Talk Your Book: Talking Bonds at the New York Stock Exchange

0:00Today's Animal Spirits Talk Your Book is brought to you by J.P.Morgan and the new J.Bond ETF. ticker JBND, go to am.jpmorgan.com to learn more or search JPMorgan Asset Management to find this fun. 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.

0:37Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:45Welcome to Animal Spirits with Michael and Ben. I think this is our first ever Talk Your Book Live. Is that fair? First one in a long time. Wait, what are you talking about, Willis? Okay. First Talk Your Book Live? I don't think so. Okay, this is our first Talk Your Book Live ever at the New York Stock Exchange. That's a fact. Okay, and I've never been to New York Stock Exchange, This is pretty cool. Did it meet your expectations? Exceeded my expectations. So we were on the floor. We were also in a couple of boardrooms. And what did we see? We saw Thomas Edison wrote a letter to the stock exchange talking about being listed.

1:16Alexander Hamilton pictures. We saw a lot of history. We saw some old, what are those things called? Were these like, are they called stock tickers? What were these things called? Yeah. From 1915? Ticker tapes, right? Unbelievable. It was pretty cool. We were there. JP Morgan was listing their new J-Bond ETF on the exchange. And we were there for the ringing of the bell. It was neat. It was a new experience for me. It was very interesting. And afterwards, we sat down with two people who work for the fixed income side of JP Morgan's team on their portfolio management side. I don't want to shortchange anybody else that we've spoken to about fixed income because we've had a lot of great guests.

1:50So I'm not going to say that this was my favorite. I'm not going to say that. I'm just going to say that this was a very good conversation. It was. So we get into not only the fun, but fixed income markets and spreads and a lot of stuff we've been talking about on the show. So we talked. We got technical and we went broad and we went deep. It's true. We got the CFA stuff and regular people stuff, right? Because you literally did ask me two months ago, like, explain convexity to me. Oh, I forgot. No, you knew what it was, but you just wanted an explanation. And we got an explanation. So we talked to Kay Hur, who is the CIO for Global Fixed Income at JP Morgan.

2:22And then Rick Figley, who is the head of their core strategy with Global Fixed Income and helps manage this fund. And we went to a bunch of different places. It was live in person. I had a Diet Coke. No Coke Zero. Can't win it all. All right. So here's our conversation with Kay and Rick.

2:40We are joined today by two members of the JPMorgan Fixed Income team. Kay Hur is the Managing Director, USCIO for Global Fixed Income, Currency, and Commodities team. Rick Figley is the Managing Director, Head of Core Strategy within Global Fixed Income, Currency, and Commodities Group. We are at the New York Stock Exchange today. It's a big day. It is a big day. My first time. Yep, I got to see the bell. My first time seeing the opening bell. Yeah, so we're here for the launch of the new ETF, J-Bond. And so we want to talk a little bit about the bond market to start, which I've been making the case to Michael that it's been more interesting the last two to three years than the equity market.

3:15Is that fair? Absolutely. And I'm not saying that just because I'm in the bond market. But I think what's happened is, I mean, if you look at 2022, we had a horrendous repricing in the bond market. And people started to question the role that bonds play in portfolios. But actually, bonds are diversifiers and they provide yield. The repricing that we had in 2022, bonds are back to providing those two key roles in portfolios. So absolutely, core fixed income has an important place in portfolios. And based on our conversations with advisors and clients and even institutions, people are pretty dramatically under allocated to fixed income.

3:50I wonder if 2022 was the way to do it. And what I mean is over the years in 2013 and 14 and all the way through, I had been telling our clients, listen, if we ever want to get some income from our fixed income, we're going to have to take a couple of steps back to take more steps forward. And boy, did we rip the bandit off. It all happened very quickly. I was hoping to take two steps back, to take three steps forward, not 19 steps back, which we did. 2022 was an unusual year just to remind the audience that they need it. But bonds – so when people buy stocks, we all understand the risks involved, right?

