Podcast Summary
Understanding the Complexity of the Bond Market: The bond market, often overlooked, offers a complex and intriguing investment landscape with various derivatives and strategies beyond simple long/short positions.
The bond market, often perceived as boring, is in fact a complex and intriguing investment landscape. Principal Asset Management, a real estate investment firm, employs a 360-degree perspective, combining local insights and global expertise to identify compelling opportunities. Meanwhile, the bond market, which saw unexpected volatility in 2023, offers various derivatives and strategies beyond simple long/short positions. Harley Bassman, a former PIMCO employee and current managing partner at Simplify Asset Management, will shed light on the intricacies of fixed income investing on today's Odd Lots podcast. Despite the perceived boredom, the bond market is full of nuances and opportunities for investors willing to delve deeper.
Understanding Convexity in Finance: Positive or Negative Payoffs: Convexity in finance refers to the degree of unbalanced leverage in a bet or investment, with positive convexity resulting in greater payoffs and negative convexity in less payoffs. Currently, selling convexity in the bond market is profitable due to its higher price, but considering economic uncertainty, taking on credit risk might not be advisable.
Convexity is a concept related to the payoff structure of financial instruments, which can be positive or negative. Positive convexity means that the payoff is greater than the input, while negative convexity means that the payoff is less than the input. In simpler terms, it's about the degree of unbalanced leverage in a bet or investment. For instance, in the context of mortgages, mortgage-related securities often exhibit positive convexity due to the potential for capital appreciation and interest income. In the bond market, duration, credit, and convexity are the three main risks, and currently, selling convexity is a profitable strategy due to its higher price. The Move Index, which measures the price of convexity in the bond market, is currently trading at higher levels than its historical average, making it an attractive investment opportunity. However, considering the current economic climate and the possibility of recession, taking on credit risk might not be a wise decision.
Managing Portfolio Risks: Duration, Credit, and Convexity: During uncertain markets, consider biasing your portfolio towards being short on convexity by selling covered calls. This converts potential gains into income, limits upside risk, and maintains downside risk. Market conditions, such as VIX level, should guide this decision.
When building a portfolio, it's essential to have exposure to all three risks - duration, credit, and convexity - and to over or underweight these sectors based on market view. However, during uncertain times, it might be wise to bias your portfolio towards being short on convexity. This can be achieved by selling covered calls, which converts potential capital gains into current income and limits upside risk while maintaining downside risk. The decision to sell covered calls depends on market conditions, such as the VIX level. It's important to remember that investing always involves risk, and it's crucial to understand the potential consequences of each investment decision. For more insights and expert advice, visit Principalam.com or listen to the Money Stuff podcast.
Jeremy Grantham's Complex Investment Ideas Simplified for Retail Investors: Jeremy Grantham, a renowned investor, simplifies his complex investment ideas for retail investors, now catering to high net worth individuals. He recommends mortgage bonds for best fixed income investment.
Jeremy Grantham, a well-known investor, shares his insights on the complex nature of some of his trade ideas and the audience they are intended for. He used to target high-end institutions and hedge funds but now caters to reasonably intellectually sophisticated high net worth retail investors. His ideas can be simplified and adapted for individual investors. Grantham also mentions his new job at Simplify Asset Management, where they turn complex investment ideas into accessible ETFs. One such ETF, the PFIX ETF, which contains a 7-year put option on the 30-year treasury, had high returns. Currently, he recommends mortgage bonds as the best fixed income investment due to their US government-guaranteed nature and attractive yield over treasuries.
Mortgage bonds' prepayment risk drives 1% premium over corporate bonds: Despite economic cycle concerns, inflation is expected to persist due to demographic shifts and Federal Reserve may not be as accommodative as markets anticipate.
Mortgage bonds are trading 1% higher than corporate bonds due to their prepayment risk, which makes them behave like covered calls. Despite the economic cycle and potential recession fears, the speaker believes inflation will persist due to the demographic shift of retiring baby boomers spending their accumulated wealth and the millennials forming households and increasing demand. The Federal Reserve's actions, according to the speaker, may not be as accommodative as the market anticipates, with Chair Jerome Powell likely considering his legacy and avoiding being remembered as the next Arthur Burns, who presided over high inflation.
Historically high mortgage rate spread due to volatility and inverted yield curve: The mortgage bond market's tightening and smaller spread to treasuries will cause retail mortgage rates to decrease, with an additional potential reduction from the Fed's rate cuts.
The current spread between mortgage rates and treasuries is historically high due to a combination of high volatility and an inverted yield curve. The mortgage bond market, which is the second largest market after treasuries, drives the retail mortgage rate. As mortgage bonds tighten and have a smaller spread to treasuries, the retail mortgage rate will come down. The spread between the retail rate and the mortgage bond rate is also expected to compress. The Fed's eventual rate cuts could lead to an additional 100 basis points in mortgage rate reduction. The inverted yield curve, which has been a topic of conversation for several years, may have predicted economic instability, including the pandemic. Matt Levine and Katie Greifeld's new podcast, Money Stuff, will further explore these finance topics every Friday.
