Talk Your Book: Navigating Fixed Income in a Crazy World

0:00Ben Carlson:Today's Animal Spirits Talk Your Book is brought to you by Invesco. Go to Invesco.com to learn more about their whole suite of fixed income ETFs. That's Invesco.com to learn more. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:40Ben Carlson:Welcome to Animal Spirits with Michael and Ben. On today's Talk Your Book, we have Stephanie LaRose-Lierre, Head of Business Strategy and Development at Invesco. Here's the thing that I learned from this episode. There are just a million fixed income of products now available to people. Duncan was asking me the other day, hey, I thought fixed income was supposed to hedge against geopolitical crises like this. And it's kind of my question was, what kind of fixed income do you have? Do you have a floating rate fund? Do you have a muni fund? Do you have some sort of structured credit? Do you have a total bond fund?

1:15Michael Batnick:That's a good point. Fixed income has gotten a lot broader and it's a lot different than it used to be in the past. Back in the day, you just assumed, all right, Risk off, bonds on. And it's not so simple anymore.

1:26Ben Carlson:Yes. And I think that's what we've learned this decade is that there's a lot of different environments in fixing and can perform differently under different environments. Rising rates, lower rates, higher inflation, lower inflation. And I think the need for diversification, if you're going to want to protect, is probably greater than it's been. So anyway, we talked to Stephanie about all this stuff, the different products they have, what's going on in the world, what's going on with the rates, how the economy is impacting it, inflation expectations, all this good stuff. So here's our talk with Stephanie.

1:57Michael Batnick:Stephanie, welcome to the show. Thanks for having me. All right. Today, we're going to be talking about public credit, aka bonds, which historically have been a boring, the boring, deliberately part of the portfolio. And given all of the headlines in the other area of the loan market, I'd say boring sounds pretty good right now. What sort of client conversations are you having these days, Stephanie? Yeah. So boring, that is very synonymous with bonds, right? These days, the conversations are again around sources of income, flexibility, and opportunity. It's about trying to balance a couple of things for a lot of investors right now.

2:38It's about earning real income, managing the geopolitical, volatile situation, and trying to stay nimble as the rate path remains uncertain ahead of us.

2:48Ben Carlson:At Invesco, you have plenty of different options. And I think there's never been more options for fixed income investors. How do you help people sort through what makes sense? Because there's so many different places to allocate to credit these days. It's not as easy as just buying a total bond fund anymore or buying treasuries. I guess you could do that, but you obviously have a lot of other options. So how do you help people sort through where to look these days? Yeah, it's about, you know, the need for income, need for stability. Where are you on the risk spectrum, right? And where do we see the opportunities?

3:17So I'd say, you know, right now we like a couple of different parts of the market. We like structured credit. There are some inefficiencies that exist there. We like investment grade. The intermediate part of the curve is a really good place to be. We like ultra short. There's all sorts of places that we find opportunity. So it's really about understanding and marrying the risk appetite with the investment at this point.

3:40Michael Batnick:Are you surprised that you mentioned ultra short duration? Are you surprised that there's still, I guess last I checked,$7 trillion in money market funds? and prior to the last call it two weeks, all indications were that the easing cycle would probably continue. And even if it didn't, the Fed funds rates are already well off their highs, and yet investors are still getting less than they could in other areas of the curve and other opportunities within the broader bond market. Are you surprised by that? We're not too surprised. Really what it comes down to is people really want to understand what's happening with rates, right?

4:20And there's this forward looking lack of clarity that we have. And we think right now with our ultra short ETF, GSI, it really allows people to have, you know, stay invested, earn that yield, but not take a really high conviction on the timing or magnitude of interest rates. And I think that's really what it is, is that people just feel super uncertain and they'd rather, you know, stay on the front end of the curve, stay in ultra short, stay in money markets rather than, you know, take more rate risk and just not know which end is up.

4:51Ben Carlson:Michael talked about the public versus private thing. And obviously, private credit is in the news a lot, which as a public fixed income manager has to be great for you. You have to feel pretty good about that. But how do you handle conversations when people talk about the more illiquid side of credit? And what do you think about do people need to have illiquidity risk in there in the credit side of their portfolio? Well, when we think about, you know, the number of companies in the U.S. and the amount that are private versus public, it's really a large majority of the companies in the U.S. that are still private, right?

