Animal Spirits Podcast - Talk Your Book: Investing in Fixed Income

Episode Date: January 22, 2021

On today's show, Michael and Ben talk with Gibson Smith of Smith Capital Investors about how the structure of the fixed income market has evolved over time, what happened to bond funds and ETFs in March? The potential problems with plain-vanilla bond indexes, 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 Smith Capital Investors. Go to Smithcapital Investors.com to learn more about their research and products and an investment process for investing in the fixed income market. 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 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. So we spoke with Gibson Smith about this. It's easy to look at the chart and say, oh, we've been in a 30 year, 40 year bond bond market. And the wind was at your back. You had high rates. You had falling rates. How come the aren't more star bond managers if it was that easy, making the case that obviously it was not that easy in real time. I remember being part of an organization in 2007 that did some crazy interest rate swap. We were consulting on this because they thought that rates were never going to go below 4%. How many years have people been predicting that rates can't fall further they have to

rise? I think at 2% pretty much everyone's bonds were in a bubble. Understandably so. Yeah. So it hasn't even as easy as it's looked. Because how many people bought those 15% coupons in 1980 or 1981 and just held them? Right. Actually, I want to clarify, it's not understandable to say that 2% bonds are in a bubble because you could say that bonds are overvalued or that you're not being paid to take risk here. But what is a bond bubble? Because bubbles have to burst. That's what bubbles do. And a bond is not going to burst. I mean, you're going to get your money back unless the company defaults. I read about this a few times. The difference between a bond bubble in a stock bubble is, I don't think bonds can really be in a bubble. And luckily, we, on this

episode, Gibson, he did a really good job busting a lot of myths about bond investing. It's obviously something that not enough people pay as much attention to as the stock market. The stock market is way more exciting. I've been contending for a few years that you have to be more intelligent with how you allocate to fixed income now because of where rates are at the moment. I actually wonder if bonds are getting more attention now than they used to because people are like, just what do I do with my bonds? Yeah, because in the past, it was an easy decision. It didn't really matter. If you're an individual, you could put money in CDs or a money market or it didn't really matter and you could earn five, six percent or whatever it was. There's no easy answers. You can buy treasuries,

have that ballast. It'll reduce volatility, give you some diversification, dry powder to rebalance if you need to. There's a spectrum in here. It's not either or, but you could take less risk or you can take more risk. There's not that many levers to pull in the bond market. And there are people who assume, well, why do you need bonds with rates at this level. And obviously, there's such a huge demand for them that even if they don't provide as much income as they did, they provide an emotional hedge for a lot of investors. I was just looking at the data recently from my site, going back to 1928, 93 annual calendar years. You know how many times the 10-year treasury has had a double-digit down year out of 93?

Twice? One time. One time. There you go. In March, the S&P 500 was down almost 12% in a single day. That's worse than the worst 10-year treasury return over a year. Ever. Ever. So that's your answer. So what's more attractive right now? Bonds are stocks. I don't think it's close. But again, it's not either or because if you don't want bonds, if you don't like barely beating inflation, then how would you like losing 12% of the day with your entire portfolio? You're just trading one risk for another. That's the rub. I guess that's like the Bernstein. There's no deep risk in bonds. Right. Well, unless they default, that's the

deep risk in bonds. If you're talking about the U.S. government, you're okay there. But yes, the other thing is, okay, so let's just say a bond defaults. People are not concentrate in the bond market, as far as I know. Right. Yes. I agree. People don't make extreme bets there. All right. Enough ramble from us. Here's our conversation with Gibson Smith, founder, portfolio manager, and CIO at Smith Capital Investors. We're joined today by Gibson Smith, Smith, founder, portfolio manager, and chief investment officer of Smith Capital Investors. Gibson previously served as the CIO of fixed income at Janus from 2016 to 2016. So Gibson, thank you very much for coming on. Great to be with you guys. Thank you.

