where people are chasing a distribution, which may not necessarily may or may not be right for them. I think you also have this other cohort of folks who are thinking about income from the standpoint of it is just a nominal number. And I think from a financial planning standpoint, we always have those targets, right? I need to generate$200 ,000 a year to meet my retirement goals. And so the nominal number is what folks, that's what they focus on. I'd say to some extent, that's what folks are kind of trained to think about.

13:30Michael Batnick:I think that part makes sense. I don't disagree. You got to budget, right? You do have to budget 100%. And people budget nominally. I mean, obviously. Agreed. And so, you know, to me, the big thing is how do we create solutions for them to mix and match, right? I always think about ETFs have become much more of a toolkit, right? I'm running a whole portfolio. How do I want to tilt my portfolio, whether it's fixed income, whether it's equity, whether it's some alternative bucket? How do I tilt my portfolio to achieve those outcomes, right? And generally speaking, especially when you're on the retirement side, for those who are in the retirement side, they're definitely thinking about, how do I meet that number at the end of the year?

14:14So I'm curious if you could talk about how ETFs have kind of changed the game. Because you mentioned that you started out in money market funds and then mutual funds and now ETFs. And there's just been this explosion in recent years in using tools like options for ETFs. This is still relatively new for a lot of people. People have been selling calls or selling puts to generate income, but now that you can do it in this ETF wrapper, just talk about what the ETF has done to the income space. So I think it's very interesting. So I've been in the ETF business for almost 20 years. So I've been working on ETFs for a long time.

14:48I've seen a lot of the evolution from the indexing world to, I'll call that smart beta or alternative indexing to where we are in active. This income bucket I think is very interesting on several levels. One, I think investors as a whole have become much more thoughtful about how that income comes to them. And as an example, 20 years ago, as I was getting the ETF world, you know, return of capital seemed to be a very negative term when it came to paying out return of capital from a fund. Now, it's almost something that people are they're seeking when it comes to this income. So I think the ETF world, being able to manage capital gains, being able to manage taxes, having all these different levers at its disposal, you have the ability to potentially take distributions and turn them into return of capital.

15:45And I think clients are, I think we have some investors who gravitate towards those types of strategies. And again, we're seeing it in the, whether it's in the product development side, whether it's in the asset flows. you know we kind of saw a couple different cohorts of the uh derivative income come out we had some who were just playing paying out income then we had another cohort who was um that came out i'll say the next iteration that came out looking to i'll say basically transform the dividend income or that distribution income into return of capital and now you're starting to see i'll say the alternatives to what are those s &p 500 and q strategies which is changing the equity component composure, right?

16:33So if I have S &P 500 or Qs as my base equity, that's what I'm exposed to, especially on the downside. I think it's probably more impactful on the downside. We haven't really seen an environment where we had really large drawdowns for extended periods of time. But these new cohorts coming out that are, I'll say, alternative equities where different views of equity around what they give the exposure to is where ETFs are starting to, again, iterate through the different styles that are out there.

17:02Michael Batnick:Brandon, I'm going to ask you a question that I don't think you could possibly answer, but I'd be curious to hear your opinion. These alternative equity strategies, let's talk about the option overlays that are generating income. What percentage of investors in these products do you think are actually using the income versus just reinvesting and just having it as part of their portfolio? Because I would suspect, actually, you know what? I don't want to call it your thinking. What do you think? So I obviously don't know. I mean, it's very hard to put a finger on it. I'll just start from my personal view on this.

17:32When you start to look at the compositive feedback that we hear from clients and or I'll say that, you know, the direct DIY type investors, I think there is definitely a cohort using them for income. I do think there are investors out there who are probably looking at these strategies as a way to kind of get them further down that path. It's really hard to tell where a lot of these assets are, but I do think there are probably some investors out there who are using these more as a means to an end to get somewhere in the future versus where they are right now in terms of retirement.

18:10Michael Batnick:All right, Ben Carlson, I'll set the over-under for you. 30 % of people that are actually taking the income from these products. For spending purposes? Yeah, that's probably pretty close to good odds. Oh, thank you. We won't even answer. No, that's not bad. I was thinking this too on the taxable side of things. How much do you think people care about the taxes on this income? Does that come into play at all where people think about that? or is it just, no, no, no, I care about the amount of the yield. But isn't that funny? I think taxes are a totally separate bucket. Like mentally. It's kind of mental accounting.

18:47Brandon, what do you think? I think I would disagree with that. I think taxes are important.

18:53Michael Batnick:Oh, I think they're very important. But I think you might be giving investors too much credit. No offense to us investors, but go ahead. But he's also working with advisors, though. So I think the advisors probably care about how the treatment of these taxes are. True. True. I'm thinking of the end investor and maybe not the advisor. The retail. Yeah, good point. But why don't you talk a little bit about the tax side of things and how that works for people on these? Yeah, I think the tax side of it. So I do think people – look, I think we can all collectively say everybody cares about taxes, right?

19:24I think most people are always thinking about taxes. I think the flows into this category reinforce a bit of the – there is a care about taxes on this. So there's a couple of different ways that I'll say the industry has developed these products. So we developed a strategy and I'll cover that in a second, which is kind of why I think where most of the assets are going now. But I'll say, you know, one of the early iterations of this was where you can use equity link notes. So equity link notes are basically, I'll say, coupon payments, bond payments out of a portfolio. When that comes out, it's income.

20:03So it's treated as income. The next iteration of this, which is the path we had taken or have taken when we developed, so PAYR, P-A-Y-R is the ticker. When we developed that, we use options. The benefit of options is you have the ability to take that option income and treat it as return to capital to the extent that what you're paying out, if you have an option that was you distributed, but it actually lost, I'll say if the option was in the money and we had to close that out. You have the ability to basically, it becomes a return of capital if you distribute it. And so clients look at that and say, I can generate income for my clients, especially now when you think about all the things that advisors having to think about.

20:45If I can generate some income that is, we'll call it another leg of the stool, but when you think about it, you have your tax deferred, you've got your Roth tax, we'll call it tax exempt, then you have your taxable accounts. If I have a taxable account that can generate some income that's essentially additional income or additional distribution, as an advisor, that creates a very powerful tool, right? That's a very powerful tool when it comes to planning in retirement, this decumulation phase, right? So I have my, I need to manage my Roth distributions. I have my Roth distributions kind of help my overall income.

21:21I got my IRA slash 401k, which is taxable, right? Then you get into R &Ds and all the things that come together that advisors have to think about to manage taxes and keep their clients, whether it's under an income limit for IRMA, whether it's you think about all the things that they have to manage through. It's a great tool for them. At the end of the day, it's a great tool for them. So talk to us about what you guys are doing using options, because as I said, it's a huge category now. And it seems like there's a lot of growth there. There's a lot of interest from investors. So how do you guys think about using options in your strategies?