4:27We've seen the charts. We've seen the drawdowns. We understand risk is tied to reward. We understand that's like the contract that we signed with the market gods. Bonds, on the other hand, they were supposed to be the security blanket. They were supposed to protect us when stocks fell. And not only did they not protect us, they were, you could make the argument, they were at the, they're why stocks fell, because of the repricing of interest rates. How did you all deal with client conversations in 2022? What was that like at JP Morgan? It was tough. If you look back at 2022, the aggregate index was down roughly 15%.

5:04And while our alpha across U.S. fixed income was strong, when you're down 13 and change versus 15 and change, nobody likes you. They throw things at you. So it was really difficult. I think it's important, and I'm not running away from 2022 or hiding from 2022. That was a very painful repricing, and the alpha that we generated isn't enough to compensate the beta that really hurt clients' portfolios. How much do you put into the capital appreciation part? Because obviously, everyone in the markets now just pays attention to the Fed. And a lot of people think the Fed is the whole game in town and they control everything.

5:39And obviously, they do control a lot to a certain extent. But do you put a lot of faith in your process of trying to understand what the Fed's going to do? Well, if the Fed cuts rates, that depends on what duration we're in. And how much do you look at what the Fed is going to possibly do versus just the risk reward based on the securities and the different structures you invest in? I think the answer is both are important. And let me dig into that a little bit and talk about why and when. So as I said, the starting point for yields is important. But if you take a step back, you have to think about what the economy is doing, where the economy is, what the Fed might be doing as it relates to the economy.

6:11And those really drive how we think about a couple of important allocation decisions within bond portfolios. So you talked about stocks. You're looking at what's the valuation and what's the earnings trajectory. When we think about bond portfolios, there's the risk of duration, right? What's the maturity risk that you have? How far out the curve are you going on it? And there's a whole other host of things that are complicated. but we're going to simplify this into duration risk and credit risk. So credit risk, high quality. So on the one hand, if you're thinking about buying treasury bonds, there's absolutely no credit risk associated with them.

6:40Those are full faith and credit of the United States government. Oh, yeah. You should see our comment section. Fair enough. I have read your comments and I've listened to these before and I think you guys do a terrific job on them. But I guess I should read more deeply in the comments. Anyway, there's no credit risk associated with that, but there's a lot of duration risk. If you're buying a 30-year treasury bond, that's going to be where things can be grossly mispriced or a lot of fluctuation based on it. So let's take a step back. And so those are the things that are really important to think about.

7:11So let's think about where's the economy, where's the Fed, where's the Fed right now, what's the Fed doing, and then how does that set us up for capital appreciation or not? So to unpack all of that, first off, let's remember, what's the Fed's mandate? The Fed's mandate is stable pricing and full employment. Okay, so how are they doing on that? Right now, They're doing really well, okay? So you've got unemployment under 4 % for, I think, 25 consecutive quarters. That's terrific for U.S. consumers, U.S. for Americans, right? If you look at inflation, I think as we all now know and appreciate, the Fed was behind the curve on inflation.

7:47They thought inflation was transitory in the post-pandemic period. There were a bunch of supply chain disruptions, and they were late to start hiking. Then they started hiking aggressively. And to your point, Michael, that's really what drove difficult performance in bonds because the Fed took the Fed funds rate all the way up to five and a quarter and five and a half. And that causes a repricing in everything, not just within the bond market, but also within equity markets. So that's what's happened. So here we are now. The Fed's got employment where they want it to be, right? Growth has actually been good.

8:21We're in what we would call a soft landing. We're in a Goldilocks type environment. So it's extremely difficult to achieve a soft landing. In fact, if you look at, you know, kind of the last seven cycles, really the Fed only achieved that one time previously. So there was a lot of expectation last year that the U.S. economy would slip into a recession. So far, that's not the case. Inflation – so let's talk about inflation in a second. But growth, GDP growth and jobs have still been, you know, Goldilocks. Not too strong, but not too soft. So maybe you can set a debate for us. Uh-oh. So we've talked about a lot of people are saying, okay, great, we have this Goldilocks scenario.