I thought maybe a good place to start since you've been doing this for such a long time. Let's just talk about the fixed income market broadly, how it's changed over time with a focus on transparency and good data around pricing, which I can't believe that's like a revolution. Yeah, it's really amazing. Just to give you a little background. I started my career in 1991 in Manhattan. And I worked for Morgan Stanley. I was part of their junior analysis program in the fixed income side of the business. An incredible opportunity, great training ground, real great experience, and an interesting time in financial markets. And over the last 30 years, we've just seen the bond market obviously explode in growth and improve transparency,

improved visibility around pricing. But back then, when I started in the business, treasuries were trading on screen. So they had, in some ways, had the technology in place where we could see the treasury market, on computer screens, but the corporate bond market was still trading over-the-counter, I mean, it's still an over-the-counter market, but very over-the-counter, where we had whiteboards where they would write up the issue and the dollar price of the bond. So you'd have the GM 680s of 32 on the board at a dollar price of 99.5, and we had these enormous calculators called quotrons that we used to calculate prices and yields and spreads

and so on and so forth. I mean, really fascinating period of time, and the bond market's just grown from then. And today, I mean, we look at what's happened here over the last several years. I mean, Michael Bloomberg came in in the late 90s, early 2000s, and really automated the bond market, really took technology and was very disruptive to the over-the-counter nature of the market and created this system in Bloomberg, which we're all highly dependent on now. It's really got monopolistic power in the bond market. And then you had advances from there where you had.

trade web and market access come in and provide trading platforms for fixed income. And so it's really been a fantastic evolution in the bond market from what was a very antiquated, very high touch system to a very automated technology driven system. Obviously, the other big change you've seen is just that rates have come down for your entire career, obviously, as it has for ours. As a fixed income manager, how much time do you spend actually worrying about that absolute level of rates versus just knowing that it's outside of your control and there's nothing you can really do about it. Well, it's critical because it's one of the most important components of managing a fixed income portfolio is the direction of rates and or the shape of the curve. And when we think about the inputs

that go into driving those valuations, that's where we spend a majority of our day, whether it's looking at macro data or in the corporate bond market looking at underlying fundamentals of companies. And we have to pay very close attention to it. We've been in a 30-year, 33-year bull market for bonds. I think today's low yields and valuations where we are today kind of warrant some caution. And from our standpoint, we remind investors that the last 30 years hasn't been a one-way shot. Think about these bouts of 100 basis point periods of volatility where yields have gone up 100 and then decline 100. It's been kind of a stair step down. We're probably entering the reverse side of that market here over the next 20, 30 years.

I will definitely get into all of that. But before we get into today, we look at the chart of 10-year rates, and it's been straight down, but not really. There have been bouts of interest rates spikes. Did it feel easy at the time? I mean, we're looking back, again, with the benefit of hindsight, you see rates even in the 90s above 7%. So you had starting interest rates that were high, and then you had the wind at your back because interest rates were falling further. So you got the high coupon, the rising prices. Did it feel easy in the 90s in the 2000s? No, it never feels easy. I mean, there are always events playing out. There are always highlight things that are happening that threaten the downside. And I remind investors,

fixed income is an asymmetric product. You earn your coupon and at maturity, you get par. And while you're waiting for that maturity or you're going through that period of time, there's always volatility. There's always some event. There's always some uncertainty. There's always some surprise. They answer your question directly. It's never felt easy. I figured as much. The important part is focusing on discipline and really having the fortitude to take risks at the right time, avoid risk at other time, and really being, again, very focused on consistency of returns, whether you're in a bull market or a bear market. People are pretty familiar on the equity side of things with active fund managers have underperformed and then they're pretty familiar with

the S&P 500. I think when it comes to fixed income, a lot of people don't really understand what's in those total bond or aggregate bond indexes in how the numbers actually show actively managed fixed income does a lot better than the equity side of things. So why is that, what are some of the more common criticisms you see of the aggregate bond index and why it may be different in terms of measuring against an equity index? We've got to look at the aggregate bond index really is a proxy for the whole market. And that's how we approach it in that it's a market cap-based index that really aggregates all of the issuance in the bond market. And so from our standpoint, it just represents the market. Now, inside of that index, where I may have some criticism about the construct of the index,

it doesn't necessarily matter because it just is the market. As the market has grown, evolve, yields have declined, durations have extended, all of these things have created indices that are more risky today than they were five years ago, 10 years ago, 15 years ago. The issue that many take with, called the inefficiency of the index, it's just the market. It is what it is. Now, how you manage against that index is really the critical question, and it's the important consideration. There are managers that will take excessive risk or always be in a risk-on position. And they've done exceptionally well in the last 30 years because they've been long duration or they've earned additional coupon for being long risk. But when you look at periods where we've had volatility,

