Animal Spirits Podcast - Talk Your Book: Fixing Fixed Income

Episode Date: September 9, 2022

On today's Talk Your Book, we spoke to Russell Feldman from IMTC on innovating the fixed income investment process, differences between trading stocks vs. bonds, risk management within fixed income, and much more.   Find complete shownotes on our blogs...  Ben Carlson’s A Wealth of Common Sense  Michael Batnick’s The Irrelevant Investor  Like us on Facebook  And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation.  Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by MTECH. EmTech is a platform that lex advisors, asset managers better manage their fixed income portfolios. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holtz wealth management. All opinions expressed by Michael and Ben or any person. podcast guests are solely their own opinions and do not reflect the opinion of Ritthold's wealth

management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Rithold's wealth management may maintain positions in the securities discussed in this podcast. Ben, on today's show, we got into the history of fixed income training with Russell. And I don't think people realize that just how big the bond market is, that a single issuer could have dozens, hundreds of different bonds floating out there, and they don't trade nearly as frequently as stocks. And there's not like a, maybe like a New York Stock Exchange where everything is listed. There's much less transparency in the bond market than there is in the stock market. Well, and it's just not very easy to trade bonds. It's not easy

to know what you're getting. Like the bid-ask spread in bonds could potentially be wider, especially if you're an individual investor. It's not easy to just go to say Robin Hood and go, I want to buy that offering of that bond. It's not as easy because a lot of these huge multi-billion and trillion dollar bond shops are trading these enormous lots with each other potentially sometimes. And it's something that a lot of people probably don't understand. You're right in terms of the depth and size of it. And also the fact that it's still kind of an antiquated market because it is so big. And for some reason, it just, it seems to have lagged way behind the stock market in terms of technology and getting up to date.

I can't remember what the exact number is, but we got into what percentage of the muni bond market, for example, is traded electronically, and it's a staggeringly small piece. It wasn't like 10% or something. The other one, I've always gotten a lot of questions about this over the years, and I've come to appreciate it more that people say I would rather own individual bonds and hold them to maturity because then I don't have to worry about, right? If I own a bond fund and I have losses, then I'm worried. But if I own a bond, I don't have interest rate risk because I can hold it to maturity.

now my way of looking at that is you're just trading one risk for another because you still have interest rate risk you're just potentially not earning more more yield if the bond rates go up or whatever but I think it's almost like private equity in the fact that the psychological boost you get from holding that and not letting it go it's almost like having an illiquid private equity holding or something or startup or VC holding or whatever just because it forces you to potentially hold it for the long term and I know that there are a lot of advisors who like building like a bond ladder or something like that for their clients just to make things easier because that spreads a risk out. It helps with spending. And from what Russell tells us,

the systems that have been used, especially by advisors, to track this stuff, it's like essentially using Excel. There's been no leaps forward and the ability to follow and track and understand this and implement that sort of strategy. And that's what they're trying to do. So if you're an advisor managing individual bond portfolies, if you're a giant asset manager, EmTech has something for you. It's IMTC.com as a website. And before we get into our conversation with Russell, full disclosure, we are investors in the company. So with that, here is our conversation with Russell from EmTech. We're joined today by Russell Feldman. Russell is the CEO of EmTech. Russell, thank you for coming in and speaking with us today in person. Thank you very much

for having me. All right, we're going to talk all about the unexciting, but maybe exciting area of fixed income today. I want to start with the history of bond, bond trading, just from like the operational perspective. How does fixed income trading, processing, all of that sort of stuff look today versus say the 80s and 90s? Very different. And I'll just say we are in fact bringing sexy back to fixed income. That's a thing and that's happening here and largely as a result of technology. But let's kind of rewind a little bit to talk how fixed income management happened back in the day. My father was a bond salesman in the 80s and 90s, so a lot of this is second-hand. Solomon?

No, BT. And so essentially, you had people, you had runners, right, who were actually taking tickets and delivering these tickets to windows, and they have to be there by a certain time in order for them to essentially lock in the interest payment for the day. If they don't get there in time, you owe the interest overnight, essentially. Ben was running back in college, so he probably would have filled that role nicely. Yeah, it's actually, you probably had to be pretty quick. And so obviously, that's not how things operate today. But as manual as it could be, it was. If you wanted to buy a bond as an institution, even, you're calling up Solomon. You're basically getting them to let you know what is available. There is no way at that time to look and see what's available yourself. If you're looking to build a portfolio of a list of bonds, they're going to fax you an inventory list. And so, again, everything is as manual. as could possibly be in the 80s and 90s.

