Talk Your Book: Do We Need the Federal Reserve?

17:02But then on the much further end of the space, we've seen a lot of action on the 30-year. Folks who just want duration and are playing the fact there's a bid on bonds and they think rates will come down in the back end of the year, for which they're going to profit handsomely if that happens.

17:17Michael Batnick:So on the long end in particular, I'm curious, do you see people popping in and out? Or do you think that like, because nobody's trying to lock in rates for 30 years. I mean, I know that there are like corporations and maybe pension funds that are. But for an ETF, I would assume that most of this is saying interest rates are bumping up against 5 % again. This always happens and they always come down. It feels like a good risk reward to just pop in here and grab some money. I think a lot of that has been the traditional use case up until, say, six weeks ago when volumes really started to pick up and we started getting some field cases brought up to us and folks picking up the phone or sending an email who look to be longer term holders.

17:59right they're not going to be here for 10 years right but they're not going to be three week five week six week traders trying to play meeting to meeting or interest rate move to interest rate move this is more of a particularly since the rolling feature of always staying in the 30 year or the 20 year or the 10 year that they're looking for a more secular downturn and rates coming down for which this is a you know multi a year to multi-year trade as they diversify generally away from equities but still looking for some meaningful portfolio return.

18:28Ben Carlson:Alex this podcast host, I'm generally the good cop and Michael's the bad cop. Is that fair, Michael? Sure. Okay. So I'm going to give you a good cop softball question. So per your website, fminvest.com, you're closing in on$10 billion in assets as of close to the end of June. And the firm is still relatively new, five years old, essentially. Yeah, about six. Yeah. So what worked that got you to this level in that amount of time? Like what actually worked for you as an ETF provider? You know, we show up to a lot of places, but, you know, we have this very deep commitment to just trying to do simple things well.

18:59Bonds in particular are not particularly sexy to most people.

19:03Ben Carlson:Yeah, no crazy thematic funds from you guys, right? Exactly. Just do the things that we're doing for others and we were doing in our own portfolios, we're doing for ourselves. Put back the security lending revenue into the fund. Do these basic things that if we had billions of dollars in our PA, what would we do? Just do that. And then the hardest part is just being able to continue to focus on making that really boring thing better without ever changing it. There are a lot of more academically pleasing ways we could do a lot of these products. We don't because that's going to change the character of what they are.

19:34And we don't want folks to be taking that risk. We want to just give them... The government does a lot of heavies lifting for us. Let's just lean into that and make sure you get the best possible experience. Last year, if you own T-Bill, the return of T-Bill was greater than its expense ratio by three basis points. So you got the 90-day, according to what Bloomberg thinks it is, plus three basis points back after all of our fees were paid, which is kind of the way it should be, right? Like if we did and took other risks, which we don't do, we might be able to tell you, well, great news, we got you five, for which we risk losing you 15, which feels like a really terrible trade.

20:08And I think that just commitment to simplicity and being able to say, this is what it does. It's not these, if you want something else, you should go and find that thing. This is what it does. It's not changing its stripes. We've got a dozen people every day who all they do is come in and try to live up to that commitment.

20:24Michael Batnick:Well, I'll do you one equal. Oh, Lord. Perhaps even better. We got an email from a listener, maybe about a year ago, maybe two. I can't remember how long ago it was, where they were misunderstanding something of the mechanics of one of the structural issues of one of your funds. And you were happy to connect with them. I don't know if you remember what the topic was, because I certainly don't. And you knocked it out of the park. The person that emailed us was so happy that your team got on the phone and there was no negative outcome, no negative surprise. He misunderstood something and you guys cleared it up and it was wonderful.

21:00I recall doing that. It was about inflation and it was actually one of the best questions we've ever had about how the tips market functions from the auction structure to structural cheapness. And it was an immensely detailed and thoughtful question.

21:16Michael Batnick:I remember the question that I was like, dude, I have no idea what you're talking about. Maybe Alex will talk to you. Drill to have it. We love wonking out on this sort of stuff because it's what we do. And, you know, it's, let's face it, a lot of this stuff is really complicated. It doesn't mean it's hard to understand. It's just complicated. And I think too many folks, particularly in bond market speak, love to hide behind the jargon and some of this other stuff because it's great job preservation, but that doesn't help the average investor build a better portfolio. And that's our mission. Let's just build better portfolios and answer the questions as best we can.