where rates have moved higher and or corporate bond spreads have moved wider, they've done very, very poorly. We look at the index again as a proxy for the market. We think there are times to own risk in fixed income, times to avoid risk. We think security selection is ever. and security avoidance is as important, particularly in a market like today where valuations are a little stretched, and actually having the fortitude and discipline to adjust the portfolio for different periods of time. That's critical. I'll throw out a criticism of the index that you often hear is that, well, you're just buying the most heavily indebted companies. Why would you want to do that? And I've always thought that was a strange criticism because that's accusing the

market of being really dumb. It's not like these companies can just flood the market at zero percent. they're not the Treasury. So I guess you are maybe owning companies that have higher debt levels, but if the bond market is the smart market, why should that be a concern? Do you buy that argument or is that bunk? I actually do buy that argument. And actually, if I kind of were to reverse it on the equity market, if we think about the Fab Five, we've been talking about for the last 18 months, obviously huge impact on returns. On the fixed income side, it might be the inverse where the largest issuers create a riskier profile for the index. So if you have a company that is highly levered and in continuing to increase its leverage, it's a higher risk factor for that

index than many of the other issuers. Again, go back to the active versus passive discussion. If you're a passive manager, you're taking that risk on, a company that is continuing to run high leverage, where if you're an active manager, you can make the decision to avoid those issuers. So I think that's a fair criticism, actually. Point taken, but my point would just be that if there is a company that's overly levered, I mean, the interest rates would probably reflect that, no?

Well, the overall valuations will reflect it. You think about coupons or absolute yield, the market will reflect it. But again, keep in mind that when you have a large portion of the marketplace that is passive investing, they can hold valuations down on certain large issuers because there's such a large component of the index. And that may create a bad risk reward profile on that issuer. Again, going back to active, those are the ones we want to avoid. I just thought of another thing. We've seen a lot of people having the opinion that into equity index funds are distorting prices. There have been massive flows into passive bond ETFs. Do you think that those flows are distorting the bond market? It could be. And it's actually not just fixed income ETFs. It's just the overall bond market. I mean, we've been in a tremendous period of time of massive flows coming into the bond market. And all of that money is seeking yield. And it may be holding down the valuations of certain credits or certain issuers in the corporate bond market and giving them more advantageous terms to issue debt and use the proceeds for whatever they deem appropriate. It can be shareholder

friendly activity, which we saw a lot of over the last five years, or it could be M&A or other outcomes. But yeah, the flows have a huge impact in terms of valuations and something we watch very closely, and it could be creating that unintended outcome of overvalued securities, putting CFOs and Treas in an advantageous position to issue more debt. Do you think it's possible that all of that demand for fixed income, so we have whatever, 73 million baby boomers who are retiring and they want yield even if there's not much today, is it possible for that to ever put a cap on rates where rates could stay low or just not go very far to the upside in the coming decades? It could, particularly in short periods of time, but I think smart investors will ultimately demand real rates of return or a positive real rate in the bond. market. And if you're investing in your principal or your purchasing power is being eroded by inflation, you're only going to tolerate that for short periods of time. It may be the case that it

provides some cap on yields or at least some regulator in terms of yields going higher, but ultimately the bond market will reflect views around growth and inflation and ultimately price in positive real rates. Now, I want to be careful because we've been in periods where it's been two, three years of negative real rates, obviously influenced by central banks. But it's an important consideration that if you're having getting your purchasing power eroded, it just doesn't make sense from a long-term perspective. What about the demand from rate insensitive buyers, like insurance companies, for example, or pension funds? Well, there's actually a counterbalancing nature of the insurance industry in that the policies they're writing are based on a rate. And then the securities

that they're buying are based on a rate. The in-between is where some of the profitability can come from. And so there's kind of a natural regulator that insurance companies will hold off on issuing policy and or investing until there's a good spread or the right rate. That's just one of the ways the markets work. Well, maybe this is a good segue into like understanding why. I think there's a lot of people out there who assume that when rates rise, ultimately that's just a bad thing because they're going to get crushed. But it seems like to me you're insinuating, which I agree with is that eventually fixed income investors want rates to rise because eventually you'll get those higher yields. So while it's short-term pain, it's longer-term gain. So you want those rates to rise eventually, right?