Why wasn't there like a NASDAQ or New York Stock Exchange like four bonds? Like, why did that not exist? I can't speak to exactly why it never came about other than to say, I think the people, the players who dominated the market really benefit from the opacity. And so... Like the dealers? Yeah. So we're talking about the banks.

Yeah. Is the market too fragmented? Certainly. One of the things that we hear from individual investors a lot is I don't like bond funds, I just want to hold individual bonds. Why can't I just go buy some individual bonds and hold them to maturity? I don't have to deal with as much interest rate risk, even though you certainly still do, and you just might not know it. But it's not as easy as opening a Robin Hood account and simply clicking a few buttons and you buy some bonds. So why don't you talk about the difference

between trading stocks and trading bonds? Because trading bonds is just a much different ballgame because institutions are such a big part of it. Yeah, big time. There are inherent differences, but fixed income as an asset class has been technologically neglected for decades. If you think back to none of us were around then, but in the late 1800s was when the first equity index was launched, the Dow Jones. It took 91 years for Lehman to launch the first bond index. That was in 1973. The first equities are traded on the NASDAQ electronically in 71, and it's another 30 years

or 28 years before the first U.S. government bonds are traded. That Lehman Index of Bonds, you said it was in the 70s. When was it actually investable? I wasn't honest. But it probably took a while. It had to be the Vanguard Total Bond Market Index, probably, which was, I don't know, the 80s, I think. It could be. This is good homework for me.

In general, I think there's been a major lag. Even the first equity ETF was launched 12 years before the first bonding TF. There's substantial lag in the bond market versus the equity markets. Were you on a bond desk? At Deutsche, I started in the covering institutions and insurance companies on the buy side, and 95% of their balance sheet was fixed income, so that was really where I spent most of my time. And that's where I was kind of introduced to fixed income technology. We had every technology platform under the sun. They didn't really talk to each other effectively, and there was no efficient way to customize portfolios for clients at scale.

And that was really where we were spending lots of our time. All right, so obviously, MTech was built out of that idea to bring all this together to optimize fixed income training. But before we get there, I just want to talk a little about the state of the industry today. And fixed income, there's all different types. There's munis, there's corporate, there's government, there's treasuries, there's all sorts of different things. But you shared with me an article, and this stat blew my face. Only 11% of municipal bond trading volume was executed electronically in May. and that basically hasn't budged that level in a couple of years.

Why? That just sounds crazy to me. And I guess maybe to answer a little bit of the question from the article, the over-the-counter market has about 950,000 separate securities, issued by tens of thousands of state and local governments, and a lot of the volume are small trades. So it's pretty much dominated by $0,000 to $25,000 lots. But so what? So why would that not be done? We're in a digital age.

Help me understand what's going on. I think it's a combination of a lot of things. I think some of the things you just mentioned, I also think folks who have been managing portfolios for many years have been doing it a certain way. And those people are probably towards the tail end of their careers. And I think there is a big opportunity for that to change. But they've been operating for 30 or 40 years,

the same way they pick up the phone, they call their dealer, they get the bonds. Again, those guys were around in the 90s. That was how they did it then. That's how they're doing it now. They've had success. They're not changing it. And so I think- Oh, wait, hold on. It just sounds so dated. So they're calling one desk and they're saying, hey, we want these bonds. Are they pricing that around? Do they literally then have to hang up the phone, pick up another phone, call somebody else to see where their prices is at? Like, does that really happen?

And that's what, so literally back in the day, that's what used to happen. You would call, I would say, I'm looking for a New York geo, what do you got? And the sales guy would say, hang on, let me go find out. He'd hang up. He'd run over to the trader and say, what do we have in New York Geos? He said, we don't have any. He said, but I think I can get something. Tell him, I think I can get the 27s, the 6% 27, call him back.

