Rethinking Bonds: How to Strengthen Your Retirement Portfolio in Today's Market With David Braun (EP.180)

0:28We all need to make smart decisions with our money. to the show to explain some important fundamental concepts that really unlock the potential of bonds, in my opinion. David has been with PIMCO for 15 years, and he's a U.S. Generalist fixed income portfolio manager in the New York office. So I asked him to join me on the New York Stock Exchange and share some of his tremendous experience in the investment and risk management areas. We cover all sorts of ground. We cover the role of core bonds in a portfolio, the impact of rising yields and how that should reset our expectations for bonds. We also touched on active versus passive management because it's a little different in bonds than it is in stocks.

1:09And finally, I was super interested to hear David's opinion on the impact of the U.S. national debt on bond investors. As always, you can find detailed show notes and links to all the resources mentioned in this episode by visiting thelongterminvestor.com. And now, here is my conversation with David Braun.

1:31David Braun, welcome back to The Long-Term Investor. Thank you so much for joining me here on the floor of the New York Stock Exchange. Thanks for having me, Peter. Super excited to be here. Well, I would try to take you to a bond exchange. But you have bond ETFs here, PIMCO has stock ETFs. But while that advancement seems obvious, when I started my careers in June 2007 and And the RIA I was at, we traded individual bonds for people. We bought lots of mortgage-backed securities, and it was really their sweet spot. And over time, the development of bond funds seemed like the obvious choice. For reasons that I could easily say, but I don't want to steal your thunder, when you talk about the management of a fund, what do you feel like are the big advantages of owning a fund of bonds as opposed to owning a portfolio of individual bonds that you're managing on your own?

2:19Yeah, so look, I get it. A lot of retail investors like that security of seeing their bonds, buying their bonds, owning them. They get to clip the coupon income. They get to control when they sell them, thus realizing a taxable gain or loss event. And it just kind of feels nice. But that strategy comes with risks or with trade-offs. And some of those trade-offs are quite expensive in our mind that could lower your return and actually add to your risk. So first, let's start with the bond market itself. It trades over the counter on like a stock market. It's less efficient. So what that means is if you or one of your clients goes and buys a share of a stock that's in the S &P 500, they're probably paying the same price that a large institutional investor would pay because it's an exchange-traded, high-efficiency market.

3:00The bond market, I guarantee if they go buy a bond, they're probably paying more than a big institutional investor like PIMCO would pay for that bond just because of the frictions and rigidities in there. And they're not even going to see that they're paying more because it gets baked into just a lower yield, right? I mean, by the opaque, it's kind of like a transaction cost that's very elusive to understand. Second thing is the information asymmetry. Like everything on the S &P 500, they file the same financials. It's hard to garner a big information edge there. On the bond market, just take the Bloomberg aggregate.

3:28There's something like 13 ,000 individual QSIPs in their bonds. So there's a big information asymmetry where active bond managers like us can get an edge by getting more information than a retail investor. Next, on the risk side, this is important. Unless you're really high net worth deploying tens of millions of dollars in the bond market, you're probably going to be stuck with lumpy positions, concentrated positions. What that means is if you get a call wrong and you get a credit that goes south, it could leave a big disproportionate size hole in your portfolio versus an actively managed bond firm that's going to do prudent diversification.

4:01The final thing I want to say is, again, unless you're a massive individual with a lot of money, you're going to be stuck trafficking in the most generic bonds out there. So treasuries, agency mortgages, and then the most liquid corporates. And in our mind, the more generic a bond, oftentimes what we observe is the less spread on those bonds because everybody and their brother can buy them, right? So kind of this juice has been squeezed. There's not a lot of yield left. We like to go where there's opportunity, where bonds aren't trampled over, aren't all the juice squeezed out of them, and we get a higher spread and maybe even a more attractive risk-reward profile.

4:34But look, we get it. Some investors really want that. So we try to partner with them. At PIMCO, we got what we think is an industry-leading investment engine, and we want to deliver that to folks. If they want their own bonds, we can run a laddered portfolio for them. We can run a separately managed account with individual line items in there. But again, it comes with those trade-offs I just mentioned. We also have a hybrid product that a couple of us in the industry have, where half your investment is QSIP-level bonds, and the other half is a 40-act mutual fund that's kind of the completion fund.