Yeah, we do. And there's a kind of a self-healing nature of fixed income where you lose maybe a little on principle as rates are going higher, but now you're reinvesting at higher rates. And I remind our investors all the time that in an environment where you have negative real rates, that's not healthy. And if we move into an environment where we have higher rates and positive real rates and we are seeing economic growth and the bond market is reflecting that, that's much more healthy for markets than the environment we've been in at certain points in time over the last 10

years. So, yeah, I agree with that, Ben. And I actually think, I hope we're on the cusp of that playing out, maybe an inflection point here where growth will start to improve. Market will start to price in positive real rates and will ultimately have a much more healthy bond market, which in my opinion leads to a much more healthy capital markets. Last week, somebody showed a chart showing that break-even is actually what the market is reflect in terms of the expected inflation. Actually, don't do a great job predicting inflation. What's your thoughts on that? Yeah, well, there's various methods to look. You can look at five year, five year forward. You can look at 10 year break evens. We can look at the tips market for

indications on kind of what inflation expectations are. Somewhere between those three of those and some others is the truth. The reality is, is that in the environment we're in right now, there is so much liquidity. And on top of that liquidity, you have central bank intervention in markets. The Federal Reserve has come in and purchased a good portion of the tips market. We have artificial, call it, inflation gauges that don't necessarily drive a rational mindset around what the real expectations are. And again, remind investors that when you think about those inflation expectations, you can't be just myopic in looking at the tips market or break-evens or five-year-five-year-forward. You've got to think about what are the inputs

into inflation, what's changing, what's the outlook for those, and then ultimately, a view on whether we're going to go from a 1.4% core rate to a 1.6 to a 2 to a 2 5 over time. Do you have a view on what drives inflation? And I wonder if that's changed over time because it seems like what they taught us in economics just throw it out the window. It seems like nobody knows really what causes inflation. And what do you do with that? So many of our lives in terms of going back to classic economic education, so many of these premises are being challenged today. And clearly when you have quantitative easing and you have other elements in the marketplace, we have to scratch your head a little bit. But going back to

inflation, we think about the big disruptors to inflation. You have demographics, you have technology, you have globalization. And I would argue that there has been a very poor government response to what's happened in the inflation world, which we can talk about in a second. But ultimately, inflation is driven by increase in prices. I mean, let's just keep it. that simple. And increase in prices are generally driven by consumption patterns around consuming more goods and the need to consume more at a higher price. You go back to basic economics. The problem today, again, is we're going through this disruptive period of globalization and technology that has been very disruptive, that finding that absolute clearing price is a lot

easier. And the production of the goods that go into finding that clearing price is abundant. I mean, it's absolutely abundant. Think about the goods. I mean, And when we were younger, we used to buy shirts at $120 a shirt, and now you can buy a shirt for $15 a shirt. It is just an outright change in the way we consume goods based on how they're produced and where they're produced. So you've talked earlier about the fact that when rates have been falling, a lot of what's happened in the fixed income market could just be people taking more risk. How do you decipher between someone who is a good fixed income manager for their clients and someone who is just taking more risk? because I think for clients, it might be hard to know that, whether they're just taking more credit or duration risk. And that's why they're outperforming when really it's just they've made a

switch in their sector of their fixed income, basically. And that's the hard part of active fixed income management is that there's a good portion of the competitive universe that we operate in that calls themselves active, but they're really just closet indexers. You look at their portfolios, they're very close to the index. And so with the index being the aggregate 6.35 years, long, It's got about 18% of the index in long-dated treasuries and long-dated corporate bonds. When rates are falling, they do well. And when corporate bond spreads are tightening, they do well. Where you can really do the checkpoint is to watch in these mini-crisices or the bigger crises we've seen over the years.

