Animal Spirits Podcast - Talk Your Book: Talking Bonds at the New York Stock Exchange

Starting point is 00:00:00 Today's Animal Spirits Talk Your Book is brought to you by J.P. Morgan and the new J. Bond ETF, ticker JBND, go to AM.jp.morgon.com to learn more or search JPMorgan Asset Management to find this fun. 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. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ridholt's wealth management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ridholt's wealth management may maintain positions in the securities discussed in this podcast. Welcome to Animal Spirits with Michael and Ben. I think this is our first ever talk your book live. Is that fair? First one in a long time. Wait, what are you

Starting point is 00:00:54 talking about, Willis? First talk about live? I don't think so. Okay. It's our first talking book live ever at the New York Stock Exchange. That's a fact. Okay. And I've never been in New York Stock Exchange, so this is pretty cool. Did it meet your expectations? Exceeded my expectations. So we were on the floor.

Starting point is 00:01:09 We were also in a couple of boardrooms. And what did we see? We saw Thomas Edison, what a letter to the Stock Exchange talking about being listed? Alexander Hamilton Pictures. We saw a lot of history. We saw some old, what are those things called? Were these like, they called stock tickers? What were these things called?

Starting point is 00:01:23 Yeah? From 1915? Ticker tapes, right? Unbelievable. It was pretty cool. We were there. J.P. Morgan was listing their new J-Bond E.T.F. on the exchange, and we were there for the ringing of the bell. It was a new experience ring. It was very interesting. And afterwards, we sat down with two people who worked for the fixed income side of J.P. Morgan's team on their portfolio management side.

Starting point is 00:01:45 I don't, I'm not going to, I don't want to shortchange anybody else that we've spoken about fixed income because we've had a lot of great guests. So I'm not going to say that this was my favorite. I'm not going to say that. I'm just going to say that this was a very good conversation. It was. So we get into not only the fun, but. fixed income markets and spreads and a lot of stuff we've been talking about on the show. So we talked to... We got technical and we went broader. We went deep. It's true.

Starting point is 00:02:07 We got the CFA stuff and regular people's stuff, right? Because you literally did ask me like two months ago, like explain convexity to me. Oh, I forgot. No, you knew what it was, but you just wanted an explanation. And we got an explanation. So we talked to Kay Heher, who is the CIO for global fixed income at J.P. Morgan. And then Rick Figley, who is the head of their core strategy with global fixed income and helps manage this fund.

Starting point is 00:02:28 And we went to a bunch of different places. It was live in person. I had a Diet Coke. No Coke zero. Can't win at all. All right. So here's our conversation with Kay and Rick. We are joined today by two members of the J.P. Morgan Fixingcome team.

Starting point is 00:02:44 Kay Hear is the managing director, USCIO for Global Fixed Income Currency and Commodities team. Rick Figley is the managing director head of core strategy within Global Fixed Income Currency and Commodities Group. We are at the New York Stock Exchange today. It's a big guy. a big day. My first time. Yep, I got to see the bell. My first time seeing the opening bell. Yeah, so we're here for the launch of the new ETF J bond. And so we want to talk a little bit about the bond market to start, which I've been making the case to Michael that it's been more interesting the last two to three years than the equity market. Is that fair? Absolutely. And I'm not saying

Starting point is 00:03:17 that just because I'm in the bond market. But I think what's happened is, I mean, if you look at 2022, we had a horrendous repricing in the bond market. And people started to question the role that bonds play in portfolios. But actually, bonds are diversifiers and they provide yield. The repricing that we had in 2022, bonds are back to providing those two key roles in portfolios. So absolutely, core fixed income has an important place in portfolios. And based on our conversations with advisors and clients and even institutions, people are pretty dramatically under-allocated to fixed income. I wonder if 2022 was the way to do it. And what I mean is over the years in 2013 and 14 and all the way through, I had been telling our clients, listen, if we ever want to get some income

Starting point is 00:04:03 from our fixed income, we're going to have to take a couple of steps back to take more steps forward. And boy, did we rip the bandit off. It all happened very quickly. I was hoping to take two steps back, to take three steps forward, not 19 steps back, which we did. 2022 was an unusual year just to remind the audience not that they need it. But bonds, so when people buy stocks, we all understand the risks involved, right? We know we've seen the charts. We've seen the drawdowns. We understand risk is tied to reward.

