Talk Your Book: Higher For Longer

0:00Today's Animal Spirits is brought to you by FM Investments. Go to USTreasureETF.com to learn more the US Treasury Benchmark Series of ETFs. It's every US government treasury you can think of from three-month T-bills all the way up to 30-year treasuries. So we're talking six-month T-bills, 12-month, two years, three years, 5, 7, 10, 20, 30. Got them all, Michael. Every maturity, which is kind of neat. UStreasuryETF.com to learn more about all those different funds. And we're going to talk in today's show about the duration and the yield of maturity and all these things. You're going to learn a lot about bonds.

0:31Check out UStreasuryETF.com for more.

0:35Welcome 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.

1:05Welcome to Animal Spirits with Michael and Ben. On today's episode, we're talking with Alex Morris, who's been on plenty of times. Alex is the president and chief investment officer of FM Investments. One of the things that we did on this episode, which I hope was helpful, is we explained in relatively plain English, because this stuff does get a little bit confusing, all of the different Wall Street jargon around bonds. everything from the 30-day SEC yield to the yield to maturity to the average coupon and all that sort of stuff. Bonds are, they're kind of boring, but they're also not very easy to understand for a lot of people.

1:47So yeah, I think we went into a lot of stuff that we tried to put it in plain English. Alex is a very sharp guy with this stuff. He speaks in a very plain English sort of manner and explains it. And so we talk about all the different places people are putting money, It's really interesting that, I don't know, they have treasury ETFs for every single maturity you could think of across the yield curve. But what is it? 80 % of the money, 75 % or so is in three-month T-bills? So hot right now. So I think it's going to be fascinating to see with their lineup of funds, how that money shifts over time as rates change.

2:21If the Fed does cut, what happens? How sticky is that T-bill money? What's the rate that causes money to come out and go into five years or 10 years or two years or whatever it is? I think it's going to be interesting to see. So here's our talk with Alex Morris from FM Investments.

2:39Alex, welcome back to the show. Thanks for having me back. We're becoming regulars together. Before we get into all things fixed income, I want you to have an opportunity to flux a little bit. I don't know when the first time you guys were on the show was, I don't know if it's two years ago, year and a half, whatever it is. You guys have had an extraordinary run over the last couple of years. So just tell the audience about that. Well, first of all, I think it's about a year and a half ago. And a lot of our success is attributable to both of you. So thank you for helping us get the word out. Okay, we'll take it.

3:17Yeah, look, we find a lot of folks who've told us this and a lot of friends come out of the woodwork who listen to the podcast. So, well, 18 months A few months ago, we put out the benchmark series. We couldn't spell ETF. We misspelled it a few times, frankly. And there was no assets then. Now across the series, about$4.8 billion. A big chunk of that's on the short end of the curve, which is where we expect to see people be right now, getting a lot of great yield. And we see folks starting to move elsewhere and use the 10 of them as they're supposed to. It even gave us the opportunity to launch some cool stuff in the IG space and then do some opportunistic income harvesting for folks in an actively managed one.

3:54So from nothing to rounds to 5 billion in about 22 months is not so bad, right? Hell of a run. All right. So we in the industry throw out a lot of terms that might be confusing to people that did not study economics or markets. And one of those terms is duration, not to be confused with convexity. Let's talk duration. When people hear that, when investors look at a tear sheet and they see whatever, 5.4, what do those numbers mean? What are some things people should be aware of? Where are some of the traps? Riff on this for a little. Sure. Well, let's be honest. It's confusing to folks who studied finance too, right?

4:39Bond math is the kind of thing that folks don't particularly like. I was just at a conference giving a talk about rates, and you have to basically ask people to lock the doors before you start saying convexity and words like that. But duration, when folks look at it, a lot of folks confuse it with maturity. And that's not quite right. It's related to maturity, but you're going to see online that it's called the sensitivity to a price relative to the change in interest rates. But what does that really mean? What it really means is if you look at a bond, we forget that it's called fixed income and we care about the income.

5:11So it's really just a measure of how much money are you going to get from that bond divided by how much money is that worth in the future to you. And what becomes interesting is the longer a bond has to go and the greater the change in interest rate, the greater the price return. And what a lot of folks are experiencing now is the phenomenon of, hey, man, where's my dividend? Where's my income? become because they've got these low coupon bonds that have a long duration, but they bought them at a relatively low price. And now when interest rates went up, that price went down. But to get their total return, they have to wait until the very end of that bond to get all their money back.

5:54And it's difficult for folks, frankly, to try to process those two. What we like to try to tell folks is, we have to say this because we're bond people, it's the first derivative of interest rates, but really means is it's sort of like the velocity at which things are going to change. So if you think of like being in your car, it's how fast you're going, whereas convexity is how quickly you're accelerating to get there. So when we look at duration, we really like to think about, I'm buying an asset that has more time value to it, and it has more cash flow that I should expect to receive, but there's a greater discount rate now.

