Talk Your Book: Income and Momentum

14:34We have had a software industry that seems currently uninvestable. Even six months ago, it was amongst the highest flying. So in times of market dislocation, I think you can expect that the turnover would be somewhat higher.

14:51Michael Batnick:What happens in a complete washout? Like what would this portfolio have looked like in February 2009 when momentum is only going negative, when there's no stocks that are working? Are you looking at, because you have to own something, would you be looking at like relative momentum? like you could be owning like Coca-Cola? What would that look like? That's exactly what it would tend to look like. It would look at, I'm going to try and define a term here, the least negative momentum. For us, we view those periods of time as fundamental driven analysts and a fundamental driven shop as opportunities, although they don't necessarily feel like it at the time.

15:32If there is nothing working in the market as our momentum portfolio is long only, so we have to hold something. And so we would be looking at the least negative momentum, if you will, if you're looking at a period like in February of 2025 in which everybody was running away as quickly as they could.

15:51Ben Carlson:I'm curious how are there any sector constraints on the portfolio? Because obviously momentum, I think one of the interesting things about it is that it's kind of a chameleon strategy. Like you said, there's sectors that work at sometimes they don't work other times. If risk is off, maybe it's these boring sectors and risk is on and these high flying sectors. Do you kind of let it be free and open or do you have some sort of like constraints on there? We don't have industry constraints. We do have position sizing constraints. So on a security level basis, we would have some constraints on. So but if it is all in a theoretical market, if the only thing that's working is a is a single industry, you would see us very heavily weighted towards towards that industry.

16:32And and happily so. But we would not be as heavily weighted as a pure momentum strategy that doesn't have position size and constraints. But at a 4.8 % position size maximum at rebalance, it does, in fact, limit the overall concentration in a specific industry, but somewhat organically so rather than prescriptively. All right.

17:01Michael Batnick:We're talking to Bill Mann from Motley Fool. The ticker is MFMO. Bill, as always, great seeing you. Thank you for your time today. Appreciate it. Great to see you guys.

17:14Ben Carlson:Okay. Thanks to Bill. Remember, check out fooletfs.com to learn more. And now in the second part of our talk, your book, here is our talk with Ketaliniak from Morgan Stanley.

17:26Michael Batnick:Kevin, welcome to the show. Thank you, guys. Thanks for having me. So the world of fixed income through the lens of a wealth manager was tricky. Talking pre-COVID times, there was a lot of duration, not a lot of income, and it was just not the most awesome thing to talk about with clients. and we all remember what happened in 2022 with the inflation and the rate hikes and the 10-year going from 1 % or even below up to 5 % and all sorts of tumult and volatility and then opportunity. And so as we look at the fixed income landscape today, or more specifically, where people are generating income, one area that you don't hear a lot about anymore that we're going to be talking about today is the preferred stock vehicle.

18:14Michael Batnick:So what is it about preferred stocks that you guys thought was so exciting that you had to launch an ETF to deliver to investors? Yeah, it's the income part of it, Michael. But yeah, I mean, going back to those times, there was very little income in fixed income. We used to call the government risk-free rate the rate-free risk. And I think for you guys in diversified portfolios, it was really difficult to see where fixed income fit in because rates were so low for so long. I mean, part of that was post-financial crisis, very low inflation, the Fed policy, QE 1 through 4. I mean, all of it really kind of kept a lid on rates.

18:54And even for high-quality investors or investors that didn't want to take a lot of risk, the problem is you couldn't see a lot of income. I think a lot of folks at that point had gone into preferred securities to find income, but also tax-advantaged income. The coupons or dividends in preferred securities, they pay qualified dividend income, which means you're getting taxed at that capital gains rate instead of the ordinary income rate. And that's a big difference. I think it juices up your yield. But even going back as we went into COVID, we went back into that really zero lower bound again on rates.

19:32And I think for a lot of financial advisors who were doing managed money, You think back 2020, 2021, I don't know what you guys charge, maybe 2%, 3%. I'm just kidding. But you can charge like 1%, 50 basis points on a portfolio. If you had munis out to 10 years or invest in great corporates, they yielded below 1%. So it was really, you know, after fees didn't really make a lot of sense, even for folks that really wanted safe portfolios, being in fixed income or high quality fixed income. So we saw a lot of people go into preferreds around that point. And at that time, we saw a lot of preferreds getting issued around 4 % or so, which, you know, brought a lot of risk as we went as rates backed up in 2022 and 2023.

20:17Ben Carlson:So there's a lot of people who probably just don't understand how preferreds work. They think, ah, it's a little equity, it's a little debt. How do you explain them to people in terms of their risk-reward profile? Yeah, I think they're a hybrid of each. They really trade like fixed income. And I see where they fit into a portfolio would be kind of in your income, fixed income area. They're certainly not as safe as munis and treasuries and investment-grade corporates, but a lot of them are rated investment-grade, actually. And I think of them as similar yielding to double B high yield, but probably with less risk.