Starting point is 00:04:31 We understand that's like the contract that we signed with the market gods. Bonds, on the other hand, they were supposed to be the security blanket. They were supposed to protect us when stocks fell. And not only did they not protect us, they were, you could make the argument. They were at the, they're why stocks fell because of the repricing of interest rates. How did you all deal with with client conversations in 2000? What was that like at J.P. Morgan? It was tough. I mean, if you look back at 2022, the aggregate index was down roughly 15%. And while our alpha across U.S. fixed income was strong,

Starting point is 00:05:09 when you're down 13 in change versus 15 in change, nobody likes you. They throw things at you. So it was really difficult. I think it's important. And I'm not running away from 2022 or hiding from 2022. That was a very painful repricing. And the alpha that we generated isn't enough to compensate the beta that really hurt clients' portfolios. How much do you put into the capital appreciation part? Because obviously, everyone in the markets now just pays attention to the Fed, and a lot of people think the Fed is the whole game in town, and they control everything.

Starting point is 00:05:39 And obviously they do control a lot to a certain extent. But do you put a lot of faith in your process of trying to understand what the Fed's going to do? Well, if the Fed cuts rates, that depends on what duration we're in. And how much do you look at what the Fed is going to possibly do versus just the risk reward based on the securities and the different structures you invest in? I think the answer is both are important, and let me dig into that a little bit and talk about

Starting point is 00:06:00 why and when. So as I said, the starting point for yields is important, but if you take a step back, you have to think about what the economy is doing, where the economy is, what the Fed might be doing as it relates to the economy, and those really drive how we think about a couple of important allocation decisions within bond portfolios. So you talked about stocks, you're looking at what's evaluation and what's the earnings trajectory. When we think about bond portfolios, there's the risk of duration, right? What's the maturity risk that you have? How far out the curve are you going on it? And there's a whole other host of things that are complicated, but we're going to simplify this into duration risk and credit risk. So credit risk, high quality.

Starting point is 00:06:35 So on the one hand, if you're thinking about buying treasury bonds, there's absolutely no credit risk associated with them. Those are full faith and credit of the United States government. Oh, yeah, you see our comment section. Fair enough. I have read your comments, and I've listened to these before, and I think you guys do a terrific job on them. But I, you know, I guess I should read more deeply in the comments. Anyway, there's no credit risk associated with that, but there's a lot of duration risk. If you're buying a 30-year treasury bond, that's going to be where things can be grossly mispriced or a lot of fluctuation based on it.

Starting point is 00:07:07 So let's take a step back in. So those are the things that are really important to think about. So let's think about where's the economy, where's the threat, where's the Fed right now, what's the Fed doing, and then how does that set us up for capital appreciation or not? So to unpack all of that, first off, let's remember, what's the Fed's mandate? The Fed's mandate is stable pricing and full employment. Okay, so how are they doing on that? Right now, they're doing really well.

Starting point is 00:07:31 Okay? So you've got unemployment under 4% for, I think, 25 consecutive quarters. That's terrific for U.S. consumers, U.S. for Americans, right? If you look at inflation, I think as we all now know and appreciate, the Fed was behind the curve on inflation. They thought inflation was transitory in the post-pandemic period. there were a bunch of supply chain disruptions, and they were late to start hiking. Then they started hiking aggressively. And to your point, Michael, that's really what drove difficult performance in bonds, because

Starting point is 00:08:03 the Fed took the Fed funds rate all the way up to five and a quarter and five and a half, and that causes a repricing and everything, not just within the bond market, but also within equity markets. So that's what's happened. So here we are now. The Fed's got employment where they want it to be, right? growth has actually been good. We're in what we would call a soft landing. We're in a Goldilocks type environment. So it's extremely difficult to achieve a soft landing. In fact, if you look at

Starting point is 00:08:30 kind of the last seven cycles, really the Fed only achieved that one time previously. So there was a lot of expectation last year that the U.S. economy would slip into a recession. So far, that's not the case. Inflation, so let's talk about inflation in a second, but growth, GDP growth, and jobs have still been, you know, Goldilocks, not too strong, but not too soft. So maybe you can settle the debate for us because – Uh-oh. So we've talked about – a lot of people are saying, okay, great, we have this Goldilocks scenario, and I'm making the case that it feels more than 90s and the 70s.