6:28So if rates come down, you want that added duration because it's like getting added gearing into the bond for no added risk, right? Particularly in, say, treasuries. There's no real risk that the government isn't going to pay your money back. So now it's just a question of if you're willing to hold that bond to the end, how much return should I expect based on what interest rates are going to do between now and then? You mentioned that duration is kind of like maturity, but not really. It's close enough, but the thing is it can change over time. So the duration of US Treasuries was much higher, I assume, when rates were all below 1 % for that short period of time.

7:05Now that rates are better and higher, that duration has probably gone down. So you can talk about how duration changes based on the change in rates. Yeah, so duration will sort of move inversely to that, right? And I think the key for folks is to remember when rates go up, you want shorter duration because you're starting to lose future value there. When rates come down, you want to extend your duration because now you're getting a gearing factor. Some folks like to call it a bonds leverage, but that's kind of not fair. It's not money you're borrowing. It's just the impact to how much money you should expect to get versus what the interest rate was at that time.

7:43I mean, the irony for all bonds is if you just wait to the very end, you're going to get paid par value back unless something goes terribly wrong, which isn't really a risk with treasuries. So now it's if you're going to play that rate change and you're going to hold a 10-year bond for two or three years, you really care what that duration is, what the rate changes. Because if rates go down 200 basis points, you're going to make a lot of money. And if you're going to make a lot of money with the same risk of default, you want as much of that gearing as possible. So you want to go as far out on the curve and get as much duration as you can.

8:13The converse is if rates don't go down, prices don't work in your favor. Or if rates go up, they work against you with that same gearing. And that's where duration gets risky. Talk about the differences between duration of an individual bond versus the duration of a fund of bonds. Does that, that doesn't, that sounds terrible coming to my mouth. A fund fund. I was going to ask about this too, because one of the things that we always hear from investors is, I don't care if interest rates rise because I'm going to hold my individual bonds to maturity. So it doesn't impact me at all. And I always say, no, that's ridiculous.

8:47A fund, an ETF for a mutual fund that holds bonds is just a fund that holds individual bonds. But they just may buy and sell them to keep a maturity or whatever. But it's no different. It's just a different way of thinking about your payback, correct? Yeah. So if you were to buy a single bond, like you just went out and bought a 10-year bond from treasurydirect.gov, you know, if it's working that day and if you can work out how to make it all happen. Really is like a 1997 website still, isn't it? It really is. I mean, it does what it looks like. Some browsers, it kind of occasionally asks me if I have an Internet Explorer still to load this page.

9:21But if you did that and just put it in the back of your desk drawer, right, and just let it collect dust, you're going to get your$100 back. So it's sort of like saying, hey, I bought a share of Meta today, and I don't care. I'm not going to look at its value for 30 years. That's all I care about. I'm just running that risk. So sure. But bond funds, bond managers, you don't pay us to just buy a bunch of bonds and wait for them to go to zero. You pay for us to run a strategy. That strategy usually targets an index, and that index has some set duration metric. And either we're going to go long or short relative to that index to try to gain excess return over the index.

9:57So bond funds, by their nature, are constantly buying and selling things. So you care what your bond manager is doing because of that. But if you literally just bought one bond, you only care about, is the issue going to pay me the money back in the future, be done with it? But bond funds buy hundreds or sometimes thousands of bonds. And now you care what that average duration looks like. Because when rights move, if your whole fund is on average above duration and rates come down, you're going to make a lot more money than the benchmark. If you're on the wrong side of that, it hurts. The way that I was taught duration was it measures the price sensitivity to a 1 % up or down move in rates.

10:39However, that's like the textbook answer because it's assuming that every part of the curve moves up or down 1 % together. And in real life, that's not how interest rates work. No, and if you look at the curve today, you're going to hear all about inversion and whatnot, which if you started in finance two, three years ago, you've only ever known this. So you don't know what a normal interest rate environment looks like, as it were, with normal and air quotes there. But the curve moves in very different ways. It doesn't move in unison. And how one end of the curve moves relative to the other is often seen as a harbinger of potential recession inbound in some number of months or conversely, recovery from that.

11:27And if you owned a short duration asset like T-bill, which has 90 days on it, so a quarter of a year, it's a very different impact. And that rate moves relative to the Fed funds rate versus the 10-year, something like U10, which is trading on very different factors. The market is controlling what the value of that bond is worth, not the Fed, ultimately. And you can imagine what the market does and what the Fed does are two completely separate things. They have different purposes, different buyers for those securities necessarily. So they're not linked. That 1 % change makes a lot of sense. You hear options traders talk about the rule of 16, or if you're trying to figure out the doubling time, it's the rule of 72.