And we're coming off a great one right now where you can look back and see what the performance of the manager was in that March period of time. And we were down, I mean, right around 3%. many of our competitors were down 8, 10, 15% in that period of time. I mean, just stunning amount to be down. And that comes at a time when you need fixed income to be the ballast in a portfolio because you have the equity volatility. So it's something you really have to look at from historical standpoint retrospectively and look at how they perform in different environments. We get the ask the question all the time is maybe it's just the right position to be long credit risk all the time and long duration all the time. I fundamentally

disagree with that because when we go into an environment of drawdown or rates move higher, spreads move wider, clients are going to be handed some pretty significant losses in fixed income. And I think those periods are where the active manager really has to move to preservation of capital focus and being the ballast in a portfolio. And I think that's something we do actually quite well. Well, zero coupon bonds, for example, I think fell more than 20% in the first quarter. Yeah, power. Yeah, exactly.

You got a lot of the upside, but that probably is more downside than bond investors are comfortable taking. So maybe that's a good chance to talk about risk adjusted returns. I've always thought about risk adjusted returns in the equity market. I've never really thought of it in the framework of thinking about fixed income. Obviously, if you're taking significant duration risk, you should think about it. And I guess it depends on who the investor is. But are risk adjusted coupons more important? How much do investors care about the price versus what they're actually taking in? When we think about risk adjusted returns and whether it's equity side or fixed income side. And I think really our goal as investors is to find or at least produce the

best risk-adjusted returns. And those are obviously very contingent on different points in the cycle. But the ability to produce the most amount of return with the least amount of risk, I view that as our primary job in managing money. What that means on the fixed income side is understanding where we are in the cycle. Go back to what I said earlier, there are a lot of managers that we compete with that are closet indexers or they just ride the market. They don't adjust their portfolios for different points in the cycle. What we believe philosophically is there are points in time to take risk in fixed income and there are points in time to avoid risk. And the portfolio has to adjust and change based on where we are in the cycle. That's the

real proxy for risk adjusted returns, in my opinion. And that's largely driven by security selection, security avoidance, and sector rotation in the bond market. So again, go back to your comments about zero coupon bonds. In zero coupon bonds, the duration is the maturity. The duration on the 30-year treasury today is 23 and a half years. If you think about the swing factor, the basic fixed income formula, change in basis points times duration equals percentage change in price. It's kind of the base formula for all a fixed income. So when you've got really long durations, you have small changes in yield, it leads to really extreme changes in the dollar price. So from a risk-adjusted return standpoint, if I don't own those long-duration

securities in a rising rate environment, I have protected my clients. I've produced proverbial alpha by making an active decision to not own that part of the curve. So one of the more strongly held views by a lot of fixed income investors, which is always been surprising to me, is that they assume, especially like retirees assume, well, I'll just hold all my bonds to matured. and that way I eliminate all risk. So maybe you can talk about, because people really have strong opinions on this, the difference between holding individual bonds and maturity and then holding a bond fund and maybe some of the tradeoffs you're making there. They both work. I mean, as a fixed income mutual fund manager, I obviously have a lot of bias in what I do. And I want to

present that first and foremost. But I do think there is an application for investors to own individual bonds. It makes logical sense. You know what the outcome will be. The starting yield that you buy the security, you own it, you hold it to maturity, assuming there's not a default on the issuer, that's your return. Now, on an active fixed income portfolio, our job is to navigate the markets and to, again, select securities that offer better risk reward profiles and avoid securities that have bad risk reward profiles, bring the whole portfolio together, and then balance those risks off with other securities that may provide some insurance or a buffer.

offer to market volatility. Usually that's treasuries, which has served us quite well. I'm not necessarily sure it's going to be the perfect source of insurance going forward, but we can talk about that too. So both buy and hold and or active management are applicable. It just all depends on what the end investor is looking to achieve. If you have an active asset allocation kind of process where you're moving from equity to fixed and you're rebalancing very frequently or you're taking active of risks in different segments of the capital markets, bond fund's probably a better place to be, because you don't have to deal with the illiquidity and the friction cost of trading individual bonds. You said there's times to take risk, there's times to not take risk. What does that

mean practically? Is this all about bond selection or is this more about making macro calls? How does that work in practice? It's actually both. The beautiful thing about fixed income investing is that it's a math-based product. And so we can calculate expected returns on virtually any scenario on the securities that we own. There is an input that comes from the macro side, what are expectations around growth, inflation, changes in inflation expectations and what we see playing out. And then there's also the individual security selection side where it may make sense to own a two-year security issued by a company versus a 30-year security issued by a company. And the components that go into making those decisions are largely math-driven, where you can look at the risk factors on a long-dated security and look at the risk factors on a shorter security and then figure out where you are in the cycle and what appropriate risks are to be taken at different points in time.