5:24So if you are just doing public markets, you are missing out on, call it, you know, over 50 % of the outstanding companies that are out there, right? So there's definitely a place for it. What I think has gone without being said, mostly to retail as of now is just the risks that are associated there, right? So the illiquidity, the fundamentals, you're not getting an S &P report on your private credit issuers. Whereas on the public side of the market, we get paid to manage these funds to make sure that we understand every individual credit. We're not only doing our internal due diligence, internal analysis on the bonds, there's also external resources we can use.

6:04So there's just this opaqueness in the private credit side of the market that I think people just need to know what they own. And it's really difficult on that side of the market. And you also need to know that more than likely that daily liquidity that you're used to on your ETF or your mutual fund, you're not going to get it there.

6:19Michael Batnick:We saw the 10-year make new multi-month lows. So it got as low as say 3.9%, which is the lowest it had been since last April. And then of course, geopolitical instability captured the headlines and immediately rates rocketed up from 3.9 all the way up to 4.3. They've since come in a little bit. How do you think about positioning a portfolio when the 10-year is rollercoastering all over the place? For that reason, we tend to like the intermediate part of the curve, right? We think that you can get a lot of downside mitigation and be better aligned to the current environment. You get a decent yield at that part of the curve.

7:05It's a downside ballast and a slowing growth environment. Volatility pressures of long duration assets also, you know, are not going to be as much of a concern. And then the reinvestment risk that's embedded in the front end, you don't have there as well. So it's kind of finding that belly of the curve is really where we like to be in terms of our particularly core plus portfolios and our core portfolios as well.

7:29Ben Carlson:I'm curious how you manage the long term thinking in terms of interest rates, in terms of like a force like AI, technology is supposed to be deflationary. Do you think about long-term trends like that in terms of positioning fixed income portfolios? Or do you think, no, there's way more that goes into setting these rates than just technology? How do you think about a longer-term deflationary force like that? So it's one of the factors that goes into our forward-looking expectation on rates. So when we think about technology and we think about CapEx, it continues to be a major contributor of growth, right?

8:06And we think about the elevated energy prices that could weigh on growth. So it's like you have two sides of a coin. You have AI that's also impacting fundamentals across software and various industries. You add to that the macro backdrop that continues to remain solid. And there are concerns about recession, which have continued to decline in the face of the economic output that we continue to see. When we think about technology, it's a factor. It's not the main factor. There are a number of other things that also weigh in and the stickiness of inflation. Now the geopolitical risk, the war in Iran, all of these things go into our forward looking assessment on what we expect rates to do.

8:48Michael Batnick:Are you surprised that given the macro headlines, the move in rates, that credit spreads have been relatively subdued? We aren't surprised. I think the fundamentals continue to be pretty strong, right? So I think We're looking at balance sheets. We're looking at companies that continue to perform in ways that we expect and have been strong fundamentally. So while you would expect spreads to blow out here a little bit, I think the underlying fundamentals are what's driving the day.

9:21Ben Carlson:So I asked Michael this today, maybe you can provide a better answer. It's interesting to me that people are so worried about what's going on in the private side of fixed income and the private credit space and worried that there's going to be real stress there. But spreads and high yield are still so tight. Do you think that that actually makes sense? Or is it kind of like something has to give in one of those areas? It does feel like something has to give. It does feel like, you know, the concern should be placed elsewhere. High yield is the highest quality high yield we've seen in our market ever in terms of, you know, just the fundamentals that we're seeing out of these companies.

9:54So, you know, your double B rated credit is not the same double B rated credit that it was 10 years ago. Right. I think that is something that isn't necessarily translating to, you know, the investing environment, your average mutual fund ETF buyer. I don't think necessarily understands that the concerns with private credit. I think those are real things. high yield, there's some opportunities here. And we should be seeing, you know, more confidence in that part of the market.

10:22Ben Carlson:So I'm curious, why is the quality so much higher in these high yield issuers? What happened that made them in such a better position? The problem children are gone, right? So over the years, you've had, you know, essentially, a cleaning of house where, you know, the weaker credits that couldn't withstand And there, the market environment have kind of not become an issue. They've defaulted. They're no longer. And so what we've been left with are companies that have much better fundamentals on a forward-looking basis and companies that are more better aligned with the current market environment.

