Harley Bassman on Why the Big Moves in the Bond Market Are Done

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1:15Hello, and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, you know what one of the weirdest things about 2023 was? I mean, I guess there's, that's an unfair question, isn't it? Why don't you just tell me what's on your mind? I could make many guesses, but why don't you just tell me? So after all the drama in the bond market, all the ups and downs, all the volatility, we basically ended the year kind of where we started, right around 3.8 % on the 10-year yield. And I know it's picked up a little bit since then, but we basically had this really round trip, but a lot happened in between.

1:54That was a great choice, Tracy, for one of the weird things that happened. Yes, that was a huge story throughout the year. bonds sell off higher rates, et cetera. And then to get to the end of December and say, oh, yeah, the 10 year is basically where it started the year. Extremely strange and unexpected. And when I saw that stat, I was like, I did not anticipate that at all. Yeah. And to me, maybe this is going to be a bit of a tortured analogy, but 2023 is sort of emblematic of the bond market overall. People tend to look at it and think it's super boring. Normally, you know, before the wild years of 2021, 2022, 2023, it didn't move around that much.

2:32You know, bonds were supposed to be boring in that sense. And I think people have this view of like, okay, you buy a 10-year or maybe you buy a tip or something like that. You invest in T-bills to get a little bit of pickup, or maybe you sell some bonds. And that's basically the extent of investing in the bond market. But there's this whole world when it comes to trading fixed income and interest rates that gets really interesting, really complicated in some ways. And I feel like we don't talk about it enough. Like every once in a while it hits the headlines. Like, you know, when Bill Gross was talking about selling volatility before he left PIMCO, everyone was like, oh, wait a second.

3:15There's a big bond investor selling volatility. I wonder how they're actually doing that. But more often than not, we talk about yields. We kind of connect them to what's going on in the macro economy and inflation and maybe the U.S. debt. And that's it. No, you're totally right. I mean, there's really two things. I mean, A, part of the story for bonds over the last two years was the end of this incredible 40-year bond bull market or treasury bull market. And there were a few interruptions, of course, in 94, et cetera, and we know about that. But by and large, bonds went up, yields went down, and bonds were like a nice hedge against your equity portfolio and 60-40 type portfolios were great.

3:57But then the other thing is you say, like, if you talk to an equity manager, they'll be like, oh, I like tech stocks. This year I like energy. You know, some rotation. We like big caps. We like small caps. We like international. But it's like different flavors of being long. Whereas, you know, when you look at how a lot of fixed income portfolio managers invest, as you say, it is often various flavors of derivatives around fixed income or, you know, spreads and things like that rather than just sort of long here, long there. Exactly. So I am very pleased to say that today we do, in fact, have the perfect guest to talk about the intricacies of fixed income.

4:35We have someone who actually used to work at PIMCO. He's now managing partner at Simplify Asset Management, perhaps better known as the Convexity Maven. So we're going to be speaking to Harley Bassman. Harley, thank you so much for coming on the show. Thank you. Good morning. Very excited to have you here. I should have added to your intro that you are also a master of colors, right? Which we're going to get into. The best color line charts in the business. Thank you. So I have a question to begin with, and this is completely out of self-interest. As a journalist who's had to write about convexity at many times during their career and has always struggled to define it in a way that satisfies my editors who want to encapsulate a financial relationship in as few words as possible.

5:23How would you describe it? You know, convexity, it's an X word, so everyone gets a little rattle about that. But it's actually rather simple. It's just unbalanced leverage, which was also a hard concept. Let's simplify it a little bit. If you have a bet you're making, a wager, where you make a dollar or lose a dollar for equal up and down, opposite payoffs, that's zero convexity. If you make$2 and lose one, that's positive convexity. If you could lose three and make two, negative convexity. The reason why we hired all these, you know, PhD, you know, quants in the 90s was to basically figure out what that's worth.

6:03Clearly, you'd rather own something that makes two and loses one than is one to one. And if it's lose three, make two, you better get paid for that. And so all the mumbo jumbo we go do around pricing out these various paths and payoffs is just to make it a fair bet when you have these different payoff profiles. And that's it. Convexity just means that the payoff is not linear. It's not one-to-one. Every once in a while, you get to do something really great on this podcast, Joe, and asking the convexity maven to define convexity is one of those things. This was a historic moment. We're going to clip that.

6:39But let's go further down that. So often you hear about, like the most common time you hear about the phenomenon of convexity in the fixed income world is often related to mortgage-related securities. Can you then, can you take it a step further and sort of give us, what does it mean? So you describe the search for positive, naturally occurring positive leverage in the world. Give us sort of a concrete example. Why does this pop up when we talk about mortgages frequently? Well, you're probably backing into the idea of, are mortgages a good value right now or not? Let's just go one step back. Yeah.