4:59So that's where we get the more off-the-run, less generic securities, more yieldy securities, and you glue those together and you're close to if you bought a fully active managed bond fund. And then finally, if you're ready to step outside of seeing your own bonds, we would promote buying an actively managed bond ETF or mutual fund. That's where we can deliver the most value to our clients and investors. Well, and I feel that people who own individual bonds did so from a place of that was the only option once upon a time. And even as I think about the development of product in the fixed income space, it's gotten so much more dynamic and intelligent where it used to be, if I am an investment decision maker at my firm, I need to decide when to extend duration or when to pull back on credit exposure.

5:43Whereas now there are these core funds that can really get you that broad market exposure, own thousands of bonds and sort of take that decision making process out of the advisor's hands and give it to somebody who does have the deep expertise. So in that line of thought, I mean, your feelings of core bonds, I mean, what is the role that that typically plays in a portfolio? What is the importance of the exposure? Yeah, so what core bonds means to folks might be different, but I'll keep it simple. Core bonds to us means U.S. public securities that are relatively modest in duration, so like five or six-year duration, high quality investment grade, and diversified.

6:19The most bellwether core index out there is the Bloomberg U.S. aggregate index, bond index. It's about 45 % treasuries, 30 % investment-grade corporates, predominantly U.S. issuers, and then 25 % Fannie, Freddie, Ginnie, agency-guaranteed mortgages. That's what most people would call core. And that Bellwether benchmark is what's out there. So when we think about the role of core bonds, which I think was the genesis of your question, bonds have been dragged through the mud the last few years, right? And let's talk about this. And I know you and I did one of these a few years ago. So why do you own bonds?

6:50You remember, why was the 60-40 founded? You own bonds in the 40, your 60-40, to offset your equity risk. So bonds are a store of value in capital preservation. That's the first reason. Second reason is they kick off income. And then the third reason is, at least historically, they were negatively correlated with stocks. So they provide insurance. If your stocks are going down, your bonds are probably going up and vice versa. Now, let's walk down the last four years and we'll show how none of those three really worked. And therefore, bonds have a bad reputation right now. But we think People are looking backwards, not forwards.

7:19So first, talk about the capital preservation. 2022, when the Fed started hiking, how'd capital preservation work out for people? Not well. Bonds generated their worst ever loss. The Bloomberg U.S. aggregate had its worst ever drawdown in 2022. Note surprise, the Fed started at zero, had to hike all the way up to 5.5%, bonds got hammered. So capital preservation didn't work. Talk about income. 2020, 2021, the U.S. Treasury bottomed out at 50 basis points, half a percent in August of 2020. That was actually attractive. German bonds, Japanese bonds were negative yielding. So people were like, well, there's no income on bonds left.

7:52And that's what we learned in 2020, 2021. And then finally, that negative correlation, ever since COVID hit, the Fed did its quantitative easing. We did fiscal stimulus, both bonds and stocks, the correlation shifted positive. For the first 18 months or so, the correlation was positive and they both went up, right? We're doing that stimulus, bond funds went up, stock funds went up, great. Then 2022 hits. By the way, nobody complained when they both went up, right? And then 2022 hits and the Fed has to hike and the correlation stays positive, but both bonds and stocks go down, everybody can play in 60-40 is broken.

8:22That's the history. That's why bonds have a somewhat tarnished reputation now. But people need to look at where we are today and where we're going. Right now, this fight against inflation, we're still in a little bit. It's almost largely conquered, but it has caused a generational reset higher in yields. You look at the yield of the ag, 4.5%. Any active manager should be able to get you up 5.5 % or thereabouts. And then if you move out in the credit risk spectrum, more of a multi-credit, like our income fund, that's more like 6.5%. So 4.5%, 5.5%, 6.5%. Those are pretty attractive yields. In fact, you've got to go back almost 20 years to find the ag yielding levels like that.

8:57So very attractive. Second thing is we think that correlation is back, okay? Because look what happened. A couple months ago, we had the yen carry trade blow up. What did people do? They bought bonds. Bonds rallied like crazy. So within that negative correlation, now that the Fed is normalizing policy and not kind of manipulating the markets by either stimulating or by inflicting pain on it in the inflation fight, Fed's going to get out of the way. And we're going to have willing buyers and sellers dictate the prices of stocks and bonds in the relationship. And we're starting to see that positive or negative correlation come back.

