Talk Your Book: The Companies Are Fine

0:00Today's Animal Spirits Talk Your Book is brought to you by FM Investments. Go to FMETF.com to learn more about the FM Opportunistic Income ETF, which we're going to be talking about today. That's fmetfs.com. 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.

0:34Clients of Britholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:43Welcome to Animal Spirits with Michael and Ben. On today's show, we had returning guest Alex Morris from FM Investments to talk about the credit space. We talked to him in the past about treasuries. And the big takeaway for me, you actually made a pretty good point that, yes, interest rates have risen, but most companies are still paying debt on much lower yields. in the past, which is one of the reasons that the bond market hasn't completely blown up from all of this, which is interesting. You know, I think I might've said this. I was almost embarrassed to have this, that this dawned on me. It just seems so obvious, but the price of these bonds have gone down to keep up with new interest rates.

1:22So Microsoft, for example, their bonds are more attractive than they were when they issued them. Is Microsoft any worse off than it was when they issue these bonds? Of course not. Right. Yeah. Which is interesting to think about credit. And now you're seeing 6%, 7%, 8%, 9 % yields in credit, which makes this space way more interesting than it was a few years ago. So we talked to Alex about a ton of different stuff about credit, how they think about these bonds, the types of yields they're seeing. So here's our talk with Alex Morris of FM Investments. We're joined again today by Alex Morris. Alex is the CIO and president of FM Investments and a portfolio manager for FM's Integrated Alpha Group.

2:00Alex, welcome back. Glad to be back. All right. One of the things Michael and I have been talking about in recent weeks and months is obviously the bond market is exciting again, especially in the credit space. So you can look at corporate bonds right now. You can correct me if I'm wrong, yielding, I don't know, six to seven percent in some cases, high yield, probably more like eight to nine percent. That's right. So I think a lot of people are looking at that and going, well, why would I invest in stocks if I can get 6 % to 8 % or so in credit. We'll look at the bright side later, but let's look at the downside now.

2:34Are there any risks to this space with yields being higher and having not gone into recession yet? Well, it's always fun to start with all the negatives, right? But I think it's fair, right? That's a bond thing, right? It's a bond thing. We just have this deeply pessimistic view of the world always. But maybe I'll turn you around on that in a second. I mean, so obviously, the first thing to remember, if you look at bonds is they do have an expiry on them. So a bond you're buying today, unless it was minted a couple of days ago, has a coupon that was set based on conditions at some point in the past.

3:03So you're going to buy it at a price and it has a yield and now pricing yield are going to work themselves out. So high yield or a higher yield doesn't always mean a higher coupon rate, right? It's a combination of the price you pay and the cash flows you get over time. This is why folks really despise bond math. But if you look at, say, some of the high yield or junk names today by rating, they may still have a 5 % or 6 % coupon because that's what junk debt would need to offer to be acquired, say, two or three years ago, even if it has a 10 % yield today. A lot of that is just price change. And that means you're going to get that experience if you stick around until when the bond matures.

3:40So aside from the inherent factors of do you have a credit that might not be able to be refinanced or a business that might not be able to pay it back, you also have to say, am I going to get the return I think I'm getting on the tin based on the time period I want to hold this security? And am I going to get the cash flow I expect? I think that's probably the biggest downside to investors is not, they just look at the headline yield numbers. They see that number and it doesn't exist in reality. Now we're going to next year come up with some products that actually fix that, where you can buy more into the current coupon cycle.

4:09So then when you say, hey, it's yielding six, like there'll be something that actually gives you six and sticks with it, as opposed to this sort of accumulation of historical prices and cash flows and other bad things, right? But if we took a turn for just a second, and if I can make just a moment of what, maybe of optimism, let's remember that debt is actually like a really deep statement of optimism, right? And we all do this in our personal lives if we have a mortgage, right? Our aspiration is that in the future, we will do better than we are today. We kind of lose sight of that in bond world.