So he calls him back. And he says, okay, well, we don't have them, but we think we can get them. Would you be okay to send us an order at this price? Because I think that's where we can get them at. And he'd say, okay, then he'd hang up. Then he'd go back to the trader. Then the trader would have to call another guy that he sold the bonds to two weeks ago to see if he's willing to sell them back because you've got to keep track of where those bonds are. That's the craziness of that process. Is a lot of it because the biggest bond managers in the world are managing trillions of dollars and they're just doing these block trades with each other. So if the big guys are probably okay because they're kind of swapping with one another, but it's the smaller players that get hurt. Is that what happens? Right, right. And that process, just to be clear, that process is not still happening in this moment. You still have smaller regional dealers who are.

are servicing smaller FAs and RIAs in those areas who are very comfortable that they know every single day, this financial advisor is going to be looking for these five names in these five maturities. And so they're going to have a stash of them. So when he picks with the phone and he gets that call, he says, yeah, we got what you need, no problem. And here they are. That makes it very difficult for price discovery, frankly, for that particular person. But again, that's what they're used to. So what we describe with the phone-to-phone combat is not really going on today anymore. Pimpco, for example, what is there, maybe you can't speak specifically to that, but just larger fixed income shops, what does their technology stack look like today? So at larger institutions, they typically have a myriad of enterprise software to attempt to kind of fill the holes in their fixed income portfolios.

That can be a series of execution softwares. It can be a series of portfolio management softwares, but more often than not, they have a combination of software because certain software, software solves specific problems for that desk. There really is no magic bullet in fixed income. There is no, oh, if you have the money by this system and it'll solve all your problems. That just doesn't exist. Fixed income as an asset cost is too complicated for that. And the technology, as we know, hasn't evolved yet for there to be a one-size-fits-all solution. So as you see it, what is the missing piece? What is the opportunity? What are you at MTEC solving for your clients? I don't want to say that we are the magic bullet. I don't think that's fair, but I do think for the problems that our clients have, we certainly do a great job of solving. And what we're looking to do is essentially to help clients make better, faster decisions about their fixed income portfolios for their clients. And we do that by connecting essentially the portfolio data that they have, the holdings that each client has with the restrictions and constraints that exist for that particular client. and we marry that into the executable offers that exist in the market right now.

So could you walk us through maybe like a tangible fake but potentially real example of what this looks like? I got an idea. So let's say we have a lot of advisors that listen to the show. I know a lot of advisors will build bond ladders for their clients. So let's say you have a bunch of different clients who all have different needs and desires. Some people want corporate. Some people want tips. Some people want treasuries. And they create a bond letter. It could be one to five years, one to 10, one to 15, whatever it is, depending on the person's. time horizon and maturity or risk profile. Let's say you have an advisor who's got 100 clients and each of them has a different ladder. How do you come in and then solve and make their life easier? Well, I'll answer both questions with an analogy here. Hopefully this analogy lands, and if not, you'll tell me and you can cut it. I think the idea here is it's a lot like filling up your gas tank. So imagine that you're at an intersection, you've got three gas stations. You've got

one cheaper, one cleaner, one faster. Michael, you're a value investor and you say, screw it, I'm happy to wait for the cheaper one. Ultimately, that's the decision that you make and you fill up your tank and you go down to the beach. Now, that's an easy decision because there's only three tanks. But what happens when you pull up to the same corner and you have a thousand gas stations? The correct combination of gas from those different stations provides the ideal output, which in this case would be the cheapest gas and the highest miles per gallon. Well, if there's a thousand stations, it's going to be a much harder play. And you may still say, you know what, I'm just going to take the cheapest one that I can find right here and I'm going to fill up and I'm going to go to the beach because it doesn't all that matter that much. That's what's happening a lot in the market right now. That gets more complicated when you think of, okay, what if you don't just have one car, you have 100 cars and 1,000 gas stations.

All right. So if I'm understanding your analogy, the gas stations are the custodians. Is that right? I'm just kidding. So the gas stations are the bonds. Yeah, exactly. And what makes it tricky is you have individual clients that have unique needs. So one of their cars needs diesel. One of them needs a charging station. One of them needs a car wash on top of the fact that they also need gas. So this client can't have any Pepsi in the portfolio or this client only wants to hold investment grade bonds or to your point, Ben, this client wants to have a ladder that's five to ten years. And so that being able to simultaneously solve that problem for all of your clients at the

same time in the context of the constraints that each of those clients have and in the context of what's actually available in the market is the problem that we're solving. Okay. I think I understand. So this platform is this type of thing where you unleash this technology, task, and managers, RAs, what have you? And then you say, it's so intuitive, go do it yourself, or is there some sales process involved where they have like a client representative or a customer service representative that is going to help them build these different allocations and put it into practice? We have a client success team that helps our clients to understand the best way to get the most value out of our platform. Ultimately, it's up to the advisor to make the decisions about those