7:13When you're in the bond market, not equities, the bond market, you have three buttons you could push. That's it. Okay. Duration, credit, convexity. Those are your three risks. You start with cash, overnight cash, and anything you do past there is taking one of those three. Duration is when you get your money back. Credit is if you get it back. Convexity is how you get it back. And what a bond manager is trying to do is move around those three buttons to find the best risk return, the best value. Presently, selling convexity in the bond market is the best thing to do out there right now. What's duration?

7:52It's when you get your money back. So a two-year security will move 1.8 points for a one-point move. So if rates go from four to five, a two-year bond will move by 1.8 points. a 10-year by about eight points, a 30-year by maybe 17 points. You're usually paid more to take longer maturity risk because there's more uncertainty. An infinite curve is kind of upside down land because you're getting paid less to take more risk. We could talk why that is in a little bit, but right now, duration is a very weird place to take risk right now because you're paid less to go out the curve and buy a 10-year versus a two-year versus overnight cash.

8:31Credit. Right Right now, investment grade credit is trading about 57 basis points. It's a little over half point over the yield curve. And you get that from looking at these interest rate derivatives. On your Bloomberg, it's going to be CDX five-year. That's actually tighter, a smaller number than its historic average of about 65, 66. You're paid 57 now. Junk bonds are paid about 360, 350, 370, which is also much tighter than its usual 440, 450, 460. So going into credit now, you know, that's not a great bet. I mean, I wouldn't say it's a disaster, but I mean, considering we're concerned about the possibility of over-tightening, a possibility of recession, which is an inverted curve kind of signals, I don't really want to go and take credit risk.

9:19Convexity, right now the move index, which is a measure of the price of convexity the same way - Which you invented, right? I did. It's the VIX of bonds, plain and simple, the VIX of bonds. Its average is maybe 90 or 100. It's trading 120 now, which averages out to about maybe seven, eight basis points a day of market movement. That's higher, much higher than its historical average. That's the kind of trade you want to go and do. and mortgage security is simply a glorified buy right. That's it. Wait, can I ask at a moment like this, when, as you point out, there does seem to be a lot of uncertainty, you know, some people are still saying that there's a lot left to do when it comes to stamping out inflation, but the market is already pricing in rate cuts and some people are still worried about a recession.

10:09Is the important thing to choose which of those risks you want to take on, duration, credit, or convexity, or is the important thing to do to identify the exact right expression of the trade? Well, clearly, if you know where rates are going to go, you just go and buy futures contracts and call it a day. I assume that we don't know where the market will be, usually. And therefore, when you're building a portfolio, what you want to do is you're always going to have some exposure to all three of those. What you're trying to do is over or underweight these various sectors, depending upon your market view.

10:45So right now, what I'd be doing is overweighting the convexity, underweighting the credit, and then duration, I'd be pulling into the five-year or earlier on the curve for a variety of reasons.

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12:32Because as you say the move index, your creation is higher than normal, unlike, say, you're not getting paid for credit. How do you express that trade of going long convexity? And what does that look like? Well, actually, we're going short convexity here. Okay, short convexity. Yeah, yeah, sorry. Yeah, yeah, yeah. In general, I tend to be a long convexity person. And I like the idea of making two, losing one. So I've done most of my career owning convexity, owning optionality. However, as they say, no bad bonds, just bad prices. There is a level where I will sell it, and we're at that level right now.

13:07Before the Fed came in and really scrambled things up in the last decade, the old rule was on the move, you buy 80, you sell 120. The problem with that is nobody would do it. Why is that? When the move got down to 70, 80, that means the market's not moving that much. And therefore, who wants to go and buy optionality? who wants to pay time decay when the market's not moving. No one does. So no one buys it when it's low. And when it's at 120 or higher, no one sells. You have some crazy event going on. People are hiding under their desks crying for mommy. So no one sells it at 120. But the reality is you're supposed to go and, you know, not go naked short optionality, but you can go and just bias what you do to make yourself either short convexity or maybe it's a little less long convexity in your portfolio.

13:52Just so that we can, like, when you say, like, okay, short convexity, What is the type of instrument that allows any trader or investor to express that idea? Well, the most simple strategy would be for an investor who owns a stock portfolio to go and sell covered calls. I mean, you're selling options, you're selling convexity. When you go and you sell covered calls, what are you really doing? You're kind of converting potential capital gains to current income. You're limiting your upside. Your downside, of course, is still large because the stock can go down a lot. But you're basically kind of doing a conversion there of taking risk off the table for current income.