12:07They don't like to tell you it's actually the rule of 69.3. That's just a little more difficult to do the math on. But don't tell Michael that. He's going to use that going forward. We can go through the logarithm for it if you're really excited. But the point of it is, it's hard to look at it and say, here's the 1%, because these are curves, right? There's some actual exponential value to these things. So when folks try to look at these linear approximations, they say, oh, well, it's close enough. Yeah, when rates were also pretty much zero, it was all flat at zero. But now that rates are material, you really do need to pay attention.

12:41And it's a great, like if you're an investor today and you hear, oh, when should I increase duration? The first thing to remember is right now, you want to stay in like T-bill. You want to hang out, earn your 5.4 % until you're ready to do something. And when you're ready, you should make that, you should pull the trigger a little early. The way the math works out, the way the market reacts to duration, you're not penalized for showing up to that trade when rates are high by a few months. So if you thought the first rate cut was going to happen in December, you can start making that trade as early as the autumn.

13:12But the problem with it is the market corrects that very quickly. So you kind of penalize for showing up just on time, and you're really hit if you show up late. Well, that's why I think your suite of ETFs is going to be an interesting tell to the markets in terms of AUM. So you said that the majority of your AUM or bulk of it is in T-bill, right? In the 90-day, three-month T-bill? Yep. About$3.5 billion there. Right. Because you're getting paid over 5 % there and you have little to no interest rate risk. Basically, you're not going to see much volatility at all, even if rates move, right? It's very stable.

13:48And since the Fed hasn't cut rates, people are thinking, geez, I can continue to get this. people were worried that there was going to be five or six rate cuts before the start of the year, and that would mean lower T-bill income, right? So it is interesting because for the last 18 to 24 months, other investors have been positioning in longer term bonds, hoping that, well, we're going to get a recession or something is going to happen where rates are going to fall, and I'm going to pick up that duration. So do you think that investors will be able to get ahead of that kind of thing? Or do you think it happens on a lag where rates fall and then people rush in?

14:23Well, certainly we see historically rates fall and where any market event happens and folks pile in after the fact, right? It's timing the markets is an impossible act. And this is what I like to tell folks, right? It's time in markets, not timing the markets. But in this case, I think investors are wise to collect that 5-4 until they're ready. You're going to get some signal from the Fed, right? The Fed made pretty clear they were intending to cut rates, but they never said five or six cuts. The market said that. It got a little jumpy. And I love the Fed fund futures market. It's one of my favorite statistics because it's always wrong.

14:59It has almost never been right. It should have statistically by pure chance been right by now and still hasn't. So yeah, folks get very focused on that and do all this Fed speak. The one bit of Fed speak that I think makes sense is we've talked about higher for longer, and we've started changing that narrative, folks for it's longer for higher. This is a new normal. And when the rates come, there's no guarantee, cuts come, there's no guarantee this is going to be 50 basis points three times in a row religiously every month. These could be small hikes. They could pause at some point as they have to deal with potential rebounding inflation.

15:34So folks are smart to start making that transition. There's nothing wrong now by being further out on the curve, like a U2 or Utre, so you're two or three or even five years out because you're making such a high current coupon that as you roll to the next current issue in our products, you're getting that insurance value basically. Hey, I'm getting a really high current coupon that I'm pretty happy with and I'm rolling to the new issue. So if the cut comes and I wasn't ready, I'm going to have my duration being extended throughout that cutting cycle, which is exactly what you want to do, right?

16:09You want to buy the longest duration as the rate set comes down. So by sitting in our products while you're waiting, you're collecting a nice income. If you want to maximize that income, go to T-bill. If you just say, look, I know rate cuts are coming in the next six or eight months. I don't want to time the market. I just want some sensitivity. You can sit at two, three, five, seven, 10 years out and just wait. And when it comes, the product is going to give you that return because rates will come down, price will go up and you'll be rewarded. All the while, you're still collecting four plus percent on the coupon, so a 4 plus percent dividend, which is pretty material.

16:42I mean, if we won the clock back three years, 4 % was a dream. That was like a fantasy for folks because we hadn't seen that in a decade. Now, you can find that across the entire yield curve. You just have to decide how much price volatility you are willing to stomach between now and then. And then when it happens, how much return you should expect. But because the ETFs are liquid, you can change your mind along the way and you're able to move in and out pretty quickly. So which of your products right now has the most money in it? T-bill by far. And T-bill is that three month or six month? Three month.