Starting point is 00:09:02 Everyone was worried about the 70s. The economy right now feels more with the 90s. So Michael says, why do the Fed need to cut rates if they haven't really impacted the economy that much? My take is, well, if inflation is falling, that means real rates are higher, and that could be more restrictive. So it does make sense for the Fed to cut. So you put me in a tough spot because agreeing, I have to agree with one of you and disagree with the other one, and I'm sitting closer to Michael, so I'm tempted to agree with him. But unfortunately, the merits of the argument that

Starting point is 00:09:28 you have made are stronger. So the Fed's favorite measure for inflation is PCE, personal consumption expenditures. And if you look at it on one-year basis, it's too long of a time series. So the best way to look at PCE is on a six-month annualized basis. And if you look at it on a six-month annualized it's running at 1.9 percent, and the Fed's target is 2%. So inflation has actually moderated to down, actually below what the Fed thinks the target is. And with real rates, with the Fed funds rate up at five and a quarter to five and a half, real rates are very restrictive. So as inflation has come down, real rates are restrictive,

Starting point is 00:10:08 and that's going to be further tightening in the U.S. economy that could slip us into a recession. But counterpoint, financial conditions, have eased so much to offset any of that monetary restriction. So that's a really interesting point. And if you look back, the, if you go back to this fall, there were a couple of real debates going on in the market. So you could say to me, hey, Kay, you could have been sitting here in 2023 and it would have been the exact same argument.

Starting point is 00:10:36 And there's an element of truth to that. But I would point out, actually, 1231, 22, 1231, 233, the yield on the aggregate index was basically the same. So what'd you do if you own bonds? You clipped your coupon, which was a good thing. You're getting five, six percent returns. Admittedly, far below the magnificent seven, magnificent seven, yes, I can't talk, far below that, but what bonds were supposed to do in your portfolio for you. So you make a good point about financial conditions, and it's like, you're right. Last year, when we think a couple of things happen, first off, everybody decided, oh my goodness, the budget deficits expanded, the Fed's going to, the Treasury's

Starting point is 00:11:16 going to be issuing all this debt, and it's all going to be at the long end, and the market can't absorb this, and foreign buyers have gone. And that really helped to move the Treasury above 5%. That was a worry for like a month. It was crazy, right? That was September October. Wasn't somebody calling for 13% on the tenure? I mean, there was some outrageous claims. Like the higher for longer, by the way, the higher for longer theme turned on a dime. Yeah. Higher for longer was consensus for like three, four weeks. And then wow, did that. And a painful three, four. four weeks for us in our portfolio, as I would tell you. You know, I don't traffic in the hedge fund community, but you're right.

Starting point is 00:11:53 You get these ideas, people all pile into them. And I think that's why people, especially individual investors, have to think about in asset allocation, what they should own for the longer term, and, you know, where bond can make sense in that. It was a really interesting time where Ackman and a lot of other hedge fund managers were short the two-year, or whichever rates they were. And then moved the opposite way. But then asset managers were super long.

Starting point is 00:12:17 So it was this really weird push and pull between speculators and asset managers. I want to talk about regular people for a second. We are regular people for the record. Not hedge fund managers, everyday investors. So in 2022, correct me from wrong, there was a mass exodus out of bond funds, right? People ran away because it was just the pain was too acute. And even though they should have been running towards higher yields, they were running away. in 2023, investors were piling into bonds.

Starting point is 00:12:48 I think there was some crazy streak of consecutive weekly inflows, which made sense. It makes sense mathematically, but everything we know about investor behavior, it didn't make sense because nobody, people don't behave with that way in the stock market. If the stock market is falling, you could better believe that there was outflows. Are investors getting smarter? Is it their advisors? Because the rational move is when you experience losses in the bond market. returns empirically become more attractive going forward. We know that mathematically. Are investors

Starting point is 00:13:20 getting smarter to that fact? So a couple of things. Yes, you're 100% correct. Second, I genuinely believe that Americans and their advisors are smart people and try to do what is logical and rational. If you look underneath the data at bond funds and what went in, it's actually a little bit more mixed. So the biggest inflow last year was actually into money market funds. So that's something like, there's something like six trillion dollars sitting in money market funds. So neither stocks nor bonds. And actually, T-bills, there was, you know, you talked about memes and things that people liked, right? Last year it was T-bill and Schill. And there was a lot of merit to buying money market funds, buying T-bills, because you could get rates north of five

Starting point is 00:14:01 percent with no risk, right? So let's hold that thought for a second. But if you look at the underlying markets, there were outflows in short-duration bond funds, which is really interesting because the curve has actually been, the yields have been more attractive there. So you can make an argument that people should be in two and five year and there were outflows in short duration bond funds. Core bond, however, actually had pretty substantial inflows. And then it was mixed. You saw outflows in emerging markets debt. You saw outflows in high yield debt. You saw inflows into investment grade. So I think it's a more nuanced story than just people were buying or not buying. And just add to this, just remember that back in the time when

Starting point is 00:14:40 interest rates were low, 6040 was dead. So nobody wanted to be in bonds. And you probably, you can make the case that that was true, right? You know, now that rates are higher, you know, investors just recognize that bonds have value. There's yield there. There's income there. And so it's not necessarily about our investor smarter now than what they were. I think you just recognize the fact that the market has changed and investors are going to go. I wrote a eulogy for the 6040 in 2019. I think we've written it. A eulogy for the 64. 70-30 was 60-40, but 60-40's back, because now you actually can.