8:59And I'm making the case that it feels more like the 90s and the 70s. Everyone's worried about the 70s. The economy right now feels more like the 90s. So Michael says, why does the Fed need to cut rates if they haven't really impacted the economy that much? My take is, well, if inflation is falling, that means real rates are higher and that could be more restrictive. So it does make sense for the Fed to cut. So you put me in a tough spot because agreeing, I have to agree with one of you and disagree with the other one. and I'm sitting closer to Michael, so I'm tempted to agree with him. But unfortunately, the merits of the argument that you have made are stronger.

9:29So the Fed's favorite measure for inflation is PCE, personal consumption expenditures. And if you look at it on a one-year basis, it's too long of a time series. So the best way to look at PCE is on a six-month annualized basis. And if you look at it on a six-month annualized basis, it's running at 1.9 percent, and the Fed's

9:53moderated to down actually below what the Fed thinks the target is. And with real rates, with the Fed funds rate up at five and a quarter to five and a half, real rates are very restrictive. So as inflation has come down, real rates are restrictive. And that's going to be further tightening in the U.S. economy that could slip us into a recession. But counterpoint, financial conditions have eased so much to offset any of that monetary restriction. So that's a really interesting point. And if you look back, if you go back to this fall, there were a couple of real debates going on in the market. So you could say to me, hey, Kay, you could have been sitting here in 2023 and it would have been the exact same argument.

10:36And there's an element of truth to that. But I would point out, actually, 1231.22, 1231.23, the yield on the aggregate index was basically the same. So what'd you do if you owned bonds? You clipped your coupon, which was a good thing. You're getting 5%, 6 % returns. Admittedly, far below the magnificent seven. Yes, I can't talk. Far below that. But what bonds were supposed to do in your portfolio for you. So you make a good point about financial conditions. And it's like, you're right. Last year, when we think a couple of things happened. First off, everybody decided, oh my goodness, the budget deficit's expanded.

11:14The Fed's going to, the Treasury's going to be issuing all this debt and it's all going to be at the long end and the market can't absorb this and foreign buyers have gone. And that really helped to move the treasury above 5%. That was a worry for like a month. It was crazy, right? That was September, October. Wasn't somebody calling for 13 % on the 10-year? I mean, there were some outrageous claims. Like the hire for longer, by the way, the hire for longer theme turned on a dime. The hire for longer was consensus for like three, four weeks. And then, wow, did that. And a painful three, four weeks for us in our portfolios, I would tell you.

11:49You know, I don't traffic in the hedge fund community, but you're right. You get these ideas, people all pile into them. And I think that's why people, especially individual investors, have to think about in asset allocation, what they should own for the longer term and where bonds can make sense in that. It was a really interesting time where Ackman and a lot of other hedge fund managers were short the two-year, or whichever rates they were. And then moved the opposite way. But then asset managers were super long. So it was this really weird push and pull between speculators and asset managers.

12:22I want to talk about regular people for a second. We are regular people, for the record. Not hedge fund managers, everyday investors. So in 2022, correct me if I'm wrong, there was a mass exodus out of bond funds, right? People ran away because it was just, the pain was too acute. And even though they should have been running towards higher yields, they were running away. In 2023, investors were piling into bonds. I think there was some crazy streak of consecutive weekly inflows, which made sense. It makes sense mathematically, but everything we know about investor behavior, it didn't make sense because people don't behave that way in the stock market.

13:01If the stock market is falling, you could better believe that there's outflows. Are investors getting smarter? Is it their advisors? because the rational move is when you experience losses in the bond market, returns empirically become more attractive going forward. We know that mathematically. Are investors getting smarter to that fact? So a couple of things. Yes, you're 100 % correct. Second, I genuinely believe that Americans and their advisors are smart people and try to do what is logical and rational. If you look underneath the data at bond funds and what went in, it's actually a little bit more mixed.