9:26And then finally, capital preservation, just do bond math, right? We're at 5 % type yields. You need a huge rise in rates to get a negative return again. The problem with 2022 is we started with like 1 % yield on the ag. So any rise in rates was going to rip through and tidal wave the yield that you were getting. Now we've got nice tailwinds from that yield that should propel us forward. Another thing I'd say is we get this a lot. I don't know if you and your advisors are getting this, but should the weights of 60-40 be static? And we would argue no. Just like any investor, you have to figure out what's your long-term goals in strategic asset allocation, but also what's priced in right now.

10:03And when we look at a market where growth is clearly slowing, like the U.S. grew in 2023, slightly north of 3%, we're probably going to go north of 2.5%, 2.6 % in 2024, depends on the fourth quarter comes in. And then next year, we're saying we're going to go more one-handle, like 1.7%, 1.8%. So that's about our potential, but that's rapidly shrinking from where we grew the last two years. And you have to recognize that when you're growing slower, there's less room for error, meaning recession probabilities have to be rising. If you're growing at 3%, the economy can handle a couple body blows and stay positive.

10:34You're growing at 1.7, you get a few hiccups in the economy, you can easily go to recession. So you've got a slowing economy, rising recession risks, bonds are priced the most attractive they have in 20 years, and then stock valuations are at all-time highs. So we might even argue, if you want me to get a little provocative here, that maybe the weights on 60-40 need to be flipped. Maybe 60 % in bonds, given the backdrop of the economy I just mentioned, the starting yields, and the starting stock valuations. So that's kind of a view we have right now. Well, it's interesting to unpack some of the things that you were talking about.

11:05When I think about 2022, worst bond market on record for the U.S. Aggregate Bond Index, one of the things that happened at the beginning of 2024 is that the market was pricing in all these Fed rate hikes far more than what we're going to have ultimately gotten. And when the Fed sort of said, hey, guys, we're not going to be hiking rates that much, there was a big jump in yields at the beginning of the year. But the starting yield was higher. And so it offset those losses. And I feel like so many bond investors have been afraid of rising rates because they cause price declines. But now that yields are higher, there's a little bit more cushion there.

11:39And as you note, with yields being more attractive than they've been in 20 years, there are some people who now have to think a little harder about where they go on the risk spectrum with their stock bond split and with what they do in their portfolio. But the one thing that is probably most interesting to me, and it's something that took me a very, very long time to appreciate and understand is that I think a lot of my listeners would say, hey, low cost indexing all the way, no matter what. But indexing in bonds is a very, very different thing than indexing in stocks. How is it that you explain the difference between active management in the bond market, relatively speaking?

12:15Yeah. So first, the debate between passive and active has been going on. It's kind of like debating politics or religion, right? But look, you asked a guy from PIMCO here, so I'm going to advocate for active, right? So look, We firmly believe in active management. Like we don't have a whole bunch of passive products and we don't talk about both sides of our mouth. We believe in the bond market. For a lot of those reasons we just talked about, the inefficiencies, the opaqueness, the over-the-counter nature of it, that active management does work. You go to our website, PIMCO.com, we have papers called Bonds Are Different that show, yes, in large cap active equities, the majority of active managers do not beat their passive peers net of fees.

12:50Something like only 25, 30 % of them do. On bonds, bonds are different. It's flip-flopped. Our data shows not just PIMCO funds, but the universe of active ETFs and mutual funds in bond land, it's almost the opposite. 75 % to 80 % over five, 10-year, even longer periods have beaten their passive pairs net of fees. Now, why is that? So the data says, hey, something's different here. It goes back to a lot of those inefficiencies I mentioned before, but I'll elaborate on a couple more. So again, go look up bonds that are different, get the data. But here's why. First of all, the bond index is inherently hard to replicate.