The inverted yield curve as an indicator of economic uncertainty: Investors use the inverted yield curve as an insurance policy against potential economic downturns, and the Fed may eventually reach their 2% inflation target by lowering interest rates, but the process is expected to be slower than the market anticipates, creating opportunities for investors to consider their strategies
The inverted yield curve, despite some debate, is still seen as a potential indicator of economic uncertainty. Market derivatives suggest that the Federal Reserve may cut interest rates significantly, but it's not necessarily a prediction of a massive rate decrease each quarter. Instead, some investors are using the inverted yield curve as an insurance policy against potential economic downturns. The Fed's goal is to achieve a 2% inflation rate, and they may eventually reach this target by lowering interest rates, but the process is expected to be slower than the market anticipates. This creates opportunities for investors to consider their investment strategies, such as investing in mortgage bonds, based on a more gradual approach to reaching the Fed's target.
Expected yield curve steepening with Fed rate cuts: Historically, a yield curve steepener occurs when the Fed cuts rates, causing the 10-year yield to stay stable, the 2-year yield to fall, and the 30-year yield to rise. This shift could lead to profits for investors and a change in the correlation between stocks and bonds.
The bond market, specifically the yield curve, is expected to steepen as the Federal Reserve begins to cut interest rates. This is based on historical trends where the 10-year yield remains stable while the 2-year yield falls and the 30-year yield rises. This situation, known as a yield curve steepener, can be profitable for investors, but it's not an easy trade to make. The correlation between stocks and bonds, which has been positive in recent years, may also change, potentially becoming inversely correlated again. This shift could happen when inflation and interest rates decrease, leading to a return to the historical pattern of stocks and bonds moving in opposite directions. The exact timing of these events is uncertain, but it's expected to occur when the Fed starts cutting rates.
Predicting Economic Recessions with Short-Term and Long-Term Interest Rates: Understanding the relationship between short-term and long-term interest rates and the behavior of buyers and sellers in the options market can help predict economic trends and investment opportunities.
The relationship between short-term and long-term interest rates, often indicated by the spread between the 3-month and 10-year Treasury yields, can predict economic recessions. However, for this relationship to change and for the 3-month rate to go below the 10-year rate, the Fed needs to cut interest rates. Currently, the market is making bets on when this will occur, but it's uncertain if these predictions are accurate. Another topic discussed was 0-day options in the stock market. The behavior of buyers and sellers in this market can impact volatility. If sellers are hedging and buyers are not, it can lead to increased volatility. It's essential to understand who is trading these options and whether they are adjusting their positions to determine the market's direction. Simplify Asset Management offers various investment products, such as pFix, which can provide retail investors with exposure to both rising and falling interest rates. These products can serve as insurance policies, ensuring investors are protected regardless of the direction of interest rates. Some products, like MTBA, are more permanent and offer a higher yield. In summary, understanding the relationship between short-term and long-term interest rates and the behavior of buyers and sellers in the options market can provide valuable insights into economic trends and investment opportunities.
Importance of mortgage market exposure in fixed income: Investors should have a significant portion of their funds in the mortgage market during steep curves and high volatility, but should reduce exposure when the curve flattens and volatility decreases.
Harley Bassman, a well-known figure in the financial world, emphasizes the importance of having exposure in the mortgage market, particularly in fixed income. He suggests that investors should have a significant amount of their funds in this market when the curve is steep and volatility is high. However, as the curve flattens and volatility decreases, investors should reduce their exposure. Bassman also discussed his experience with a specific mortgage product and a large distribution, which affected the product's performance. He encouraged listeners to reload now as the product is improved. Despite the challenges in the mortgage market, Bassman emphasized the importance of understanding macro concepts and expressing views through specific trades. He also shared his unique approach to using colors in his commentaries to grab attention. Overall, Bassman provided valuable insights into the mortgage market and the importance of staying informed and adaptive in investing.
Exploring the Complex World of Fixed Income Investing: Fixed income investing involves strategies like total return swaps, index options, and swaptions, which can significantly impact returns for investors. These strategies are not as straightforward as buying or selling stocks, but they're worth exploring for diversification.
While stocks may be the more commonly discussed investment vehicle, the world of fixed income investing is far more complex and nuanced. Large scale portfolio managers employ strategies such as total return swaps, index options, and swaptions to express views on interest rates and other market conditions. These strategies are not as straightforward as buying or selling stocks, but they can significantly impact returns for investors. It's important to note that this hidden world of fixed income investing doesn't get as much attention as equity markets, but it's worth exploring for those looking to diversify their investment portfolios. If you're interested in learning more about fixed income investing and the strategies used by large portfolio managers, consider following Harley Bassman, the Convexity Maven, and checking out his writings on his website. For more in-depth analysis and discussion on all things finance, be sure to listen to the Odd Lots podcast and subscribe to their blog and newsletter. And if you enjoy Odd Lots, don't forget to leave them a positive review on your favorite podcast platform. Additionally, be sure to check out the new podcast from Bloomberg, Money Stuff, where Matt Levine and Katie Greifeld will dive into the world of Wall Street finance every Friday.