4:42And Jared Dillian did a great piece on this where he went through the sort of math and the emotions behind it. But it's true. And I think that's a really important point as we look at credits here, right? Hope is not a strategy, but these companies are investing in themselves. And they're investing themselves in a meaningful way. And then when we do this underwriting process, it's really to work out, are those aspirations going to be obtainable? And are we going to reliably be paid on those? And that's how we try to find a good credit in this world, even if, you know, some of the ratings, some of the other math doesn't look like it should hold out.

5:13That is an interesting paradox that people with higher debt loads are optimistic about their ability to service that. And that was a really interesting post by Jared. I read that as well. But there's a difference between the individual's propensity to take out debt and corporations doing the same thing. Can you just talk about that dichotomy? Sure. I mean, so obviously in our own lives, we need it because we just don't have that big pool of money. Corporations, particularly those are profitable are now trying to balance how do they deal with cash flows, right? I want to invest in a project today for which I need to have a big sum of money.

5:48And now I expect to get some regular repeated cash flow based on that debt. And you got to hope as a debt offer, because you're going to part with your money today, that that company is going to do two things. One, actually execute on some plan to do this. And two, that the market conditions aren't going to go against their ability to repay you. And where I think, you know, like you hear junk bond, you think of Michael Millen, all these other things in the background, right? I think that the key to remember in the debt world is we're buying companies and we're exchanging cash flows. And the hope is that they'll be able to continue to do this.

6:22And there's two types of companies, really, those who need debt to continue and those who are using debt to grow. And if you looked at the NASDAQ circa, I don't know, 1995, let's say, the vast majority of those companies needed debt to grow. And that's why interest rate risk was so high. Like if interest rates went up, many of those companies couldn't afford to refinance their debt from two or three years ago, they weren't going to make payroll. And that just isn't true for many of those companies today. Like at one point, believe it or not, that was true for Apple, right? Apple was on the brink of bankruptcy a handful of times.

6:53And now it's one of those profitable companies in the history of mankind. And they've gone from that, hey, I'm an issuer who needs this to just stay afloat, to I'm an issuer that is using this as a mechanism to grow or in lieu of issuing more equity and diluting equity investors. And yeah, I'm sorry, I'm sorry, finish your thought. Well, so there's kind of a weird phenomenon, right? Banks also issue debt through bank loans. So we're kind of looking through the same way. And a lot of bank loans get re-securitized into debt in the public marketplace. And the US is oddly good at this. I don't know if you guys read the unhedged pieces from the FT, but they made a really interesting point that there are very few zombie companies in the US.

7:33And there's a lot of zombie companies in Europe and Asia, these companies that have just broken, dysfunctional, non-working business models. But the sort of cutthroat ruthlessness of US banks and the US bond market kind of prevent those companies from existing. So you think that even with the zero interest rate world, because a lot of people were saying that like we have all these zombie companies that aren't being allowed to fail because rates are so low, that didn't really happen. I think the ones that are here have found a way to make it work. And the ones that are failing have largely failed.

7:59And there have been some pretty big name bankruptcies, right? Bye Bye Baby and Bed Bath & Beyond are gone, right? Like some of these happen, but the ones that are here - Right, my Bye Bye Baby down the street is turned into a spirit Halloween. There you go. Like if that's not the best - How is there a spirit Halloween? It doesn't even make sense to have a seasonal story. Is that seasonal? Does it leave? Yeah, I think it's seasonal. And then it turns into a Jake's Fireworks during the summer. There you go. So, Alex, this is an interesting dynamic that I hadn't really considered. And I'm sort of embarrassed because it sounds so obvious what I'm about to say.

8:31The relative attractiveness of bonds that were issued, say, three years ago is better, right? Because prices have come down, rates have gone up on these bonds. But the companies are not necessarily in a worse-off position to pay the coupons when they took it out. Like, if anything, some of these companies are actually in a better position. Net interest expense for companies paradoxically has gone down because they're earning more on their cash than the new debt that they have to service. So isn't that a weird dynamic where companies are, not in all cases, but in some cases as well off or better off, but their bonds, the attractiveness of their bonds has increased dramatically?