20:51Now, there's a little bit of interest rate risk, but we're able to kind of manage that out. And I think one of the unique interest rate components to the preferred securities market is the retail part of the market is perpetual and kind of fixed for life, meaning that if they issued a preferred right now around 6%, it'd probably be callable in five years and would still be a perpetual. Some of the ones that were issued at 4%, they were callable after five years, which has now come up. But they're trading between$0.70 and$0.80 a dollar. I think a lot of those securities will never see par again.

21:25But the institutional part of the market, which is a real growing part of the market, and I think the opportunity in the preferred space, especially where we're invested in EVPF, they have this unique fixed income yield, basically interest rate component that you don't see in other parts of fixed income. And what is that? They're issued as a fixed rate security, but they're either called after five years, typically after five years, or they float. And they reset off the five-year treasury, sometimes quarterly, sometimes every five years. But it's actually a fixed to floating rate security. It keeps your duration lower.

21:59And really kind of what else is like that in an advisor's portfolio that has a kind of inflation insurance or floating rate type of insurance. And so these, we really only find them kind of in the institutional market or they're much more prevalent in the institutional preferred market. I think they've become very popular in financial advisors' portfolios who understand this part of the market. And it's a unique part of the market. I think it's growing in popularity.

22:26Michael Batnick:Why would a company decide to issue preferred stock as opposed to traditional plain vanilla equity or bonds? I think it's a great question. And there's a couple of different reasons for that. But they're essentially priced in between both. The investment grade corporate market yields a little over 5 % right now. Preferred to kind of trade between six and six and a half right now, let's call that. Cost of equity, you guys are the smart guys running CAPM and everything else, but that's probably north of 10%, right? So it's more expensive than investment grade debt, but it's less expensive, much less expensive than equities.

23:06For a financial institution like a bank, you know, they post Dodd-Frank in 2010. We got a whole new set of kind of financial rules and the preferreds, I think, kind of fall under a lot of that stuff. A financial institution can issue up to one and a half percent of the risk-weighted assets in preferred securities and have them count as equity for the regulators. And that's a big thing. So, you know, the financials go all to go through annual stress tests for the biggest banks. And their issue prefers is a lot cheaper than issue equity. So there's kind of the arbitrage in that. And if you were able, if you had to go through another thing, like we went in the financial crisis, and God willing, we never will, is that, you know, there are areas where preferreds would actually help recapitalize the bank and probably would get wound down with the equity.

23:57And we've seen this with a few of the kind of regional bank, you know, kind of wind downs since then. Why else would a company issue them? A lot of corporations are starting to issue preferreds. And I think the issue here is the rating agencies give them equity credit out to 10 years. And Moody's kind of changed the rule on this just a few years ago. Why is that important? Well, you see like a sector like the utility sector right now. They've got huge CapEx states, right? They're able to issue preferreds and have a certain sliver that count as equity so that they're able to kind of lever up and do a little bit of CapEx.

24:34But they're issuing a sliver of this stuff in the preferred world because between six and six and a half percent, it's a lot cheaper than equity. All right. And so we're seeing them issue a lot more of these. They probably will call them after 10 years. At least that's kind of our expectation. Why? Because they will no longer count as equity. So they'll just be kind of expensive debt at that point. But with the call features on these securities, it keeps the duration lower. And portfolio managers are able to kind of model that out versus other kind of fixed income risks that they have. So there's a little bit of an equity arbitrage, regulatory arbitrage of why they issue this stuff.

25:10And that's brought opportunities to the market. Last year, we saw 25 billion of utilities issued in the market. Would you like to buy an investment-grade utility north of 6%. We think that's really attractive. And some of these are now in bond indices for core and core plus. So we're seeing some of the traditional fixed income managers start buying some of these preferred hybrid securities from the utility space.

25:34Ben Carlson:So I have this theory that people in finance and the market people only have the ability to concentrate on one story at a time, right? This is a general theory. But in fixed income... There's a lot of stories going on right now. I don't know. It's a hard thing, yeah. True. But in fixed income, risks, how about? We only focus on one risk at a time. But in fixed income, that risk right now is private credit. Everyone's talking about it. And it seemed like a couple of years ago, private credit kind of boxed everything out in terms of interest from advisors in the Wealth Management Channel, too. So it's interesting to see both sides of that, right?