14:30And there's a price where you want to go and do that. And there's prices where you don't. When the VIX is at 40 or 50, I mean, you probably want to sell covered calls. Of course, you won't do it because you'll be in a panic. But that's kind of the idea. And theoretically, portfolio managers are supposed to have no blood in their veins. And they can go and do these various trades when the time is right. This is why I'm not a portfolio manager, Jared. Yeah, me neither. Because I, in fact, have blood. But actually, this brings me to a question I always wanted to ask, because a lot of your trade ideas, I think they're publicly available.

15:00So like every year you publish stocking stuffers, which is kind of a series of trade ideas. And I'm never quite certain who those trade ideas are aimed at. And the reason I say that is because you will say stuff in them like, you know, and if you don't have an ISDA credit agreement, here's a way to get around that. But then the trade itself is still quite complicated. So I assume it's not aimed at your average retail investor. Who is the target audience for some of these things? Well, I'll say that as my career has gone by, I used to target high-end institutions and hedge funds. I've now moved more towards, I would call it reasonably intellectually sophisticated high net worth retail.

15:43Is it geared towards the average person? Probably not. But you can still take these ideas and take the flavor of them. You don't have to do the exact idea. You can just do the flavor. So if it's a duration concept, you can take your portfolio from a 10-year area to a five-year area. If it's a credit area, you could move into, you know, single A from double A. Things like that. But yes, you're right. A lot of my ideas are a little tricky and entertaining, hopefully also. But yeah, it can be a challenge. They are always entertaining. That is definitely true. But, you know, if you say something like short convexity, for a simplified trade, I would think do something with the MBS index.

16:25But that's not what you're advocating at all. Not right now. Well, my new job, I'm with, I hate to give a plug over here, but I'm at Simplify Asset Management. And what we are doing is we're taking a lot of the ideas that I've had and putting them into ETFs. There was a SEC rule change a few years ago that allowed people to put derivatives, futures, options, all these various things into ETFs. And what we've been doing is putting these derivatives into ETFs, which you could basically point and click on Robinhood. So, for instance, two and a half years ago, I created an ETF where I put a seven-year put option on the 30-year treasury, more or less, into an ETF.

17:07And this was actually, I think, Bloomberg Rankin is one of the highest return trades for a while. I mean, from - Is this the PFIX ETF? Yep. It was up 200 % for a while. And it's basically a straight up, you know, way to make money if rates go up. That was it. And it was a way for civilians to get to institutional products. And I have a new product out there where it allows civilians to go and buy mortgage bonds. Mortgage bonds are, it's the second biggest asset class of bonds after treasuries. And it's almost impossible to buy them for ordinary people for a variety of reasons. And what we've done is we have institutional quality trading abilities that we could put into ETFs.

17:54We're allowing, enabling civilian investors to buy mortgage bonds that are trading near par. And right now, these par mortgage bonds, bonds trading near 98, 99, 100, are what I view to be the best fixed income investment on the planet. Right now, they're trading about one and a half points over treasury. Sorry, just a minute. What instruments are the best fixed income investment in the planet? Near par. So near us right now, five, five and a half percent mortgage bonds. Okay. And how come? Sorry, you were about to explain it. Why are they the best investment right now? Well, mortgage bonds, for all intents and purposes, are U.S.

18:32government guaranteed. Fannie and Freddie are not guaranteed per se. Ginnie Mae are. I can assure you, Fannie Mae will never go bankrupt. If it was to go bankrupt, my advice then is to go buy cans of tuna, a gun, and small denomination gold coins, because it will be the end of civilization. Okay. So Fannie Mae is not going bust. You could buy these mortgage bonds yielding about 5.5 % right now, which I could help you go and do, which is about 1.5 % over treasuries. Corporate bonds that can default are only 57 basis points over treasuries. And this is kind of crazy town where you could buy full faith and credit of the US government almost 1 % higher than a corporate bond that can default.

19:13And if you are a believer in a hard landing, will default. But the risk with the MBS, like the normal MBS that you would see in the index, not the stuff that's trading really close to par that you're picking out, is prepayment risk, right? That's what you're trying to avoid. So I think the better question is, excuse me, why are these mortgage bonds trading 1 % higher than corporate bonds when clearly there are smart people in the world? The reason why is a mortgage bond looks and barks like a covered call, like you're selling this big call option on a 10-year treasury. And with the move at$120 ,000, that's the way you basically do a covered call.

19:53This is the way you go and take convexity risk as opposed to credit risk. These par mortgage bonds can be prepaid. Therefore, a bond trading at$99 ,000, maybe it can go to$102 ,000,$103 ,000,$104 ,000 before it gets called. That's what you're giving up when you buy a mortgage bond. is you're giving away the big upside. So if rates go from four to two, a par mortgage bond, not gonna be so good. I mean, you'll make money. You'll just make a lot less. And if rates go up, these bonds will go down like a seven-year treasury. You mentioned credit risk just then. At this point in the economic cycle, how worried are you about credit risk?