9:15It is. That's exactly what happens and what has happened. So if you look at who's like the real buyer of super short term corporate debt paper, it tends to be much more the money market space. And that's why it's hard for them to generally, for money market funds, buying that sort of paper to make a lot of money. You have to kind of buy it a year or so out where there's still some risk. But now as that thing gets closer and closer to par, that company has enough cash on its balance sheet already, and it's earning more money than it's going to pay out. So it's incentivized to just sit there. The question and the fear becomes, all right, it's safer to buy that debt.

9:47They have the money to pay me. But it might be much more expensive for them to get net new debt. So are they going to make best use of that cash? Because it's super safe to just sit on it, right, and pay out less than you're earning. But at some point, they're going to pay out that cash. It's gone. And now they're going to need to go back to the debt markets to get fresh debt to continue to grow. Or they just decide they want to get off the debt train. Turns out, though, that's fairly rare. Any company, most large companies that can get a reasonable debt stack will. And they'll continue to use that for growth, which is a good thing.

10:17R &D ultimately drives equity value in the long run. The big worry, I think, for a lot of people in credit space would be, listen, we've been preparing for a recession for 18 months. It's coming eventually. When that happens, spreads are going to blow out, and then credit is going to get dinged. Is it possible, though, that since we've already had this huge rate hiking cycle, that spreads do blow out, but it's only because treasuries are falling and not because corporate credit interest rates are rising? Is that a possibility in any world, or do you think that's not possible if we go into a recession?

10:45I think it's possible. And I think recession happens or fears of recession happening, right? Doesn't actually need to be a recession. Just needs to look like from enough people's view that there might be for that to happen because spreads will tend to lead the market, not the other way around. And I think if that were to happen because treasury rates fall, the credits that you own are probably still going to be cash good, right? And that company's theoretical ability to buy more credit might actually start to go back up in its own odd little way for companies that are well-rated and that have a history of prudent debt service.

11:20I think that's where things get a little funky in the credit world, in the bond world. We think about it, there's about 5 ,000 stocks in the US today, right? That's basically the total stock market, including some of the OTCs. There are over 2 million QSIPs for fixed income instruments. So it's not like every issuer is made equally, and it's not that every debt that that issuer has is made equally. And that's where underwriting matters. And we look at like XFIX and the way we go about it, think of us as more like a value investor, you know, traditional equity value investor. But as opposed to trying to just buy a stock at a depressed price, hoping it goes up over time, we're able to look within a company, find one who's a prudent user of capital, and then find the right space in that capital stack where we've got multiple ways to win.

12:03If they pay us back, hey, we made a nice coupon and we're really excited. If the company gets better over time and gets upgraded, which is really what we're shooting for, we now get immediate capital appreciation and we still get our cash flows, right? So there's a couple of ways for us to win there. And that's where it gets exciting. And that's when you look at recession. If a recession were to happen, there are some companies that are going to be hit terribly hard and some that are not, and they still have business models that work, right? Even in recessions, people still go to Starbucks. So, you know, debts of those types of companies are going to work.

12:34I don't know that I'd want to be holding on to Carnival Cruise Lines because I don't know what the salvage value of a gigantic ship that became a meme is when people stopped going. But there are plenty of places in between where those companies have proven time and time again that they have management that rewards debt holders. And they do a good job of paying their debts back and managing their treasury. And those are companies you're still going to want to buy. And the debt that's out there will become more valuable because it will just be harder for them to issue new debt. So you're going to want to hold on to those other credits as long as you can.