13:21Again, S &P 500, it's 500 stocks. Right. It turns over four or 5 % a year where maybe 10 or 20 names drop out and new ones come in. The Bloomberg aggregate is over 13 ,000 individual bonds and about 25 to 30 % of them drop out every year. So you're inherently chasing a more complicated index to replicate and it's got much greater velocity of turnover. Second thing, that information edge I mentioned, right? There's a lot of bonds that aren't even in the index that an active manager can go shopping for and put in a portfolio that give a more attractive risk adjusted return profile rather than just stick with the generic stuff in the index.

13:54Next, in the bond market, I don't think a lot of central banks, Southern Bank of Japan has bought equities in part of their QE. In the bond market, oftentimes valuations in our space get tidal waved by non-economic investors. Look at the Fed. During COVID, they bought 5 trillion of bonds. Peter, when they were buying those bonds, they weren't trying to pursue alpha like I am. They were buying to stimulate the economy and provide lubricant to the market. That creates distortions. You also have asset liability players who are buying bonds simply to defease and match a liability, not really generate a bunch of alpha.

14:23What that does is it creates distortions in the market that we act and manage to take advantage of. Something as simple as agency mortgages. When the Fed did its QE during COVID, they bought so many mortgages, trillions of them, that they distorted valuations. We basically sold all of our mortgages or the bulk of them, waited for prices to rebound and then bought them back. That's something a passive manager doesn't do. Passive manager says, by the way, 2020 and 2021 was the largest refinancing wave America's ever seen. So guess what? More mortgages went in the index. The same that Fed was buying them, the spreads were really not attractive at all.

14:55And you were forced as a passive manager to buy more of them. Doesn't make sense. And then finally, if you look at the corporate components of the ag or corporate index itself, they're debt weighted. Meaning you inherently lend more of your money to the most indebted companies. I'm a simple person. I always try to use analogies. Imagine if you and I started Dave and Peter's bank and our underwriting manual on how we give out loans was simply to ask customers, how much debt do you already have outstanding? And they said, I've got none. We would say, you know what? You're not for me. You're not in my index.

15:24If my analysis is not clear. Yes. If they say, I've got a ton of debt already. I just need more. We'd give them a big loan. It's the opposite of how you should lend your capital. So we think we're actually past the point of peak passive, right? So I think a lot of people are now embracing this bonds or different narrative that we've been championing for five, 10 years or even longer. But I think peak passive was probably during those low rate environments of COVID, right? 10-year treasury, 50 base points at ag yielding less than a percent. Maybe people are like, I'll just camp out on passive. And maybe I get that.

15:52Maybe I don't. But right now you've got a dynamic where rates are higher. There's a lot of uncertainty in the market. Think about what's going on. What's the next presidential policy going to be? What's going on with the geopolitics? Are we done with inflation? Uncertainty breeds volatility. And you see it every day in the market. Look at the last 15 months. 10-year treasury has been 5%. That's been 350. That's been 470. That's been 360. Now it's above four again. So moral of the story is volatility, uncertainty, and the third element is dispersion. We've got the Fed cutting. We've got Bank of Canada cutting even faster than us.

16:26And you've got Bank of Japan hiking rates. So you've got major disparity, dispersion across the globe. That creates opportunities for an active manager. Like we sign up all day long for volatility, uncertainty, and dispersion. That's a fertile backdrop for us to generate alpha. And if you look at it right now, you've got a lot of managers, some who are well-known passive managers who literally five, 10 years ago, I'd be on podiums with them and they'd be trashing active management. Now they're all setting up a cottage industry, launching more and more active funds, ETFs, mutual funds in bonds.

16:55Because I think the math has illustrated that it does work. People are willing to pay for extra performance. And this is a target rich environment for active management in our opinion. Well, there's two points that you made that I think are the things that flipped it for me. Because as I mentioned, my first exposure to bond funds were ETF index fixed income products. And that was great. That got us very diversified. It was very liquid. Those were the benefits of using those products. But it was the fact that not everybody's trying to maximize profit. You know, people don't go to buy stocks. They're trying to make money.

17:27Whereas, as you pointed out, an insurance company might just be matching assets and liabilities or a pension or, yeah, like you said, the Fed. The other thing, though, is like the debt waiting. Like if you and I go into a bank and ask for a loan and I have more debt than you, they're going to give me more money than you. That just doesn't make sense. I'm still a way to work. You know, I think there's a place for any products based on situation, but that's really what changed for me when thinking about the active conversation. Also, the fact that, yes, you pay a little bit more for active management, but the cost of still come down dramatically.