Starting point is 00:15:13 60-40's back. Comfortably hold 40% your assets, earning 5% of the money market thing. By the way, it was dead. When rates were zero. Well, yeah. Yeah. But the 60 did a lot of the heavy lifting for you. Stocks were doing 40% of year.

Starting point is 00:15:24 100%. But do you think that that's a reasonable expectation year in, you're out? Of course not. But how do you think, let's say someone took the 40 and they said, you know what, my bonds got crushed. I'm going to the money markets or T-bills and I'm clipping this and I'm not, I'm taking the volatility out of it. I think a lot of those people are wondering, like, well, if the Fed

Starting point is 00:15:40 cuts, I know my short-term rates are going to fall. So that's exactly the right question. And I think, to your point, Michael, investors, we as humans, worry about the last thing that happened to us, and they don't worry about the next thing that's going to happen. So the next thing that's going to happen in our view is reinvestment risk, okay? So we started to talk about the Fed, and then we went off on a different tangement. But if you go back to your question, people think, I lost money in bonds. That's a bad thing.

Starting point is 00:16:07 I can get five, five and a quarter, my money market fund and T-bills. But if we're right, and the Fed starts easing because real rates are too high, then your money market fund yield is going to go down. Your T bills, when you look at a 5% and a quarter percent T bill, that is an annual rate for the 12 months. That assumes if it's three-month T-bill, that assumes that you can roll that over. And we don't think that that's really what's going to happen. And so now is a good time to lock in yields for people.

Starting point is 00:16:38 So if you're right, this is the big question on everybody's mind in 2024. Can't believe it's 224. It sounds weird. 30 days into it. So $6 trillion in money market funds, I think another $2 trillion in CDs. What happens to that pile of money? The CFO of another large asset manager said he goes to bed salivating about all of that money and the potential to rotate into fixed income flows. my suspicion or my working thesis, which obviously will either be right or wrong, is that I think

Starting point is 00:17:11 there'll be a lot of inertia. Money was slow to move in. I think it's going to be slow to come out. And I also think it's more checking account than people selling bonds or stocks and going into there. But even still, even if it's only a fraction, there's still trillions of dollars up for grabs that will probably a piece of it will come back into fixed income. So how are you all thinking about that piece of the puzzle? So a couple things first. So number one, when you look, I think the market's focused, people are focused on the wrong thing that right now. They're focused on, is the Fed going to ease in March? Is the Fed going to ease in June? And actually, it doesn't really matter. If we're

Starting point is 00:17:42 sitting here a year from now, that's not going to be the debate. Oh my gosh, we got it right. The Fed eased in in May and not, or June, not in March. What actually matters is from the time that the Fed stops hiking rates in the subsequent two-year period bonds outperform. The aggregate index outperforms cash by something like 13%. And I think that's what's going to happen. I think people are waiting for the Fed to ease. And then they're going to say, oh my gosh, I can't, or they're going to see their T-bills mature and they can't roll them into another one or their money market fund rate. And then they're going to start going. And that gets to where we think they're going to go. We think they're going to go into core bonds. Well, the problem is, as we know, the market doesn't

Starting point is 00:18:20 wait. The market doesn't wait for the Fed to move. The tenure is already down to 4-1 or wherever it is this morning. So, Rick, how should invest, like, how do you think about the tenure? Is a tenure already pricing in several cuts? I think the market overall is pricing in cuts for 2024. The real question is, you know, is the market pricing in too many cuts or not enough cuts? And I think that that's where it gets a little tricky when you're talking about duration. But just because of we didn't, I didn't just say anything about hikes. And that's the important thing here, right?

Starting point is 00:18:52 We're talking about cuts. So whether or not they're maintenance cuts. So we just bring real yields down a little bit or whether or not, let's say, hypothetical, at the end, you know, in 2024, 2025, that we start talking about recessions. And then there's what I call the bad cuts. The bad cuts are those cuts that, you know, if we go into recession, maybe it's not 25 basis points. Maybe it's not three cuts of 25 basis points.