13:39So the biggest inflow last year was actually into money market funds. So that's something like, there's something like$6 trillion sitting in money market funds. So neither stocks nor bonds and actually T-bills. There was, you know, you talked about memes and things that people like, right? Last year it was T-bill and shill. And there was a lot of merit to buying money market funds, buying T-bills, because you could get rates north of 5 % with no risk, right? So let's hold that thought for a second. But if you look at the underlying markets, there were outflows in short-duration bond funds, which is really interesting because the curve has actually been – the yields have been more attractive there.

14:16So you can make an argument that people should be in two - and five-year, and there were outflows in short-duration bond funds. Core bond, however, actually had pretty substantial inflows. And then it was mixed. You saw outflows in emerging markets debt. You saw outflows in high-yield debt. You saw inflows into investment grade. So I think it's a more nuanced story than just people were buying or not buying. And just to add to this, just remember that back in the time when interest rates were low, 60-40 was dead. So nobody wanted to be in bonds. And you probably, you know, you can make the case that that was true, right?

14:49You know, now that rates are higher, you know, investors just recognize that bonds have value. There's yield there. There's income there. And so it's not necessarily about are investors smarter now than what they were. I think you just recognize the fact that the market has changed and investors are going to go. I wrote a eulogy for the 60-40 in 2019. I think we've written it. A eulogy for the 60-40? 70-30 was 60-40, but 60-40 is back because now you actually can comfortably hold 40 % of your assets. But a lot of people, you mentioned the money market thing. By the way, it was dead when rates were zero.

15:19Well, yeah. Yeah. But the 60 did a lot of the heavy lifting for you. Stocks were doing 40 % a year. 100%. 100%. But do you think that that's a reasonable expectation year in, year out? Of course not. But how do you think, let's say someone took the 40 and they said, you know what, my bonds got crushed. I'm going to the money markets or T-bills and I'm clipping this and I'm taking the volatility out of it. I think a lot of those people are wondering like, well, if the Fed cuts, I know my short-term rates are going to fall. So that's exactly the right question. And I think to your point, Michael, investors, we as humans worry about the last thing that happened to us.

15:52And they don't worry about the next thing that's going to happen. So the next thing that's going to happen in our view is reinvestment risk, okay? So we started to talk about the Fed, and then we went off on a different tangent. But if you go back to your question, people think, I lost money in bonds. That's a bad thing. I can get five, five and a quarter, my money market fund and T-bills. But if we're right and the Fed starts easing because real rates are too high, then your money market fund yield is going to go down. your T-bills, when you look at a 5%, 5.25 % T-bill, that is an annual rate for the 12 months.

16:28That assumes, if it's a three-month T-bill, that assumes that you can roll that over. And we don't think that that's really what's going to happen. And so now is a good time to lock in yields for people. So if you're right, this is the big question on everybody's mind in 2024. Can't believe it's 2024. That sounds weird. 30 days into it. So$6 trillion in money market funds, I think another$2 trillion in CDs. What happens to that pile of money? The CFO of another large asset manager said he goes to bed salivating about all of that money and the potential to rotate into fixed income flows. My suspicion or my working thesis, which obviously will either be right or wrong, is that I think there'll be a lot of inertia.

17:12Money was slow to move in. I think it's going to be slow to come out. And I also think it's more a checking account than people selling bonds or stocks and going into there. But even still, even if it's only a fraction, there's still trillions of dollars up for grabs that will probably, a piece of it will come back into fixed income. So how are you all thinking about that piece of the puzzle? So a couple things first. So number one, when you look, I think the market's focused, people are focused on the wrong thing right now. They're focused on is the Fed going to ease in March? Is the Fed going to ease in June?

17:39And actually, it doesn't really matter. If we're sitting here a year from now, that's not going to be the debate. Oh, my gosh, we got it right. The Fed eased in May or June, not in March. What actually matters is from the time that the Fed stops hiking rates in the subsequent two-year period, bonds outperform, the aggregate index outperforms cash by something like 13%. And I think that's what's going to happen. I think people are waiting for the Fed to ease. And then they're going to say, oh, my gosh. Or they're going to see their T-bills mature and they can't roll them into another one or their money market fund rate.