portfolios, but we are giving them the tools to line up those bond ladders or those unique optimizations that they want to run or rebalancing. They want to run every minute, every second, frankly, if they so chose. But so if I just told you that I wanted to have a one to three or ladder of financials, industrial, utilities, whatever, you could help us build that. Yeah, you can click five buttons and it's there. We work with on the stock side of things, a platform called canvas, where we can essentially add rules, add algorithms, and make it a rules-based framework to take some of the decisions off of our plate and make good decisions ahead of time. This is something similar for the bond market. Exactly. That's exactly right. I'm familiar with the platform,

and they are certainly a provider of that type of technology in the equity space. Really, that type of tech doesn't really exist outside of M-Tech in the fixed-income landscape. So assets that are being, is it like ran through your platform? I mean, the assets are not held at EMTEC. You are a service provider. So this integrates with whatever custodian that the institutions are already working with. Yeah, absolutely. So we are connected to custodians. We're connected to aggregators. And ultimately, we're taking in that data on a start of day basis. And essentially, you're logging into EMTEC. It's a fully cloud-based platform. So you're pulling up a browser. You're logging into EMTEC. And you're seeing all holdings across all of your portfolios for all of your clients

at the start of the day, and you can use the system, obviously, to slice and dice to see where there may be overdrafts, where downgrades have occurred, where there's cash to put to work, et cetera. We're not actually servicing the assets ourselves. We're just a technological provider at the moment. It's a SaaS platform, and therefore we function off of a recurring fee. So let's say that you get in front of a bond desk, who would be the person that, if you could only speak with one person in the company, who is the person that you would say, okay, this is the person who, when I show this to them, their eyes will light up and they will get exactly what we're trying to do. Yeah. So the good news for us is that person can actually be one of many

people because the platform provides value to compliance personnel, to traders, to PMs, to analysts, and certainly to the head of the desk, there is value for us to actually almost speak to anybody on the platform or on the desk. But I think in general, speaking to a portfolio manager is usually one of the first touch points. It may be a PM, it may be somebody in the opposite side of the business, but ultimately, we're meaningful to talk to anybody who's looking really to scale their assets without necessarily having to scale their expenses. You mentioned that the technology is pretty far behind here, especially when it comes to the equity markets. There's plenty of analytics people can pull up at their fingertips as far as the stock market goes or individual stocks.

What type of analytics are you providing on the fixed income market that some of your clients would kind of be blown away by and don't realize that they even need at this time? That's a great question. There's a ton of data that exists in fixed income. It's part of the reason why I think cloud actually has a much. bigger impact in the bond market than in the equity markets. But ultimately, because bonds are not standard, there's no clear terms and conditions that exist for every single bond. That's why largely retail investors aren't buying bonds through Robinhood and whatnot is because they're too complicated. The ability to, at your fingertips, see all terms and conditions for a given

security, but also to see option adjusted calculations, enhanced liquidity scores and whatnot that we're providing on the securities that are both available in the market and available generally that are still outstanding. You talk a lot about optimization, portfolio optimization. What does that even mean? There's a lot of chatter about optimization in the market today. And some of our competitors talk about optimization, but their optimization is really allocation.

And so the idea of kind of allocating a single bond across a lot of portfolios or taking one car and filling up with gas from a myriad of different stations. the distinction between allocation and optimization really comes from the fact that we're not just allocating a single bond. We're optimizing, we're providing you the best fit outcome, given all of the unique constraints on every given portfolio, given the targets that you may have as a PM or as an advisor, and given the availability of bonds in the market right now. And we're doing that all simultaneously. So across all of your holdings at once. So let me ask you like this. Let's just say that a team was running a bond model and there was 100 accounts and a dozen of these accounts

had specific restrictions, things that they couldn't own. Would you be able to execute that using your technology? Absolutely. A dozen would be a small number. You can ramp that number up by 10x and we can still do that. Who is the ideal client here? Is it a financial advisor and RIA? Is it an asset manager who manages strictly fixed income? Is it both? Who's the ideal client here? It's both. So we started really with smaller FAs and RIAs to kind of get into the industry, and that's really how we made our start. And we have since evolved and added sophistication to the platform such that we can not only satisfy a workflow for an advisor who's looking to in-house some of their assets or to manage bond ladders more dynamically. But we can also now satisfy workflows for much larger enterprise institutions who have full trading desks and full portfolio management desks as well. This is for people that are using individual bonds, right?

this wouldn't necessarily be integrated with somebody that was just doing ETFs or mutual funds? So we do have clients who are using what they call an alpha overlay strategy where they are investing in funds and they're layering on top of that individual securities as well. So that's all represented in the platform. One thing that we are pressing forward towards is indexing, custom indexing, similar to Canvas, but on the fixed income side of things. Michael mentioned the Muni bond market being kind of screwed up as far as electronics goes. Is there any segment of the market?