Starting point is 00:19:17 Maybe now we're talking, talking about 50 basis points. The point is, like, money managers sitting here today, we don't really know. Now, I'm going to come back to one thing that you were talking about. Then you're 100% right to talk about flows independent. fixed income now. And you're talking about that tricks six trillion dollars in money markets. Now, the thing you have to keep in mind, though, is what is the composition of that six trillion? And how much of that potentially could actually come into the high grade fixed income market? And it's not going to be $6 trillion. But you don't need $6 trillion to come in and move

Starting point is 00:19:52 that tenure from $4.10 down to three and a half in a very short period of time. And nobody in, I'm just going to include us, obviously, and that's when we think we're the experts here. You can't predict when that's going to happen. And so when we talk to clients, we say now is the time. You should be getting into fixed income, whether or not it's your high quality fixed income, or if you think it's going to be the soft landing, and maybe you want to go for a little bit more yield. You know, that's going to be up to the individual investment. And that's the question, like, our listeners and advisors have been asking is, okay, I know the Fed's going to cut. I don't know when. I don't know how much, but I want to lock myself from my clients into some more duration in case yields fall

Starting point is 00:20:31 or just get a higher yield because of the short-term yields fall. Maybe the longer-term ones don't go down that much. If the economy keeps humming along, maybe the 10-year stays in the 4% to 5% range. Who knows? So probably a good transition into your new ETF that we're here for today, J-Bond. This is a, I guess you call it a core-plus strategy? No. This is a straight core strategy.

Starting point is 00:20:51 This is investment-grade only. Okay, so plus would be with high yield. Correct. Right. Okay. So this is just investment grade. And I guess a lot of investors probably aren't really familiar with like a bond index. People might invest in a bond index fund or an ag fund. But most people these days kind of know it's really hard to beat something like the S&P 500, right? But the bond market is different. So maybe you could just start there talking about how that aggregate bond market works and then how you try to tweak and go different

Starting point is 00:21:21 from that. Right. So out of the entire fixed income universe, high grade, so investment grade, the U.S. Ag index makes up about 50 percent. Maybe it's a little less than 50 percent of that entire investable universe of debt. What J Bond is going to attempt to do is it's going to leverage parts of that index that are underrepresented in the index. So, as an example, J-Bond, the way we've designed this, even though it's going to be benchmark versus the ag, it's going to have a securitized heavier allocation. So let's say the ag is on agency mortgages. It's around 30%.

Starting point is 00:22:08 Securitized credit, it's going to be another 1.5%. J-Bond, the way we've designed this, the way that we're going to run this, is that we have minimums and maximum. So it's going to be a minimum of securitized plus 20% is how J-Bond is going to be. That's a minimum. So let's say that's 50% securitized at all times, J-Bond. We're actually going to run that between 60 to 65%. And we'll talk about that in a minute and why we think that's a good idea.

Starting point is 00:22:39 But then on the corporate credit side, where we still think we do a great job of corporate credit, what we've seen over time when the product that we have on the product that we have on the 40X side. So the 40X mutual fund, when we look at attribution over a long period of time, our attribution, our alpha producers come from the securitized sector. And that's why we really decided to focus in on the securitized for this ETS. So for Ben's benefit, because not my, I know what you're talking about, but what does securitized credit mean? So securitized in general is going to be a combination of government guaranteed securities. That's that 30%. And then it's going to be everything else, securitized credit. So whether or not it's auto receivables, it could be

Starting point is 00:23:24 credit card receivables, it could be related to commercial real estate, it could be related to residential real estate. It's everything else that has some credit component to it other than just the agency. So a lot of that securitized stuff is not in the ag is what you're saying. The ag makes up about one and a half percent of that entire universe. So let's say securitized in general is $6 trillion, it's a fraction. Can we talk about the mortgage part of it? So the one of the reasons why interest rates on mortgages went up so much is obviously from the Fed's actions, but also from their inaction.