21:47And sometimes the answer is, this is actually really complicated or complex, in which case our response is usually, that's true. Maybe it's not for you. And we'll be the first to tell you.

21:57Ben Carlson:My general way of explaining the bond market to clients that we work with is, listen, we're not trying to guess which way inflation is going to go. We're not trying to guess which way rates are going to go. We've yet to find many people who can do that consistently. We're trying to figure out where the best risk reward lies. And so I'm curious when it comes to the risk-reward side of bonds, what is something like the corporate or high-yield spreads telling you? Because they've been pretty tight for a very long time now, it seems like. They've been really tight. And every time I think they can't get much tighter, they try to do it for us.

22:26And then, of course, recently, on the opposite end of that spectrum, it's super high-yield. The CLO market, folks are just piling into that, into private debt and some of these other things that lack some of the transparency and character. that even, you know, triple Bs tend to offer today, triple B plus space. I think the short answer is the economy, like the actual real economy of big companies borrowing is pretty good. Like all the reforms we've done over all this time, all of the other theory of central banking and lending, everything else, it's kind of worked out. We have some companies that are pretty stable, right?

22:58If we were to go back 25 years ago, maybe 35 years ago, the average company in the NASDAQ 100 would need to refinance before the end of the month to make sure that it could hit payroll. That's not true today, right? We have these hyper, these like not even, you know, large cap or hyper cap, like super hyper cap, you know, mega cap, IPOs coming to market. We're going to see two or three more of those, right? A trillion dollars was a lot in the equity market, you know, not five years ago. Now we're going to have to see three new trillion dollar companies just burned out of paper in the next, well, one now and probably two, three more for the end of the year.

23:33All of this comes down to like, it's fueled on the whole system working together and it seems to be working. The question is, can we just make it work so well that we can break it, right? Like, is this the, we can't, this is why we can't have nice things moment.

23:47Ben Carlson:So the reason that, so spreads are very tight, is that why we're seeing so much money pile into things like CLOs and these types of things? This isn't an area of the bond market people could have invested in very easily in the, until the recent past, correct? Good, it's very hard to do. Even now with ETFs, you gotta be a little careful as to which ones you get involved in. But it's a complicated part of the market. There is a hunt for yield. You know, we try to remind folks, you're still getting pretty nice yields, right? From the treasury market and even with tight spreads from corporate and then in the high yield space.

24:16Ben Carlson:Yeah, think about where they were just five years ago. You had, you were getting nothing. Yeah, you had to do these other things five years ago because you got nothing. But response is, well, maybe just because you're getting something and it's pretty decent, maybe it's not time to be greedy. If you're going to be greedy, that's what your equity book should be for. There are other ways to go seek that sort of return for your portfolio, taking it, you know, particularly the more risky the asset type that you're buying in the bond world, the more correlated they tend to be when something goes wrong, right?

24:44And if you're buying your bond portfolio specifically for diversification, then buying things that are highly correlated to each other, even though they're different from what you're buying, more flavors of that isn't actually doing you more favors. You know, this is a, you're getting a pretty healthy return from the government itself. We could discuss its risk rating and whether that's warranted or not in the separate discussion from high-quality investment-grade companies and even some pretty high-quality, high-yield companies. There's a lot of money to be made there on a regular basis. You don't need to get greedy, so you probably shouldn't bother with it.

25:16Michael Batnick:I have a dumb question. I'm so ignorant to how this works. So, NVIDIA issued bonds for the first time in a while, I think since 2021. Google is doing the same. How does this work? I guess my primary question is, is it an auction similar to the way the government does it? How much of this paper ends up inside of ETFs? I have no idea how this works. So bonds go through an underwriting process, right? And don't forget bond market, three times the size of the equity market, all of it, which with the exception of some of the perps, very small percentage of them, all of it will get retired probably in the next, on average, seven to 10 years.