13:06Carnival's money good. Those boomers are going to be on cruises for the next 30 years, Alex. Have you been on one recently? I've never been. I've never been on a cruise, but I love the concept. It's actually pretty fun. I'm going to make it a mission of mine to do that. So for your fund, is this fund entirely credit? Can you also own treasuries? What is the actual strategy? So it's a largely credit-based fund. We can own some treasuries, and for cash management reasons, we do from time to time. We can also buy preferreds and other places within the cap stack that are non-equity that allow us to sort of maximize the income capability.

13:46And that's really what the fund is, right? It's trying to shoot for income and income where we have other ways to win through capital appreciation, through how debts that get converted from one type to another. But practically speaking, that income component is really what we're trying to optimize for. And then we want some added security for that income to be returned. What does that mean, added security? So obviously, you can always go and find a higher coupon by accepting a subordinated debt or being further down should something go wrong. And we want to be in a position where that's less risky for us.

14:23So you'll find us buying more higher up in the security level as opposed to just the true junk and aspirational items. But by the same token, we want to get rid of issuers who just are imprudent, right? To the point earlier, the debt markets tend to reward folks who issue a lot of debt. Well, that's like saying the person who has the most mortgages or car loans is the person you should give more debt to, right? And that's true for some people. There's a reason why having no credit is risky to your mortgage lender. But at some point, having some credit is good. Having much more credit is a bad thing.

14:56So let me ask you about that. So that's been one of the pushbacks on why cap-weighted index funds in the bond market might not be the best option. Because as you just mentioned, this idea that buyers are sort of indiscriminately rewarding people that are overly leveraged. Whereas the case, if you're an individual, of course, the bank would look at your ratios and say, well, this is out of whack. But doesn't the market do the same thing? The market is not oblivious to the fact that there are companies that are just issuing tons of debt. And won't the market punish those companies demanding higher rates?

15:29Yes and no. You'd think so, but the math doesn't bear that out. And we're actually, as we looked at 2024, coming up with some ETFs that will do much more equal weighting and much more, shall I say, realistic weighting of securities to get away from that concept. But if you look at, say, the two or the three-year credit indices, about two-thirds of all of the names are going to be banks. And it's because banks are prolific issuers of debt, right? They give loans out and then they issue debt to help fund those loans. And that's their business model. But if you go through it even further, if you look yesterday, like some of the top 10 in the high yield space, as an example, five of the top 10 names were different Ford Motor Company credits that were traded.

16:06And it wasn't Ford making vehicles. It was Ford giving out auto leases and auto loans, right? So, and Ford's got everything from, you know, a six and a half percent coupon to a 2 % coupon, all of which were issued recently and all of which are due in the next six years. So it's kind of all over the place. Companies that have an underlying business model where they're cash good tend to not have to take that premium. Companies that issue a lot of debt and don't have a history of actually making good investments with it are the ones where they get penalized. But at some level, in this mad rush for debt, a lot of companies who may not be able to do a whole lot with it are able to raise that credit.

16:45And some of them actually pull it off, whether they meant to or not. And as a result, there's a sort of indiscriminate buying behavior that happens. And if you talk to folks on very large desks, they'll tell you, we participate in every new issue. And some of that's because some of the larger bond funds have so much money. They kind of have to participate in every new issue because they otherwise wouldn't have anything to invest in. And that would fall outside the mandate. So there's this weird balance of just the supply of capital in the credits world that just keeps issuing and buying the new credits.

17:17versus the selectivity of how much those things have to be sensitive. And in all fairness, 6.5, 6.4, 6.6, right? Sometimes the deals just get priced because that's where the market is that day, and it gets priced. It doesn't have enough time for all of the participants to sit down and have a very reasoned debate about it. And if you've got capital that has to be invested, at some point you've got to buy the Ford credit that came out or the bank credit that came out or the something else that came out that day. And that's what a lot of bond managers end up doing. This might be hilariously dumb, but just as a thought exercise, what do you think a fixed income portfolio that mirrored by weighting the S &P 500?