How much more important is fiscal and monetary policy to you as a bond fund manager today? Because I think a lot of people look at all the government spending and assume, well, inflation has to come and potentially growth has to come. So why is the 10-year treasury still hovering around 1%? For a lot of people, that doesn't seem to make much sense. Is there something else going on there where you just have to understand that stuff more to understand why rates are where they are today? Yeah, it goes back to what we were saying earlier about our classic economic education. We're taught that stimulus comes into the economy.

Stimulus drives growth. The growth ultimately leads to inflation. Inflation leads to higher rates and a steeper curve. And that's how the system works. and it worked famously for many, many years. What I think we've had a difficult time understanding, and when I say we, I mean markets is really understanding those three components we talked about earlier,

which is the demographics, the implementation of technology and globalization. And I would argue that today markets really don't understand what governments are supposed to be doing in light of those three factors as well as what we were traditionally trained. And we're going through this process of trying to figure it out. Think about MMT as a new thesis or a new theory on how monetary policy should be conducted along with fiscal policy. We're just in a different environment that we haven't necessarily adjusted or evolved through,

but I think the marketplace understands disinflation and deflation more today than they did even just three years ago. And I think as time progresses, we're going to start to realize that policy change at the federal level is going to be more powerful than fiscal stimulus, changing the behavior. sending the right behaviors that ultimately lead to the outcomes we need to achieve in a very different economic environment than we operated in just 15, 20 years ago. So in a world where the tenure is, whatever, just barely above 1%, you could crush it, relatively speaking.

What are investors supposed to expect from you when you're fishing in a pond that where rates just are what they are? So can you knock it out of the park and return 200 basis points above your benchmark? still deliver a fairly paltry return through no fault of your own? I don't know about no fault of my own. I think there's an active process that goes into generating 200 plus basis points over the index. And some of that is duration and yield curve management.

Some of it is security selection. And truthfully, a lot of it is just being very logical and rational about your decisions and what you're putting in the portfolio and what's leaving the portfolio. So yes, I think 200 basis points is achievable. What's really interesting and I think fixed income investors have to consider this is that you can beat an index by 200 basis points and still have a negative return. It's kind of that funny victory where you beat your competitors by 200 basis points. You beat the index by 300 basis points, but you're down 3%. Doesn't feel good. Part of our process in this preservation

of capital focus is not just focusing our competitive universe, focusing on the index, but also thinking about the importance of absolute returns and preservation of capital, particularly in this low yield environment we're in. You mentioned that bond investing is really more about math. So I think it's a little easier to set expectations for returns and risk. But of course, there's so much more data these days and computing power. So everyone has models for their bonds. So where do you find edge? Is it just in the macro? Is it in your sector calls? Or is it just maybe setting the right expectations for your clients or the type of strategy you're going to pursue? Where is the differentiator in bond investing these days? It's a lot of what you mentioned. And I think a big port

of it comes back to experience, understanding markets, really paying attention to risk. Going back to a good portion of the marketplace has a natural level of complacency because they're closet indexers. The index is the market. We're just going to accept what the market is and we're going to manage around it and try and outperform it by a small amount. And we take a very different approach in that there are a risk inside of the indices that we're measured against and there's risks inside of the market that just aren't appropriate risks. Again, I know that sounds silly, but I'm going to go back to the question earlier about the company that continues to issue debt, maybe into a highly levered capital structure. Those are risks you just

don't need to take. There's no reason to take them. I mean, if the management team makes a left-hand turn and decides to go into a deleverging process, that's a great risk to take because you have a backstop of improving fundamentals behind the credit. But then, go back to your question of where's the edge? The playing field is fairly flat. I mean, we've got great advancements in terms of information. Information travels very, very fast. Markets adjust very quickly. Speed of capital is real and it's accelerating by the day. It's not decelerating. So things are priced quickly. The real advantage or edge in fixed income management, particularly on the active side, is really focusing on the risk management side, really understanding portfolio positioning, defaulting to the math behind

the market in terms of setting expectations, and kind of letting that process just work. There are times where taking risk and fixed income makes sense. There are other times where it just doesn't. And knowing when those points in the cycle are and adjusting the portfolio in on the risk spectrum or out on the risk spectrum, I think is how you produce consistent risk-adjusted returns in the marketplace. You mentioned how some of the losses we saw in March. And I think people in a crisis pay more attention to the stock market.