25:56So it turns over a lot. So investment banks underwrite it and they come to folks like us and say, hey, here's what we're offering. It's this bond, which usually have multiple tranches with different interest rates and different conditions and terms and different expected ratings to be attached to it. And we put in for it, just like an IPO. And then we are, as an issuer, allocated some or none of each issue. So that underwriting tends to be some amount of subscribe between not subscribe very well and oversubscribe. Depending upon what type of fund you are, what you're looking for, you want one tranche versus the other.

26:29And then it starts to turn the secondary. But it's a very well coordinated, underwritten process by the investment banks. And there's not so much an auction where we all show up. We just say, okay, we're interested or we're not. And they'll give feedback. Most of the more prolific folks, like in particular, the folks who offer car loans, like Ford Motor Company, those folks, they're used to doing this all the time. So there's a revolving set of investors who show up to buy those. When you get some of these headline issues, like Google issues the most stock it's ever issued in its life or biggest secondary issue ever, and then a bunch of other bonds, bond buyers were also paying attention.

27:03Equity is good. That's money that could be used to pay back bondholders. We like to see that. But now we're going to bid on whether or not we think Google is able to pay its bills back over the next five or 10 years. And the spoiler alert for everyone is most bond investors thought, yeah, Google was going to be able to do that.

27:19Ben Carlson:So people in the equity market are worried about like, oh my gosh, how is there going to be enough money to soak up all these IPOs, right? We have these huge companies coming to market. If all these hyperscalers decide that they're going to start, you know, instead of issuing equity, they're going to issue debt. Is there enough, people have to ask, is there enough money to keep this train going in the bond market? There probably has to be, right? There's certainly enough money in the bond market, but there's also a lot of cynicism. Will they be able, because it's nice to go and buy debt, right?

27:49sell debt to individuals for short-term projects that need to be built, right? And you can do the NPV and say, we're going to borrow at 6%. Our expected return is 10%. Therefore, the spread is four. This is a good trade for us. The problem is bond issuers want to make sure that that money in the back end of that model is actually going to show up, right? So you building a whole bunch of new facilities and hiring a bunch of people and developing a whole bunch of products have to actually return it. Otherwise, we're not going to get interest payments or we're not going to get paid back. So there's a gentle balance now that needs to be done as a corporate treasurer between how do we capitalize the business?

28:27The bondholders expect to see their interest payments every three or six months like clockwork. And at the end of the bond, they expect to get all of their money back, right? Subject to some of the other clever features that bonds can have. Sometimes you can pay it off early. Sometimes it has auto extension. There's all sorts of other things that can be be done. But it's a pretty rigorous payment. It's like your mortgage. The bank doesn't come to you and say, well, you had a really great year, so we want a little extra. But same token, they say, well, you had a bad year. We're willing to cut our payments a little bit.

28:55So it's a much more strict and rigorous way for lending to be done. The good news is you know your exact costs from the outset. When you sell equity, you could shoot the likes out and you just gave away some of your upside. So it's how do you do those two? I think the bond market is going to be more concerned about these high cost, high life assets that take a lot of energy to go in and require a few other macro things to be right. Like I don't think they would question the ability, can someone build a data center? It's you're building a data center because you see this demand. If everyone else builds those data centers and demand doesn't actually meet up to everyone's expectations, we're all now holding debt that may not be worth what we paid for it.

29:35So you have to sell more equity to pay us back. Are you willing to do that? And that's, that's where this balance becomes difficult to strike. But also why I think you see hyperscalers and others and why a lot of venture capital, there's more venture capital firms providing equity than venture debt firms providing debt. Because it's just as a project creation mechanism or funding mechanism, you have to feel pretty good about the returns to get the debt to do it. I mean, the famous story here is obviously Chobani, right? Who did this through bank loans and debt as opposed to equity. And it worked.

30:08But the Small Business Association is littered with folks who tried this and had it not work. So that's skepticism.

30:15Michael Batnick:I don't know that story, but I do like yogurt. Let me ask you this, Alex. Last question. I'm guessing that you saw... No, I'm guessing. You obviously saw an opportunity to come to market with a high-yield bond offering, bond portfolio that you thought was better than there's two gigantic ETFs out there. What is it about? So I'm talking about the ZTOP, which I do like. It's a good ticker. The FM high yield 100 ETF, the ticker is ZTOP. What are you trying to do here that is different than the more popular ones? So the popular ones are so big now, they have to buy everything, which means when there's a lot of flow, they end up buying the exact opposite of what you want them to buy and selling things you want them to sell the least.