10:55We talk a lot about AI and, I guess, the cockroaches and all of that. None of that really is in the high-yield market. A lot of that is in other parts of the market. So I think even that is less of a concern for high yield than it is for perhaps investment grade in other parts of the market like private credit.

11:15Michael Batnick:So fixed income ETFs have obviously exploded in popularity over the last couple of years. What do you think it is about this wrapper that makes it so attractive for the everyday investor? When you think about fixed income ETFs, you have the tried and true. It's a play on mutual funds, right? Right. Fixed income active ETFs are basically taking what people over the years have come to expect in a mutual fund and put it into a wrapper that is more tax efficient and more cost efficient. So when we think about, you know, the ETF wrapper, we've got lower operating costs than you do in mutual funds. You also have, you know, no transfer agent costs, all these other costs that are built into a mutual fund.

11:56You don't have that here. You have fewer platform related expenses. And so we're talking about, you know, a management fee that is much lower than what you would get in a mutual fund. And then when you add to that, the tax efficiency, right? So the in-kind creation, the redemptions, it limits capital gains. And a lot of times, you know, we always say this in our muni suite, it's you earn the yield, but if you have to give it back in capital gains, that's not a very pleasant experience, right? With the ETF wrapper, the fact that capital gains is much less than what you would have in a mutual fund.

12:28And then PMs can choose what to deliver. So they're not triggering capital gains inside of the ETF. It also allows for active managers to harvest losses, manage turnover, and avoid selling the bonds that they don't want to. So I think all of that for the end user makes it a very attractive vehicle.

12:48Ben Carlson:My contention is that a lot of bond investors in the early 2020s kind of woke up to the fact that maybe they're not diversified enough in their fixed income portfolios. Because if they just held, you know, a broad-based bond fund and rates rose, they got crushed. And they kind of said, wait a minute, this is not what I signed out for. I thought bonds were the balance of the portfolio. They're the anchor. And there were some of these other areas in fixed income that actually weathered the storm pretty well. Something like a floating rate fund, right? It's shorter duration. The yields changed considerably with the market.

13:18Ben Carlson:How do you think about adding these other pieces to a portfolio when someone is trying to figure out, OK, what do I need to do to protect myself against scenarios like that where inflation spikes and rates rise very quickly and my bonds get crushed? How do you think through something like presenting a floating rate option to a portfolio? First, you have to understand your duration exposure. And are you comfortable with it, right? So if you're not, then floating rate might be a really good option. You know, we have our variable rate investment grade ETF here. It helps to address one of the biggest concerns out there, which is rate uncertainty.

13:52It allows you to reevaluate how to generate income without overcommitting in terms of where you want to be from a rate perspective to a single macroeconomic outcome. Right. It's anyone's game in terms of where things go. So with that particular strategy, we think you can get investment grade credit with coupons that reset that reset as rates change. and it helps to reduce that interest rate sensitivity, but you're still generating that income. So I think that's a nice thing about floating rate is that you get the best of both worlds, essentially.

14:23Michael Batnick:Getting back to the AI stuff, is there any worry that these companies are now getting over levered? I guess Oracle as opposed to trial now that we have to discuss individual names here, but the amount of debt is definitely starting to weigh in free cash flow. Is there any concern that investment rate spreads might widen? That is something that our team is evaluating. You know, there are some concerns right now with credits inside of AI. That has definitely been driving some of the performance that we've seen there. But a lot of companies are benefiting from this as well, right? So it's making sure you're doing that credit research to understand which companies are benefiting and which companies are over-levering and how that will affect their bottom line.

15:03Ben Carlson:So I'm curious, as a fixed income manager, how you deal with credit when it seems like we haven't had a real credit cycle in like 17 years, right? We had one small short recession, but it wasn't driven by financials or credit. There wasn't like spreads blowing out. It was just, it was the pandemic. And so it seems like there's probably a lot of investors who are worried, like, I don't want to allocate to a specific space if a recession is going to happen. And obviously there's reasons that maybe that we haven't had a recession, that economy is just bigger and more dynamic and more diversified and all these things.