But you had like the corporate bond ETF fall 20% in the matter of a couple weeks. How crazy were credit markets during that few week period before the Fed stepped in? This is one of the issues with having an over-the-counter market. There's a natural price discovery process that happens and where you're lining up buyers and sellers. And when you go into a dramatic uncertain period like we were in, where there is no bid in the marketplace, you see a downdraft in valuations trying to find the right clearing level. And that obviously impacted the ETF. She saw big discounts in the ETF space, some disruption and some concerns in that space in terms of how it was going to play out.

and truthfully, it was a bit of a scary period of time because the communication flow from those managing the ATFs was pretty quiet also. It was an interesting period of time. From our perch, we were fortunate that, again, 30 years for me, going through the great financial crisis, you had a front row seat in how things played out then, and there were so many similarities in this period of time. You go back to even the dot-com correction, a lot of similarities in the COVID crisis or the COVID correction that we went through.

So it was really, I think, for me, a little bit easier to step back and look at the markets and see what was happening. And then as we got changes in fiscal policy and monetary policy, the Fed flooding the market with liquidity was right out of the great financial crisis playbook. It can give you a little more comfort in terms of taking risk. When you saw that dislocation in March, did you think that ETFs were part of the problem or were they reflecting reality and the navs and the funds were stale? Being a skeptic, I mean, I kind of laugh about being in fixed income. we see dead people. I mean, we really can kill the optimists of the world because we're just so dire and we can see really bad things happening. There was a tremendous amount of skepticism around what was happening in the ETF space. And I think the Fed coming in and buying ETFs and providing a backstop to ETFs, for many of us, it was the question bubbled up of do we have a systematic problem or do we have someone who's in trouble? And we'll never know the answer to that question because what the Fed did was basically stifle that outcome.

come and make sure that it didn't happen. And discounts on ETFs have closed. The liquidity in that market is back and everything is kind of back to normal. But yeah, I had to have a lot of skepticism in that period of time on what was happening in the ETF market and then why the Fed shows that vehicle. It almost feels like they pulled it from the Bank of Japan playbook in that they're going to get involved in the ETF space and continue to manipulate markets and create these artificial markets that we live in and operate in right now. You mentioned the skepticism. I think the stereotype is that bond investors tend to be more skeptical, whereas equity investors are more optimistic. Is that true? Do you have to have a certain personality type to be a fixed income manager?

Is there any truth to that? Back in 1994, there was a front page of the Wall Street Journal. I wish I would have taped it or cut it out and put it on my wall. It said bonds are for losers. And I go back, if you remember 94, rates would hire. But think about the return profile for a fixed income investor being very asymmetric, where you earn your coupon. And if everything goes right, your bond matures and you get your money back. Again, it's just a loan. That asymmetry creates a level of skepticism. And in many ways, it probably is a personality trait. I think there are certain personalities that are better bond investors and there are other personalities that are better equity investors. In our shop, we're fairly significant credit investors. And so you have this nice

divide to where you get the optimism from the equity side and then you get the skepticism and the caution on the fixed income side. And it's really a fascinating market and just absolutely love it. take the high yield market and put it on steroids. It's fascinating. The Fed has always been a player on the field. Their presence is definitely more felt than it used to be. That's for sure. It seems that this is the new reality. And people can whine and complain all they want about artificial markets or whatever. But this is the market that we live in. You have to play it as it lies. So I guess that causes all sorts of weird things. Obviously, people are benchmarked to the overnight rates that they set. You saw Microsoft borrow for like, I don't remember what the numbers