Starting point is 00:24:02 So they removed themselves in a big way from buying, even I think in March 2020 when they started raising rates, right before that they were still buying whatever it was, $20 billion a month. I mean, they had their hands all over the mortgage market. And they stepped away while they were raising interest rates. So not only did interest rates go up, but the spread between mortgages and treasuries also blew out. Is that now more attractive? I mean, obviously it's more attractive than it was three years ago, but just how much more attractive? What does that look like in terms of the

Starting point is 00:24:31 portfolio? That is a very interesting question, because when we look at the investment-grade sectors, it's basically going to be, you know, what we invest in, it's going to be treasuries, it's going to be corporate credit, it's going to be those agency mortgages, and then securitized credit. When we look at how the performance of corporate credit did in 2022, well, 2023, and then the beginning of this year, it's rallied. It's done tremendous. And for a variety of different reasons, but it's been one of those sectors that has done extremely well. Agency mortgages, on the other hand, they blew out to a spread. They rallied in a little bit in November and December, and that's because of the market all of a sudden thought that,

Starting point is 00:25:16 that there were going to be seven to eight rate cuts in 2024. Whenever you have rate cuts and those rates were going to come down, it made that that's a positive technical for mortgages overall. The problem with the mortgage market, though, is that when you take the Fed out of being one of the largest buyers in the market, and then the other thing that happened was last year, was that because of the stress that we saw in the baking system in March of last year, banks are also no longer in the market buying agency mortgages. So they make up about two-thirds

Starting point is 00:25:51 of what is in the mortgage index. So there's not a natural buyer really left to drive mortgage spreads tighter. So money managers through the first half of 2023 went overweight agency mortgages, so more than neighborhood of 5 to 10%. So then the only big buyer that potentially could come in the market at this point in time to really tighten spreads in, barring something changing with banks, is the foreign buyers. And they're not showing up at this point either. So here it is that you have mortgage spreads that have widened out to a certain level, and they're staying there. And it's a huge spread. So I look at it today, it's still 6.9% for the 30 year today and that's 10 years at 10. 10 years at 4, sorry. And so it's almost

Starting point is 00:26:37 a 3% spread. I looked at this historically. I think for the last 20 or 30 years, it's maybe 1.5, 2 it the most. So 3% is a very high spread. So my hope is if the Fed does lower rates that mortgage rates come down, which I think could be a boon to the economy in terms of housing activity, what causes that spread to compress? Because that would be great for people who are wanting to buy a house, obviously. So one of the problems, so when you think about how mortgages are priced and how agency mortgages trade compared to treasuries, volatility of the treasury market is very important. And when we started this, you were talking about the significant volatility we saw last year. So when there's that much volatility,

Starting point is 00:27:11 it, when people think about pricing, what that option and when things are going to be called or, et cetera, early, then the spread for mortgages widens out. So in the absence of natural buyers, the Fed, regional banks, banks buying, and with a high degree of treasury volatility, you've got much wider spreads either on agency mortgage securities or also in an actual mortgage if you go buy a mortgage compared to the 10-year rates. That's absolutely true. What happens exactly as you said when you when you get confidence in the market that it's not wait are we hire for longer or is the fed cutting when you start to get confidence in that then I think mortgage spreads come in so just add to this a little bit it's a it's a little bit more complex of a story when you

Starting point is 00:27:56 start talking about mortgages because there's this thing called the coupon stack so basically there are mortgages that start you know that you can buy at 2% and go all the way to six and a half maybe you can find some 7% mortgages out there because of different dynamics within low coupons versus the higher coupons or the current coupon, they react differently to rates in different environments for different reasons. There's a term that I'm going to throw out there that unless you're a bond person, you're not going to know it, but it's important when you talk about investing in two mores. Convexity. Positive convexity versus negative convexity. Positive convexity basically means that if rates rally, your bonds are going to.

Starting point is 00:28:39 going to rally with them. If rates sell off, your bonds are going to sell off for about the same amount. Michael called me about a month going to ask me what convexity is. Because you know what? No, it was a big, I remember it was a big portion of the CFA exam. That was a long time ago. Right. So when you have a, when you have a portfolio of negative complexity, your duration, as rates move around, your duration is also going to move around. But in the opposite direction of what you wanted to do, when rates are, if rates are going down, your negative complexity is moving against you. When rates are going up, so think about this. Like, rates are going, higher. You're measured to an index. Rates go higher. All of a sudden, your duration extends,

Starting point is 00:29:16 right? But you're extending when you don't want it to extend, because rates are going higher. You want a shortened duration. That's that negative convexity, and it works the other way, too. So as rates come down, if you own that negative convexity, your bonds are actually going to get shorter to the index when you want it to be long as rates are going down. That is really the key of how you manage mortgages, and that's why you really have to understand what you're buying between a low coupon mortgage or that current coupon mortgage or that high coupon mortgage, and that's why you want the expert. Right, to your point, the people who wanted to stay under 3% mortgages like us,

Starting point is 00:29:52 that made the duration of mortgage bonds longer because they weren't going to get bought down as quick, they weren't going to get refinanced. Correct. So dealing with all these different moving pieces, there are lots of difference. So how do you manage that, and what are you looking at to make changes to your portfolio, if you're going to go from one sector to another or one type of bond to another, what are you looking at to make changes there and what are your parameters? So first and foremost, we want positive convexity, positive convexity versus the index.