20:31Given that going into 2023, there were a lot of recession fears. There were a lot of credit experts that explicitly said they thought that defaults were going to pick up substantially, things were going to start to fall apart in the credit market. And instead, you know, November, December, we saw a pretty big rally in the space leading to very low spreads, which you've already pointed out are kind of in crazy town territory, at least compared to some other possible investments. So how worried are you about things like defaults in 2024? Defaults in 2024, not going to happen. Next year, they might, when we have to refinance all the debt that was taken out.

21:10This is called the maturity wall. And there's plenty of graphs and charts about this. On this podcast, you have to say looming maturity wall. That's the rule. OK, looming. Yes. Well, it's looming, but it's coming. So I'm more interested in inflation than in default, than in hard landing ideas. And the reason why is I think that the demographic of these boomers retiring, retiring with a lot more money than their parents had, which means they're going to keep on spending. The old rule was when you got older and you retired, your spending was reduced because you had lower income. The boomers, well, we took all the money, OK?

21:47I'm sorry. At least you're honest about it. I appreciate that. We took all the money with the stocks, with the bonds, with the housing, with everything else. And so we're going to keep on spending, but we're not going to work anymore. So we're pulling out the supply of labor, right? The millennials, they're working and they're getting married and they're having kids. So they have this demand. They're going to buy stuff as they form households. And that's what I think is going to keep inflation pressures up. The same way we had inflation in the 70s as the boomers, right? Matured, formed households, bought cars.

22:18So I'm a believer that inflation, the 2 % target is not coming anytime soon. There's a good story why it might. I'm just not a believer in that. And I also think that the Fed is not going to take rates down nearly as much as the market is implying by the futures market. And I think that Jay Powell, good guy, bad guy, I don't know. What I know is this. He has a lot of money. He's a nice family, nice kids, probably a nice house also. What does he care about? What do we think about? What is humanity all about? We still read the Greek tragedies. We still read Shakespeare. What do these guys all talk about that's still so interesting 3 ,000 years later?

22:55hubris, ego. That's what drives humanity. It's always the fall of humanity. And I think what Jay Powell's thinking about now is really not inflation per se, but what's my tombstone going to say? Yeah, legacy is a nicer way of saying ego. Is it going to be Arthur Burns, who basically, we all, as the poster child for inflation, you're going to get a hand? Or is it going to be Paul Volcker, the saint who saved us from inflation? Some people will say that it wasn't him, It was demographics, but whatever, whatever. He wants to be Volcker, not Burns. And therefore, he's going to go and I think hold rates up longer than people might think to go and ensure inflation is truly, wouldn't stake in the heart dead.

23:33So, I mean, I definitely want to get more into the sort of, I don't know, maybe psychological approach to forecasting the Fed. Maybe we spend the rest of the show on that. But I do want to go back and talk the sort of boring stuff about the mechanics of mortgages real quickly. on spreads. So the spread between the 30-year, I just did like a subtraction function, the most crude thing, but, you know, 30-year mortgage minus 30-year treasury. You know, a few years ago, that spread was, I don't know, like around 1%. It got as high, you know, got around three and a quarter. It's come down a bit, 2.8.

24:07So just why are spreads as high as they are? How would you describe that gap between mortgage spreads and treasuries right now? Why is it still at such historic highs? Okay. You're supposed to use the par mortgage rate on Bloomberg MTGE FNCL. Use that. Okay. Versus the 10-year swap rate or the 10-year treasury rate. It's not going to be much different, right? You'll see about a 75, 70 basis point spread historically back 30, 40 years. Okay. It's now at 150. Why is it there? Two reasons. The easy one is vol is high. The move's at 120. That's the easy one. The harder one is that the curve's inverted.

24:45That's going to require a lot more explanation that you can go look at my commentary on my website to go read about. But those two things, the inverted yield curve and high volatility. And you're going to see when this curve steepens out, which means the two-year rate comes down below the 10-year rate, you're going to see mortgage bonds in general go up. You'll see mortgage yields come down. You'll see the retail mortgage rate come down. So that's coming. Not yet, but that's coming. Wait, but one of the questions about the recent dynamic in mortgage rates is it has fallen quite quickly, even though the spread between mortgages and treasuries is quite wide.

25:23I think that's the question. Like, why is it? It moved up really quickly in 2022, 2023, shot above 7 % and then eventually 8%. But now it seems to be falling really quickly, even though a lot of people thought there were structural changes in the market that meant rates were not going to be able to come down that fast. Look, as I said, the mortgage bond market is the second biggest market after treasuries. of that spread of 150 drives the retail rate. The retail rate is going to be, let's say, another three quarters to 1 % over that rate. It's a business and it's a competitive business and it kind of grinds along.