Maybe it just is munis. I have to imagine treasuries are one of the biggest most liquid markets in the world. Are there any segments of the bond market, whether it's munies or corporates that are harder to trade or harder to understand for people? Is it all kind of in a similar bucket? I mean, there's definitely asset types within fixed income that are more challenging. I mean, the structured securities, the CLOs, the ABS, MBS, those are definitely going to be more challenging. But, yeah, holistically fixed income is a challenge. And I think there are pockets of it that have evolved more so than others.

So in the article that Michael referenced, you're seeing that 66% of, I think, the Treasury markets are now trading electronically, 42% of corporate bond investment-grade markets are trading electronically. So there are certainly pockets of fixed income that are more electronified than others, but it is certainly a holistic problem. Hey, Ben, how do we get Russell an introduction to Treasury Direct? Seriously, at least update their website for them. It's the same since it's 1997, I think.

What is it about the technology that you guys have that's so special? Why hasn't anybody done this before? Well, I think twofold. One is, as I mentioned earlier, the market structure was such that the larger players are benefiting from stagnation. I think from a technological standpoint, the advent of cloud has really helped us, propel us forward. We're able to synthesize so much more data and so much more information at a much more affordable price than our competitors. and that's really led to a big change for us. When I was at Deutsche, it was very obvious to me that we needed a better solution to be able to customize at scale

because that was just happening as individuals sitting in Excel trying to figure out exactly what bonds go in a given portfolio. And we needed a better way to digest all the information. When we talked about, there's over a million bonds just in the mini market alone, being able to digest all that information and make good decisions about it in real time is crucial. I guess it would be like if every company had like 15 different share classes of stock. Right. Yeah, I mean, maybe even more, frankly. But yeah. All right. What did we not get to that you wanted to hit on, if anything?

I think there's some risk mitigation that we should just talk about here as well. I think it's not just that we can make your life easier. I think we talk to a lot of folks who come to us who say, I bought the wrong bond in the wrong portfolio. I made a trader. It was actually costly, both in time and dollars, and I don't want to do that anymore. Help me not make those types of mistakes. So I think there's a risk management element here as well, which is cataloging the requirements of your clients electronically. We used to actually pull out a binder and flip through the IPS statements, just literally

in laminated pieces of paper within the binder to make sure that we were in compliance. There's an element here of risk management that's really important to note and to be thoughtful about as an advisor and as an RIA. At that same level, a lot of the people will come to us with a whole stack full of positions that they hold from their current advisor. Can you take those positions and then say, all right, here's your current portfolio. You thought your risk profile was this. Here's actually what's happening and then kind of show that client. Here's a better portfolio for you based on your risk parameters. And that's a huge selling point for what we do. So we make it really easy for advisors to win new business, to be able to both upload the existing

holdings to get a clear picture of what the risk profile and what the characteristics of are of their current portfolio. And then again, with two or three clicks of a button, to be able to say, well, here's actually the model that we would suggest you work off of, or this is the model that we would suggest based on your risk tolerance and your profile. And here is actually the exact change that we'd make. Click, let me get this in a PDF report and let me show this to a client. And all of that can happen in under five minutes. Russell, if people want to learn more contact you. Where do we send them? Send them to IMTC.com and or send them to meet me out at FutureProof. I'll be with you guys. So we're going to be at Future Proof Huntington Beach, California, September 11th through the 14th.

Comes to how to Russell, if you're there and interested in learning more about this solution. Russell, thank you. This is great. Thanks very much, guys. Really appreciate the time. Thanks again to Russell. Actually coming in studio to do this one, next to Michael at least. I was still on Zoom or some other thing, Riverside. Remember, go to I, mtc.com to learn more if you're an advisor or a big fixed income manager, send us an email animal spiritspot at gmail.com.