Starting point is 00:30:20 Now, the index actually has a lot of positive convexity because it's made up mostly of low coupon mortgages. So twos, two and a halfs and threes. But the problem with buying just those coupons is that it's price, it's valuation. Because of banks, that's what banks own. That's what got them into trouble last year. Asset liability mismatch. They had longer durations as rates went higher, right? So it's that component, and then the Fed owns another large component.

Starting point is 00:30:49 And so there's not a lot of float of that mortgage out there, which means that it didn't really have that opportunity to blow out and make an attractive type of investment for us, right? Conversely, when you talk about or when a lot of people in the market talk about agency mortgage, is being attractive. They talk about that current coupon and because it's a relatively widespread. Currently now, it's about 125 treasuries, which is relatively attractive, historically, from a historical standpoint, but it's got that negative convexity component. And it's more negative convex now than what has been in the past. Because when we think about where we're at in that race, we're talking about rates coming down next year, those bonds are going to shorten when you

Starting point is 00:31:33 don't want them to shorten, and when they shorten, the spread widens. It does all the things that you don't want it to do. So when we talk about positive complexity, right, we want to find mortgages that have either a low coupon mortgage that's going to be at 85 or a $90 price security that actually has components to it that does pay a little bit faster so that not only do we have some price carry, we actually get our money back in a shorter period of time. So 85 cents on the dollar, getting paid back par, that is pure Alford, the portfolio, if you can find those types of securities. Or if you can find something at a slight discount that has positive convexity that from a valuation standpoint is relatively attractive, that's another thing that we're trying to do. But it really comes down to that positive convexity because when we talk about rates going lower this year, we do not want our portfolio to shorten.

Starting point is 00:32:30 we actually want it to say the same duration as that index duration is going to shorten. We've gone deep into the weeds on convexity and mortgage bonds in particular. I wonder, since a lot of your podcasts are more focused on equities, I wonder if we should take a step back and talk about the index and how we think more broadly. Sure. I'm glad you asked. I was going to go a slightly different direction, but we could, so maybe a segue into that. We didn't talk about corporate credit at all. That's where I was going. Okay, perfect.

Starting point is 00:32:59 So, 2022 was a very unusual year where bonds got killed, not because credit quality was deteriorating. It was all duration. So junk bonds actually outperformed. And we never really saw in this tightening cycle, we never really saw corporate spreads do much of anything. I mean, there was a few wiggles. But spreads remained relatively tight to, certainly to what you would have thought, if you knew that there would be 500 base points of tightening. So talk about how corporate credit has responded and where you think there might be opportunities. So we went from a period.

Starting point is 00:33:28 in March of 2020, when the market basically shut down, where corporate credit spreads blew out to the actual OAS number or spread was 374. And from there, spreads just went on a tightening cycle. And they happened for the next two years. 91 yesterday, right? What's that? I think it's 91 basis points yesterday. 374 to 91.

Starting point is 00:33:52 That's where we're sitting at right now. Now, for a couple of different reasons. So we talked about flows earlier. flows into fixed income, high-grade fixed income, is a very powerful force because two-thirds of that index is put into passive money. So of that, you know, of the investments that go in there, two-thirds of that market go into passive money. I always say that passive money is the uneconomical buyer. They don't look at spreads. They don't look at value. They just come in. They buy the current coupon agency mortgage. They take the negative convexity. They buy corporate credit

Starting point is 00:34:26 spreads where they're at. They don't try to distinguish where any value is. But it just comes in and it piles in the market and it artificially keeps spreads tight. And that's what happened in the first half of last year. And so we saw a little bit of widening in the third quarter of last year. And then the Fed indicated that, hey, the tightening cycles over and the market starts pricing in all these rate cuts. And then ever since that, it's just been a straight move on IG corporate credit from 1.30 straight to where we're at right now, down to 91. And what's interesting this year versus last year, though, is last year it was passive money flows into everything. This year, the flows have been targeted. And so far, it's been targeted into high-grade investment

Starting point is 00:35:11 corporate credit. Interesting. I've heard that argument made a million times about how passive flows are keeping the S&P 500 and stocks. Sorry, I never heard on the bond side. So you're saying that Obviously, economic forces pulled spreads in because the economy is doing fine. It spreads should, but you're saying that this might be a new regime where the steady state of corporate spreads just might be lower today than they were, say, 30 years ago before there was automatic money coming in every two weeks. Every once in a while, there will be a big move in rates. And Michael and Josh and I will get on our slack and we'll say, what just happened? Why did two-year go way up or go way down? And we go through the, you know, it's inflation or the economy.