were, but basically nothing over. The spread was ridiculous. I don't know why anybody would buy that in their right mind, but people did. So with all that, are we ever and ever's a long time, are we going to see 4% in the next decade? Is that happening ever in our life? I hope so. I mean, I really hope so. I mean, I go back to our earlier comments in that rising rates and having positive real rates in the bond market is a sign of economic health. It's a sign that things are somewhat normal. And it may be a sign that central banks aren't influencing the markets as much as they are today. One of the big questions for the bond market today is whether or not the Federal Reserve

is going to come in and implement yield curve control in terms of targeting maybe a five-year or 10-year rate and holding down rates so that we can ultimately get the deficits at the federal level financed. I hope we see higher rates. I hope we see a return to positive real rates because I think that is very healthy. I think it's healthy for the bond market. And I think it's even more healthy for the equity market. Now, will we have to go through a transition period, which we'll,

might be a little painful where we have some drawdowns and fixed income and maybe some revaluation in terms of equities. I think so. But overall, I think that would be a much better environment than worrying about disinflation and deflation. If we gave you in 10 years, in interest rate target and inflation target, we said, all right, interest rates are going to be 4% in 10 years. Inflation is going to be three. So things have worked out and they're growing. Would you be able to create a portfolio for that? Or would you have to say, no, it's all about the journey and getting there because I don't know what the volatility is going to look like to get there, like, almost if we gave you the headlines, would you even be able to make a portfolio?

What is it about, like, what you're going through at the time, and that's how you create a portfolio? I think it's much more of a journey, and I think the excess return that can be generated through an active process of getting there will be far more accretive than just building a portfolio and letting it go to 10 years. I think about fixed income as part of a asset allocation, a process where majority of us come to the table with an equity bias. We're all raised with an equity bias and we know mathematically that the return profile of equity is better than that of fixed income. And so I do think that the process of going from the starting point to the end point, we're going to have a lot of equity volatility. We're going to have a lot of

correlations moving higher and then lower. And I think that will create great opportunities for fixed income investors. So Ben and I have spoken about this in the past that a bad year for the bond market is a bad afternoon for the stock market. I did this. post a few years ago, I think. The 10-year went from like under 2% in 1940 all the way up to almost 20% in 1981. And over that time, the worst annual loss for a 10-year treasury investor was 5%. Now, that's nominal. Obviously, your bonds aren't going to blow up if interest rates rise. At least your treasury bonds. What can potentially really, really hurt, it's inflation. That is truly the silent killer for a bond investor. So can you just talk about that? Just for fixing

income investors with rates so low, what are the biggest risks? Well, clearly a change in the real inflation and the market adjusting to a positive real rate would be significant. I mean, we think about a negative real rate of 50 basis points or 1%. Inflation running at 1516, that adjustment of 200 plus basis points will be significant, particularly with durations as long as they are right now. You have to remember also that if you're going through that process of adjusting to higher inflation, there are points on the curve. They're going to be much more impacted than the overall bond market. 30-year treasury has a duration of 23 and a half years. Two-year treasury has a duration of 1.85 years. And that environment, you're going to want to

be in on the front of the curve and avoid that long end of the curve. And that's how you manage through it. But I think it's a great question of how do you actively work through that process of adjusting inflation expectations. I think the other element that we tend to forget is that if the bond market's going through a process of moving yields significantly higher to adjust for inflation or to adjust for other elements, there is an impact on the equity market. I talk to advisors every day and they say, well, I hate bonds. I'm abandoning the bond market. I'm not going to have any exposure to the bond market. I said, why? And they said, well, rates are going a lot higher. I said, so what are you investing in? Well, I'm all equities. Like, well, that's fascinating. You don't think there's any

relationship here that rates will move higher and ultimately it will affect the multiple on stocks. And usually the phone goes quiet or they kind of redirect the conversation. But these markets are interrelated. And I think for really good investors, you have to step back and think about those different discount mechanisms and how multiples are impacted by rates. And I think that's really the true tell test of whether or not you can produce great risk adjust returns is understanding the relationship between these markets. Gibson, we spoke for 40 minutes about bonds. I didn't think it was possible, but you made it interesting. So thank you very much for coming on. You're very kind. Thanks for having me. Great to be with you guys and look forward to

spending time with you in the future. All right. Again, this was Gibson Smith from Smith Capital Investors. We will link to all the topics discussed, their website and the show notes. Animal Spiritspot at gmail.com. We will see you next time.