17:14Okay. So the reason why people are so comfortable sitting at the very short end of the curve is because it offers one of the highest yields out there. What should these people be thinking about though that they may not? What are some of the risks? I guess it's called the reinvestment risk. What does that mean, and why is that important? Yeah, so reinvestment risk, and particularly in the bond world, is theory of if I get cash flow today, as opposed to, say, an equity where I don't, I just get long-term appreciation, am I able to put that money into a security that's going to pay me just as much money, right?

17:49Or am I getting cash flow that I can never get the same return on? For the short term, and that longer for hire regime, there's not a real risk of that reinvestment risk going much down. You're going to get 5 % or more. You can reinvest it and continue to get 5 % or more. So on a short-term basis, I don't think there's any real fear that investors should have. We hear a lot of folks who are using T-bill and the six month, which is X-bill, for cash alternatives. And then folks, both the cash that they'll keep in their portfolios forever, and then strategic short-term cash because they don't know where to be positioning.

18:24Our advice to folks have been, if you like that return and you're uncertain, stay there. It's a great place to be. You're going to see us, though, start talking more about winding into that duration. So moving further out the curve into two, five, 10-year products, because we know eventually that rate cut is likely to come. The Fed's made pretty clear that something needs to happen. Inflation is largely kind of static. And at some point, they'll need to do something. And we want to be ready for that. In the interim, we're happy to collect that coupon rate. But we accept that as if you look at the 10-year, 10-year yields have dropped 15 basis points in the last week or two when we're talking about this.

19:01And that has an impact to the price of U10. And we're OK with that. Some investors may not be. And if they just like to see that stability to your point, they don't want interest rate risk, then they should be in T-bill or X-bill where they have virtually none. And they're going to still collect a really healthy coupon in the interim, which is great. The psychology of bond bear markets, Ben and I were talking about this, is interesting because bonds are still very much underwater. I'm just looking at an index, for example. If you're an index fund holder of bonds, you're still very much underwater.

19:34I'm talking nominal, inclusive of the interest payments. If you tack on inflation, it's obviously way worse. Do you think the simple explanation for why people just behave differently in bonds and stocks, and there's a few reasons, but you're still getting the income. Like, in other words, I think that for a lot of investors are less anchored to maybe the market value than they would be to equities as long as those income payments are still coming in. And if the income payments are floating higher, all the better still. I think that's right. I mean, if you think about it, it's almost like the 90-10 rule and then the 10-90 rule here, right?

20:09Bond investors are all about income and some are less sensitive to the price, particularly those who have a portfolio where they know they've got liabilities or they're going to hold that bond to the end. It's just, give me the income and make sure the issuer is going to pay me back. Equity investors, the exact opposite. Very few people really talk about dividends nowadays. We hear it about dividend growers, but it's 2%, 3%. Most folks are in equities for the capital appreciation. The thing that's quoted every day about Google, about Apple, isn't its dividend amount. It's its price. That's what we talk about.

20:43So you have to think where you're going to be. That doesn't mean you can't lose money as a bond investor. You can get some really high current income. You can reinvest it. But if you're constantly reinvesting in bonds that are losing value, you're still losing principal value. And some folks have been fairly well burned by that. I think the way to tie all of that and inflation together, though, is what happened to tips over the last two or three years? Tips were like, hey, I'm supposed to buy this thing, and it protects me against inflation. It's right in the name, Treasury Inflation Protected Security.

21:14There it is. How did I lose money when inflation went up in TIPS? And the answer was our friend, duration. Most TIPS funds had duration that was two, three, or more years out. So although the TIPS actually did protect you against inflation, the thing that the Fed does to fight inflation, which is hike interest rates, multiplied by your duration effect, took away all of your inflation protection, and you lost principal value. So you kind of see all that coming together, like that thing that seemed like the really smart thing to do, let the government insure you against inflation, hurt you because you bought something that had some duration in it.

21:50And the thing the government did to protect the economy against inflation injured you personally more than the protection they provided you against that exact inflation. It kind of comes full circle to what we started talking about as duration is I think a lot of people who own tips probably didn't realize that the duration piece was going to override the inflation piece. And these are going to act more like bonds than the inflation protection. Exactly. And I talked to a lot of investors who are like, we talk about tips and why now is a great time to be thinking about tips. Oh, my God, I never want to buy a tip ever again.

22:19Like, it just injured me so much. Like, well, but it's because you kind of bought the wrong ones. You really bought a long duration bond. It happened to have this other feature, just like a bond being callable, just like a bullet. Like, all these other features, there's just one of them that wasn't the one, though, that was driving the market price. And your tips fund wasn't holding it to maturity. It was marking it to market every day. You saw red ink got scared and sold. But if that fund held it to maturity, you'd actually be fine. You just didn't have the horizon to do that. Neither did the fund manager.