Starting point is 00:35:49 And then our conclusion is always it's positioning. So that's kind of what you're saying, right? That positioning is. It is. The two is a little bit different, right? You know, so the front end of the curve trades on basically the market perception of what's going to happen with the Fed, right? And then the back end of the curve is going to basically trade on what's going to happen

Starting point is 00:36:06 to the overall economy, growth is, you know, ultimately. So we're talking two different points of the curve and what happens there. But the flows into fixed income, when flows start to get targeted into markets like this, It really tightens, spreads for those specific markets, and not everything participates. So this year versus last year, we see a tightening of corporate credit. We have not seen that tightening in agency mortgages this year. Securitize credit, which we haven't even touched on, is going to be that sector that always lags that move in corporate credit, but it's going to happen and they're going to have some catch up

Starting point is 00:36:40 and we're getting those now. But Ben, I think it's also important to remember what the actual yields are. So the debate really in the investment grade market has been about, and high yield as well, has been about yields versus spreads. So if you look at spreads in investment grade or high yield corporate credit, some would argue they're not compensating for any risk of a recession, which still may happen. But on the other hand, you're looking at five, five and a half percent yields in high quality, high grade investment grade bonds, which are yields people haven't been able to capture for a year. So that's really the debate in the market. Is it a yield buyer or is it a spread buyer? And the discipline that we have to have as active managers is looking holistically at what valuations are, as you said, the fundamentals. So Michael touched on that. Absolutely. Corporate credit has still been very resilient. Corporate management's have been very disciplined. Balance sheets are in good shape. It's the quantitative, which is valuations, which, as I said, attractive yields, but more nuanced on spreads. But nevertheless, spreads have come screaming in, you know, a year ago, I spreads at 130 over, and people thinking, well, you would really need to get 175 to get compensated for the risk of a recession, and they've gone straight into 90. And so that's the balance.

Starting point is 00:37:56 You can still pick up a really attractive yield, which you couldn't get in bonds for the last several years. So remind listeners, so we understand how the SP500 works, right? Apple's or Microsoft is the biggest company in the world or in the United States. It's the biggest company. the SB 500. How does the index for fixed income work? Yeah, so Microsoft gets there because of huge earnings and then a multiple put on there. The way the benchmark for fixed income works is the biggest issuers of debt have the largest weighting. So that's slightly perverse and not necessarily what you're looking for. So that's why we're big fans of active management and fixed income because you've got a team of portfolio managers and research analysts thinking, as we

Starting point is 00:38:43 said, about your duration, about your convexity, but also about sector selection, looking at relative value across IG, across mortgages, across securitized credit, and then also security selection within each of those, so that we're buying the companies that we think will perform well, and you will, at the very worst, get paid back in full while collecting the good money. Or the idea is if the U.S. government issues a bunch of treasuries of a certain maturity, the ag picks that up based on what they're issuing. Exactly.

Starting point is 00:39:10 They're not picking and choosing somehow. Exactly. And we are picking and choosing, and I think that really gets back to Rick's comments about how we think about particular bonds that we're buying for portfolios and the duration and convexity profile of those. Perfect. So if our listeners and advisors want to learn more about J. Bond, where do they go? JPMorgan Funds.com or talk to your advisor. Okay. This is great.

Starting point is 00:39:31 Thanks. Okay, thanks again to J.P. Morgan Ascent Management. Thanks for New York Stock Exchange for hosting. Remember, JPMorgan Asset Management, check out the J-Bond ETF to learn more, and email us Animal Spirits at a compoundnews.com. Investments and bonds and other debt securities will change in value based on changes in interest rates. If rates rise, the value of these investments generally drops. Investments in asset-backed mortgage-related and mortgage-backed securities are subject to certain risks, including prepayment and call risks, resulting in an unexpected capital loss and or a decrease in the amount of dividends and yield.

Starting point is 00:40:07 During periods of difficult credit markets, significant changes in interest rates or deteriorating economic conditions, such securities may decline in value, face valuation difficulties, become more volatile, and or become illiquid.

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Animal Spirits Podcast - Talk Your Book: Talking Bonds at the New York Stock Exchange

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