26:05Ben Carlson:It's the only thing people can talk about because the yields are so great and it's floating rate and all this stuff. And now people are talking about the risks. What do you think the private credit impact has been on the rest of the income landscape in terms of just, you know, interest from people and then flows? Has it impacted the rest of fixed income land at all or not quite yet? Absolutely. I mean, I speak to financial advisors all the time. And, you know, there are folks like me who go around the branches and try to discuss our solutions. It was very popular to run into this whole private credit crowd, the BDCs, over the last few years.

26:40In fact, I was probably marketing against them for the last three or four years, just saying, we're a little bit different. And that if you get 6%, 6.5 % in preferreds, you've got something, especially in an ETF, you've got something that's liquid, transparent, and public. and, you know, but there were better returns to be had, double-digit returns to be had in the private credit world. So we saw a lot of advisors really kind of running income strategies as a barbell, a lot of higher quality munis and investment grade, and then taking their yield where they either gone into bank loans or, you know, other kind of yield to your products in the past and going into private credit.

27:20And I think it was, it's a real, you know, was a real popular area. Probably north of 10 % of these BDCs are retail money. I think with some of the larger financial advisor teams who do private credit became a real interesting allocation for them. We've seen this many times before in the past. I've been doing this 30 plus years. When you offer equity-like returns in fixed income, you're always taking risk. And I think what you're trying to do there is you're trying to harvest the illiquidity premium. I think advisors right now are a little bit worried about private credit also trying to get out and they're realizing there's a reason for this illiquidity premium.

28:04The gates are up. There's outflows are north of kind of 5%. Now, we think the gates here make sense. I mean, I find myself almost like defending private credits to some folks more than, and I was marketing against them for years. But I think maybe some of the risks are either not well-known or kind of maybe over-concerned. I think of people starting to say, this reminds me of 2008 and CDO squared. That's a little overdone in my view.

28:29Michael Batnick:I'm so glad you said that. I tend to agree. I think that there is legitimate smoke, right? I don't think the outflows are completely media panic-driven. I think there are genuine reasons why assets are leaving. And they started to leave, as you mentioned, the floating rate nature of some of these vehicles, they started to leave not just last month. The attractiveness of these BDCs, and you saw it in the publicly traded ones, they peaked a year ago because as we were entering a rate cutting cycle, it was plainly obvious that the rates were going to come down. And then you mix in the software fears on top of it, which is the 25 % of some of these portfolios.

29:08Michael Batnick:There's legitimate reasons to be concerned. But this idea that there is systemic risk, I think is a bit hyperbolic. And I'd be curious to hear your take specifically, and I understand that we're talking to a Morgan Stanley employee. The model of the banks lending to these alternative asset managers who are then lending to these companies as opposed to the banks going straight to it, is there any concern that the banks are exposed to some of these loans going bad. Yeah, look, I absolutely agree with your take that you had there. And the banks are clearly exposed here in that we do lend to non-bank financial institutions, but it's much safer than lending to them directly.

29:50I mean, you'd have to have a complete Armageddon model before you had any type of risk. I have a good friend who's a portfolio manager at one of the large private credit firms. And they're looking to kind of spin off maturities and capital that gives them probably 8 % a quarter. That's why the gates are set up around 5%. They want to pay that organically. They also have bank loans and high-yield bonds in there and a little bit of cash to help assuage some of those outflows as well. If they couldn't solve all of that stuff, there's backstop facilities set up with the banks that would help with any of real outflows.

30:29I do think the SaaS situation with software is serious. Then again, we work with a lot of folks here from our tech team. They're very excited about everything going on with Claude Cowork and OpenClaw and all that kind of space. I remember when it kind of rolled out of like a month and a half ago, they were so excited. I probably should have shorted all the SaaS stocks at that time. But you're not going to replace everything right now. You're not going to replace your CRM. You're not going to place your cybersecurity software. It's just not going to happen. So, I mean, I think it's probably more of an equity issue than is a debt issue.

31:04But I think when you have too much debt concentrated in one certain area, it's going to be risky. So some of these BDCs that have 25 % risk in one sector in software, I guess I've - And with leverage? Yeah. And there's leverage on, yeah. And you're levering up recurring revenue. And I think the risk that we have with AI here is people are really guessing that recurring revenue. I do think that's risky. Is it systemic? No, doesn't strike me that way at all. It kind of reminds me of commercial real estate back in 23 that hit the regional banks. And we're involved in that space as well. What we would do there is just really kind of shun the regional banks that have very heavy CRE exposure in their portfolios.

31:50Some of them have problems. Yes, was it systemic? No, it wasn't. A few of them had real issues that we saw with kind of Silicon Valley Bank. But I think those are a little more idiosyncratic. It was an issue that needed to get worked through in the banking system that it did. I view this kind of somewhere more analogous in that we're all looking at the risk and probably re-rating where we see some of the risks. And software is definitely one of them. Now, you brought up, too, that there were risks some of it ahead of time. And yeah, I think rates going lower was one of them because these are floating rate assets.