31:04ZTOP said, well, as opposed to doing underwriting, right? Because high yield issuers, some might default. So you guys spend a lot of time working out who's who. Let's let the market do that for us. Rather like, Ben, your theory of the two years setting rates, let's let the market decide. So we're just going to buy the largest, most liquid issuers. And it turns out the market's really good in that liquidity measure at determining who's going to pay back their debt on a timely basis and who's not. So we've turned the entire market of buyers into the selectors. So we just buy the largest, most liquid issuers who have the most liquid bonds.

31:34When things are going well, they tend to keep up with the market. Sometimes they're a tick behind because they're a little safer, as it were. But when the market runs away from you, they also hold their value the best because it's the greatest, most likely, greatest chance of being paid back. And the market's the adjudicator of that, not the rating agencies, not someone else, not some analysts sitting in an investment bank. We let the market do that work for us.

31:56Michael Batnick:I love that. That's so simple and makes a lot of sense. Before we wrap, and you guys are free to edit this out, can I show you guys something? I know that listeners are going to be like, oh my God, they're just trying to show his screen. But I'll let you guys - We could describe what's on the screen. Go ahead. So we're talking about Kevin Warsh, who came in. You know, the laboratories here are always doing something. You're going to see this later this week, shortly before this drops. as FM Labs. But a conversation with me and a guy who runs our communication, a long-term friend of mine, Jim Prosser, we say, well, Kevin's going to tell us less.

32:32And he said, well, why don't we fix that? So we built a large language model. This runs on Claude in the background. We made an exhaustive search of all of Kevin's writings from the FOMC, from his congressional testimony, everything. You can see 1 ,784 documents. And you can just ask it questions where you're talking to Kevin. The model starts at an anti-hallucination base. So it starts with no response and then builds a response only from the transcripts and the data that we've given. We gave it lots of economic data, but you can ask it questions like, what is your preferred inflation metric?

33:11Which it'll go run away. It'll do. I'll tell you like, okay, it's consulting the record. It's a little slow because it's sitting on a development box, but it does a bunch of testing. How many writings did he have that you guys put together? 1 ,784. Wow. Every day it updates. It goes in scrapes for everything he says. And so, yeah, quick analysis. I report Kevin Ward's views. I'm not Kevin Warsh. That's compliance me to say that. I really wanted to do that. But you can go. It says, here's what he talks about. And it was, we always will give you some measure of where rates were when we quote something.

33:43Trimmed averages. He's a trimmed averages guy, me too.

33:46Michael Batnick:I thought I was the only one. No, he's your guy. Now, a lot of folks assume that he said, well, I'm really into the Dallas feds, trimmed mean PCE measure, which they put out. And the answer is, well, he kind of is. But so down here, we tell you that. By the way, we know that context is here, but we're not going to allow what we know popular opinion is to actually get in the way of what he said. All right. When are you launching this? By the way, you are a confirmed super nerd. I love this. When is this coming out? This will be out before this podcast drops. That should come out. July 1st around here is FM Labs.

34:19You'll see more of us in there. By the way, if I could do this for Kevin, you can imagine we could do it for others, and we did. And there's going to be some pretty interesting stuff in the pipeline as we start to really get all of that together.

34:30Ben Carlson:The ghost of Alan Greenspan could be commenting on current policy. It's almost as if maybe we've done that in the background. So some cool stuff coming out around that, some other investment tools around inflation. Send us this, we'll link to this in the show notes for sure. Will do. It's good stuff coming, but I thought you guys would enjoy that. I like it. All right, Alex, if people want to learn more about FM Investments and all your ETFs, where do we send them? FMinvest.com. It's all there. All right. Thanks, Alex. Thanks, boys. All right. Thanks to Alex. As always, FMinvest.com to learn more about their whole suite of funds, tools.

35:06Ben Carlson:Email us, animalspearsatthecompoundnews.com. Personal emails, personal responses. See you next time.