15:37Ben Carlson:Is it more about picking the right sectors for you instead of trying to figure out what's going to impact the entire fixed income market. It's interesting to me to think through how different things would look during an actual credit cycle if and when that ever happens. Yeah. So I think it's about having some flexibility. In some of our strategies, our core plus, let's say, our ETF there, GTO, that's one where we are adjusting our exposures based on macro conditions, valuations, and risk-reward trade-offs. So we're not tied to any particular sectors of the market. The portfolio does invest across treasuries, agencies, investment-grade corporates.

16:14We're looking for multiple streams of income, but we're also trying to maintain a AA average credit quality in the portfolio. So that particular strategy takes a more thematic approach, and it's a more macro-aware strategy that adapts as conditions change, which we think is really important in an environment like the one that you just described.

16:34Michael Batnick:2022 was, Ben alluded to this earlier, really tough environment for fixed income investors. That was supposed to be the ballast. I don't think anybody foresaw interest rates going from zero to 5%. Highly unlikely. Well, I shouldn't say unlikely. Interest rates are not at zero percent, so they can't possibly go from zero to five again. What does the starting level of interest rates do to the overall level of protection and income that bonds can help with the portfolio? When we look at where rates start, It's an important part of the carry that you're able to earn in a portfolio. So when you're starting from a higher rate environment, you actually have the benefit of those higher yields that you're earning in your portfolio.

17:16So that means that over time, typically, you can weather a rate change a little bit better because of that carry in the portfolio. That's something that, you know, our investment grade team has done quite a bit of in terms of just how we position our portfolios. It's been a big selling point for a lot of our investors. It's just understanding how the portfolio is positioned on the curve and where we are from a starting yield perspective is going to dictate where you end up.

17:46Ben Carlson:So let's say we did go into recession for whatever reason. There's an actual credit cycle. We have a minor recession because AI companies and the tech companies spent too much. And CapEx brings us into a bubble because they spent too much and they didn't get the return on their investment. What areas of fixed income would you be most concerned with heading into that in that situation? A situation where yields fall, we have spreads blow out. Any areas where you say, like, all right, that would worry me if we had this situation with this part of the fixed income spectrum? Yeah, I think non-agency mortgages would be an area of concern, right?

18:22You start to see a recession, people, unemployment's going up and you have more and more where people are potentially defaulting on their mortgages. So that would be one area of concern. Another one would be munis. Munis tend to be very much tied to the economic conditions of the country. So if we're looking at, you know, a recession, then, you know, your municipal bonds, particularly your high yield munis may actually have a bit of a tough time. Typically high yield, but right now, given the state of the high yield market, I think it would take a pretty deep and wide type of recession to actually affect the high yield market in ways that it's historically been affected by recessionary periods.

19:05We talked about AI and the exposure there. I think that would be a big concern as well, particularly in the investment grade space.

19:12Ben Carlson:So you actually think because, like you said before, high yield companies are so much higher quality that you wouldn't see like a, unless it was like a financial crisis situation, you wouldn't see a huge run in defaults on these companies because they have higher quality balance sheets. I do think that that is likely the scenario. Yeah.

19:29Michael Batnick:If investors are looking for some sort of liquid proxy for private credit, should they look to senior loan ETFs? Is that close or is that like not really a good way to think about it? I think that's a pretty good proxy. Yeah. You're talking about a lot of similar issuers in that part of the market. So yeah, I think that would be a good proxy and you have much better liquidity in that space than you would in your typical private credit. So the story in private credit is fairly well known. Risk shifted from the banks making these syndicated loans to banks making loans to large asset managers, alternative asset managers, and they're making the loans to these companies.

20:11Michael Batnick:Do you think that some of the potential contagion fears that some people are talking about are overblown? That, uh-oh, we haven't eliminated the risk. We just shifted the way that it's been exposed. And ultimately, this does come back to the banking system. I think that as we're seeing private credit make its way into retail, there is a shift that's happening that is actually moving the risk from the banks and institutions into the retail investor. Great. In a way that maybe is not being talked about enough. I think private credit, it's a pretty sophisticated part of the market. And there's a reason why you had to be a type of investor, a certain type of institutional quality investor to invest there.