18:01So if you have a bond portfolio and 80 % of it was Apple debt and 5 % of it was Amazon debt or whatever, what do you think that would look like? Would that just look like sort of a generic LQD type of ETF? I think it would look probably fairly different than what you see today. It's just because so much of the debt that's out there, et cetera, is banks. I mean, the bank sector, and let's call it 20 names, just dominates those indices in general. Okay. So the equity market is overweight to information technology. The bond market is overweight to financials? Absolutely. That makes sense. And if you think about from a standpoint of the company itself, Google doesn't need to.

18:39It issuing debt is really just an exercise in what's cheaper for me today, debt or equity. And for a while, they were issuing debt more or less exclusively to buy equity back, right? Because they could get debt near zero and buy equity back. That was a great game. It worked. It worked. And it worked for a long time. And some of that debt is still outstanding. And great news is the equity value return was so high that it worked out. The other companies that tried that didn't work out so well. But statistically, I think you'd have an interesting portfolio, but I don't know if that's a portfolio you want to own because the bigger the equity – take the companies in the information technology space.

19:17I don't know that those are always the best credits because many of them now are so profitable that they can command really, really low coupon rates. Some of them trade. Some of them don't. If you take LQD out of it, but look at the AG or AGG or a handful of these large funds that track traditional bond indices, you'd have to go and check the math out. But I assure you, not every security in those indices trades every day. They all have prices. They've been asked to spread, but they have no actual volume. And if you go into the muni world, it's even worse. There could be a large percentage in the muni world that doesn't trade on any given day.

19:52and you look at a bond deal that comes out, right? Ford has one equity. It's got a thousand other Q-sips, but a new deal might have 10 or 15 different tranches in it. They don't all become as liquid as folks think. They didn't say there wasn't a market for it. They just don't have trades. Isn't that actually a good thing about the fixed income market? Like they shouldn't be trading so much? Maybe, I mean, until you want to trade and then you're in trouble, right? Like there's the balance of liquidity. Like buying more liquid things is better. You can look at an OAS or you could adjust that for duration and say, okay, where do I want to be?

20:24And there's that balance. Institutional investor who knows I'm going to hold on to these credits till maturity doesn't care about liquidity at that point. They just want to know that they're cash good. But as individual investors, particularly those looking at bonds or us putting things into XFIX or SMAs, we care very much about liquidity. We want to know that the price you're getting marked at is a fair price that you could buy or expect to sell at tomorrow. Otherwise, why would you give us your money, if the first thing that's going to happen is you lose some percentage of it to bad pricing.

20:53And in general, we've done a good job of avoiding that. And you see this all the time, right? Like a bond will come out exclusively in round lots. And the first thing that happens to it is it gets distributed into all these different odd lots. And the odd lots trade with a different price than the round lots. And then you watch as folks who are sellers of it for whatever reason, go to a broker dealer who picks up the odd lots, eventually accumulates them until they get to a round lot and then it can go off to one of those. Alex, can you just for the listener just explain the difference between the two?

21:21Sure. So folks are very used to going to an exchange to buy security. You put one share in and someone will give you a price. That price would be pretty close to the NBBO today for liquid stocks. But in the bond world, you start trading things in$1 ,000, $10 ,000 face and you start accumulating a different set of bonds. So the round lot unit in the bond world is worth a certain trading factor that you see that bid ask spread on. But now when you're going to sell individual bonds or smaller numbers of them, 17 here, 256 there, the actual pricing is different. There's no exchange. A broker-dealer is actually going to buy that from you and probably sit on it for a day or two before they can find someone else to buy it.

22:01And when we allocate, we tend to allocate to round lots. We don't tend to allocate to odd lots. It just wouldn't make sense from an investment standpoint. So to overcome that risk, the pricing for an odd lot is just historically worse than the pricing for a round lot. And the broker-dealer industry for bonds is very developed because there's no exchange. So if I have a bond I want to sell, I put out a request to a handful of brokers I work with, and then they'll come back and start bidding me prices. But they're not necessarily aware of what anyone else in that process is bidding. So there isn't this like open amount of information.