18:14And then they're going to start going. and that gets to where we think they're going to go. We think they're going to go into core bonds. Well, the problem is, as we know, the market doesn't wait. The market doesn't wait for the Fed to move. The 10-year is already down to 4-1 or wherever it is this morning. So, Rick, how do you think about the 10-year? Is the 10-year already pricing in several cuts? I think the market overall is pricing in cuts for 2024. The real question is, is the market pricing in too many cuts or not enough cuts? And I think that that's where it gets a little tricky when you're talking about duration.

18:46But just because of – I didn't just say anything about hikes. And that's the important thing here, right? We're talking about cuts. So whether or not they're maintenance cuts, so we just bring yield – real yields down a little bit. Or whether or not, let's say hypothetically at the end, you know, 2024, 2025, that we start talking about recessions. And then there's what I call the bad cuts. the bad cuts, or those cuts that, you know, if we go into a recession, maybe it's not 25 basis points. Maybe it's not three cuts of 25 basis points. Maybe now we're talking about 50 basis points. The point is, like, money managers sitting here today, we don't really know.

19:24Now, I'm going to come back to one thing that you were talking about, and you're 100 % right to talk about flows into fixed income now. And you're talking about that trick,$6 trillion in money markets. Now, Now, the thing you have to keep in mind, though, is what is the composition of that$6 trillion and how much of that potentially could actually come into the high-grade fixed income market? And it's not going to be$6 trillion. But you don't need$6 trillion to come in and move that 10-year from$4.10 down to$3.5 in a very short period of time. And nobody, and I'm just going to include us, obviously, in this when we think we're the experts here, you can't predict when that's going to happen.

20:06And so when we talk to clients, we say now is the time. You should be getting into fixed income, whether or not it's your high-quality fixed income or if you think it's going to be the soft landing and maybe you want to go for a little bit more yield. You know, that's going to be up to the individual investor. And that's the question, like, our listeners and advisors have been asking is, OK, I know the Fed's going to cut. I don't know when. I don't know how much. But I want to lock myself and my clients into some more duration in case yields fall or just get a higher yield because if the short-term yields fall, maybe the longer-term ones don't go down that much.

20:35If the economy keeps humming along, maybe the 10-year stays in the 4 % to 5 % range. Who knows? So probably a good transition into your new ETF that we're here for today, J-Bond. This is a, I guess you call it a core plus strategy? No. This is a straight core strategy. This is investment grade only. Okay. So plus would be with high yield. Correct. Right. Okay. So this is just investment grade. And I guess a lot of investors probably aren't really familiar with like a bond index. Like people might invest in a bond index fund or an ag fund. But most people these days kind of know it's really hard to beat something like the S &P 500, right?

21:12But the bond market is different. So maybe you could just start there talking about how that aggregate bond market works and then how you try to tweak and go different from that. Right. So out of the entire fixed income universe, high grade, so investment grade, the U.S. Ag Index makes up about 50%. Maybe it's a little less than 50 % of that entire investable universe of debt. What J-Bond is going to attempt to do is it's going to leverage parts of that index that are underrepresented in the index. So as an example, J-Bond, the way we've designed this, even though it's going to be benchmark versus the Ag, it's going to have a securitized heavier allocation.

22:03So let's say the ag is on agency mortgages. It's around 30%. Securitized credit is going to be another 1.5%. J-Bond, the way we've designed this, the way that we're going to run this, is that we have minimums and maximums. So it's going to be a minimum of securitized plus 20 % is how J-Bond is going to be. That's a minimum. So let's say that's 50 % securitized at all times, JBOD. We're actually going to run that between 60 % to 65%. And we'll talk about that in a minute and why we think that's a good idea. But then on the corporate credit side, where we still think we do a great job of corporate credit, what we've seen over time when the product that we have on the 40X side, so the 40X mutual fund, when we look at attribution over a long period of time.