32:23We have cut rates 175 basis points. And the reason that a lot of this asset class has grown so much over the last 10 years is because the banks kind of stepped back from this. In Dodd-Frank, the legislation that we got post-financial crisis, we decided that the regulatory environment made it really expensive for the banks to be lending. So a lot of this lending kind of went out of the banking system and into the shadow banking system. And a lot of these private credit firms set themselves up. And there are different parts of private credit. I'm not going to get into all the nuance there. It's not just, you know, one large leveraged lending area.

33:02I mean, there were asset-based lending in a lot of other areas. But I think for the overall system and for our overall advisors and clients, it's important to know you would rather this lending to be going on in an unlevered solution owned by private credit folks than I think in a 10 to 12 times levered bank. And that's where it was going on before 2010. And by the way, we were more levered than 10 to 12 times pre-financial crisis. And that was a different issue.

33:29Ben Carlson:So I think a lot of traditional fixed income investors felt kind of betrayed by the 2022 bear market. Like, hey, I didn't sign up for this. I wasn't planning on getting smoky. Like an aggregate bond fund lost 18 % or something, piqued the trough. I think one of the cool things about the market now and ETFs these days have opened up that there's so many different income products you can invest in. You have preferred securities you're talking about. You can do CLOs and asset-backed securities and there's income-oriented products with options and there's just a lot more fixed income opportunities, right?

33:58Ben Carlson:Bank loans and floating rate debt. And I think a lot of those traditional bond investors have realized or should have realized, is I probably need to diversify my sources of income more. So I'm just curious how you help people think through those decisions, because there are just a lot more products and strategies to consider these days. Yeah, I think advisors have a lot in their place when they're thinking about asset allocation. There is no free lunch in investing, but diversification gives you the closest thing to it. And it allows you to kind of build a portfolio, get you closer to the efficient frontier.

34:29And I think, as I said, the interest rate component here is really kind of unique to the preferred market. But I think there's a lot of decent income solutions. But if you're getting a decent amount of income in the high single digits, you're taking risk. And look, I'd even say you're taking risk in the corporate bond market or even the treasury market. We have$39 trillion of debt outstanding right now. We're at 100 % debt to GDP. The debt and deficit issue in this country kind of continues. And I would say the one we call a horseshoe politically where both sides get together closer to the link in the horseshoe.

35:07And that is both parties don't really seem to care about deficits right now. So I would say there's risk in all parts of the capital markets and in all parts of the fixed income market. And I think diversify some of that and going to some of those asset classes that you mentioned makes a lot of sense to me.

35:22Michael Batnick:Kevin, for people that want to learn more about Eaton Vance's EF, EV, PF, where do we send them to? You can go to the Eaton Vance website and we've got a case for preferred securities kind of primer that just kind of takes you about, walks you through the overall market structure and our overall solution. It's interesting, Michael, that there's probably around 40 billion of preferred ETFs outstanding. About half of them are passive. And I really do think there's a great opportunity in Active here. And you've probably had a gazillion PMs that have come on here and told you why active makes a lot of sense.

36:02I would just say, there's a lot of people wonder why fixed income portfolio managers are more intelligent than equity portfolio managers. And I think it's because we create indices that are easy enough to beat, where the equity guys have a lot harder time. I'm just kidding. Jump over those six inch hurdles, not six foot hurdles, right? Exactly. Exactly. Or 6 % hurdle. Active here makes a sense because you can diversify away from some of these different indices. And it allows you to access different parts of the market or take a different interest rate bet that you can if you just go off the passive index.

36:36You know, a bunch of these solutions only own the 25 part of the market and they don't have that interest rate structure that I mentioned, the fix the floating rate rate reset structure. 90 % of our portfolio is set up that way. We do think there are some interesting retail opportunities in the 25 par market that portfolio managers who only access have limited opportunities to buy. So we do have part of our portfolio there, but it's a small, it's 10 % right now. So we think in the corporate hybrid market, that utility story that I was telling you, we think there's some attractive new issue opportunities there.

37:11And in the global part of the market, anything issued outside of the U.S. is considered a contingent convertible security, also known as COCOs, also known as AT1. and Basel III regulation kind of covers the rest of the world, the U.S. has decided to kind of go, we're good with what we had after Dodd-Frank and we said, you know, we're going to keep the structure here. But there's decent opportunities outside of the U.S. We have the right to own up to 30 % of them in our portfolio there. It's a little bit lower than that right now, but we think that's a real opportunity.

37:44Michael Batnick:All right, Kevin, well done. Appreciate the time. Thank you for doing this. Thanks a lot, guys.

37:51Ben Carlson:Thank you to Kevin. number check out eatonvance.com to learn more and then email us animalspirits at the compound news.com