17:56Yes. And I think in general, I don't want to oversimplify your job. You oversee a lot of money. It's a lot of hard work. But at the end of the day, there's a lot of math involved that, yes, there is still some prediction, but you can deduce what return should be based on just some simple math. And why sit there and take the bad math when you can see the good math sitting right there? I really appreciate that opinion. one thing that I think will be nice for people who do utilize an active manager is when there are unexpected events. Now, I'm going to put a timestamp on this question in case any of us look silly.

18:26It is October 29th. We don't know who our next president is going to be. So this is a question, David, that has no political tie to it. So trust me when I say that. But a big topic that comes up, regardless of who's in office, regardless of who is in Congress, is the national debt. And as the national debt has grown, we've never seen a failed auction. In my perception, as a portfolio manager, you probably can't say one way or another, but I get the feeling that the Treasury just calls the portfolio managers directly before they have a failed auction. So if you're a bond investor and that's your big concern is the country's debt, what would you say to those people?

19:02I'd love to know, one, how you think about it as you're managing a portfolio, but then going all the way down to the end investor, how should they feel about their bond allocations? Because I talk to a lot of people who feel like if I own bonds and the national debt leads to a failed auction and interest rates, I'm going to lose a whole bunch of money. Big question. No, I get it. And it's an important one, right? We're talking about the U.S. here. Our debt dynamics look very questionable. And neither a presidential candidate nor anybody of significance running for Congress has articulated a viable plan to get it under control.

19:34That doesn't sell votes. So it's very hard to see the path forward. Let's just look at some math here. We're running 6 % to 7 % annual deficits, right? And that's in peacetime, not wartime. And that's when the economy is growing above potential. I said earlier, we grew 3 % last year and over two and a half in 2024. Yet we're still running 6 % to 7 % deficits. That's not good. Our debt to GDP as a country is well over 100 % right now. And by our projections and the CBO's projection, most other people's projection, the next 15 years, it's gonna get above 180%, closer to 200%. I believe the social security actuaries, I'm a former actuary, So I sympathize with them.

20:09I think they've started ringing the bells and saying, look, at some point in the next nine to 10 years, we're going to have to prioritize payments where we can't pay par on every social security guarantee we've made. So that's a challenge. And like I said, nobody in Washington has articulated a grand plan to tackle it. And unless we tackle entitlements and other issues, we're going to have a tough time getting that cut down. So let's talk about this. Is it a big problem? Yes, and no. In my working career, in my lifetime, it seems hard to figure out how this is going to end ugly because the U.S.

20:39is, U.S. dollar is the world's reserve currency. As important, if not more important, the U.S. treasury is the world's reserve asset. U.S. treasury is the world's reserve asset. Like I said, go look what happened when the yen carry trade blew up a couple months ago. Everybody bought treasuries. Look what happens when hot wars erupt. People buy treasuries. Next, we have the largest and most vibrant economy and most adaptive economy, right? Most innovation, most high rates of productivity, best rule of law in our economy, and then pair that with the largest and strongest military, we can get away with degrading our balance sheet longer than most of us Americans would like to see us do.

21:14Right. Because you can't replace something with nothing, right? That's a very obvious statement. So what is going to knock us off our perch? Hard to see. Now, that doesn't mean we just sit back and say, it is what it is. we try to position our clients' assets to take advantage of what we think will be the market reaction to these unsustainable deficits and debt levels. So first, curve steepeners. What do I mean by that? If we continue to degrade our balance sheet, yet foreign investors and people have to continue to buy treasuries, like think about if you're a big exporting nation, you gotta soak up the dollars you collect on your exports and something, you buy treasuries.

21:47Well, guess what? If you're worried about the long-term dynamics of the US, you're not gonna buy a 30-year treasury, but you'll buy a three-year and in-treasury. So we've been positioning our clients for a curve steepener, meaning the long end goes up, mainly belly to the long end. And that's worked incredibly well. But I was talking to you back in April of this year, the slope between a five-year treasury and a 30-year treasury was five basis points. Now it's almost 50 basis points. So moral of the story is that's something an active manager can have a view on. And it's not a huge risky trade, like I'm buying some company that might go to zero.