Latest / The Issue at Hand by Madison Investments / Fixed Income, in a Language Clients Understand
Transcript
- speaker-0: Unlike equities, which in theory have infinite upside potential, a bond. speaker-1: We're not thinking about it when he's here. Come on. speaker-0: We don't talk about equity. Everybody wants to talk about equities. are much more much more important. speaker-1: you Hi there. Welcome to Madison's inaugural podcast, The Issue at Hand. I'm Chris Alamon, an investment director here at Madison, and here with me is Mike Sanders, head of fixed income and portfolio manager. How you doing, man? speaker-0: Do well. Do well. speaker-1: So the plan of this podcast is to launch a new episode the first Tuesday of every month. And I guess our hope is that you listening in, you'll gain a little bit more confidence about having fixed income discussions. Maybe learn a little bit about why Mike and I have a passion for it. So I guess with that, let's get started. So Mike, I think one of the things that we want to tackle on is what we consider fixed income basics, fixed income risks. So I guess let me turn it over to you. Why don't you set the stage for us? speaker-0: Yeah, think when you look at investing in fixed income, I think a really good place to start, to your point, is just look at the risks involved and where you're earning your return. And so investors, advisors, allocators, however you want to look at it, they all have to take on a specific risk within fixed income to generate performance. I think to set the stage, like you said, in terms of looking at those risks, defining them, and kind of understanding what they mean. think it'd be a good place to start and kind of get like a baseline understanding for everybody. speaker-1: No, I think, and again, I think what we're trying to say here, what Mike was kind of getting at was fixed income isn't boring. I think everybody needs to understand that there are nuances to it. It's not just coupon clipping. And we feel that having an understanding will enhance the relationship you have with your clients. And I think my biggest takeaway is that when a client asks you to allocate, I guess, allocate their money, you need to recognize that you're helping them manage a lot of risks simultaneously. And I think that's a big deal. And I think that leads to a valuable relationship. So think with that said, I guess let's, let's set the stage. So Mike, how should people, I guess, frame risks and fixed income for their clients? speaker-0: Yeah, so when I think about risks and fixed income, I think of really four different buckets of risk. So you have when you get your money back. And I'll define these in a little bit more detail. If you get your money back, how you get your money back, and then kind of the conversion to cash, which is obviously a little more interesting now than what it has been in the past couple of months, given some of the redemption issues and some private credit funds. But if we just go in a little bit more detail on those, you know, those other risks. So when you get your money back, that's really maturity risk, duration risk. That is, do you buy a short bond that matures in one month or do you buy a 30 year bond? How does your view on Fed policy impact which maturity you want to invest in? Just because the Fed's cutting interest rates, the Fed's cut interest rates for a while now, but a 30 year treasury is at 5 % now. So there's a lot of different moving parts there and that's a pretty big ⁓ input in terms of you maybe the performance going forward is you know how much duration how much maturity risk you're taking and then how that influences your your coupon clipping or total return opportunities I would say the next one it would be if you get your money back speaker-1: Hang on, I want to take you there because I think the flip side is also, I think we talked about cutting rates, but then you have the flip side that could go back to, I guess, that takes me back, what was it, 2022, when the Fed was aggressively hiking rates. I mean, that takes me back to an advisor in Boston who was just scared, and he was just concerned that if I have a long duration portfolio, what impact is that going to have? So I think stressing the importance of diversification there, I think, is another thing I wanted to hit on. So sorry, I interrupted you. You were saying? Yeah. speaker-0: No, mean, that's exactly it's, you know, you said moving up, said moving down QE QT, you know, there's a lot of different things to think about when you're allocating a specific bond in a specific part of the curve and kind of determining, you know, what maturity makes the most sense for your client or your personal goals and whatnot. So, you know, if we go to the if you get your money back, that's again, credit risk. That's, you know, I buy a corporate bond, I'm going to earn a little bit of income and I want them to give them back to me in five or 10 years. you know, bonds are unique in the sense that there's really a capped upside, right? You get, unlike equities, which in theory have infinite upside potential, a bond. speaker-1: We're not thinking about it what is here tomorrow. speaker-0: ⁓ Everybody wants to talk about equities. Bonds are much more, ⁓ you know, lend money to a firm, they pay me back interest. But if they don't pay me back, I get a lot less. I can get back what I gave them more or less 100, know, 100 cents a dollar par. But if they don't pay me back, it's a lot less. so, you know, that's a risk I think most investors, most individuals understand lending money to another institution. ⁓ and earning some income back. That's probably the easiest one to understand is default risk. And that's really what you're getting paid for when it comes to if you get your money back. speaker-1: I think it's also important to know how fast I think that can turn too. think when we look at maybe let's use a recent example, First Republic was one of the last ones that I can remember where it happened within a two week period, the downgrades. mean, it can happen that quickly. I agree with you. think it is the easiest to understand, but at the same time, it can happen a lot faster than I think what people realize. Is that fair? speaker-0: Yeah, no, 100%. It builds up and then it escalates very, very, very quickly. that's why when you're investing, lending money to other entities, you really have to understand all the different levers of that business and how they can pay you back. you that's pretty important to obviously risk that you have to think about when you're lending money and it changes very quickly in different environments, which is what we saw back in 2022. And kind of on that topic in a sense is that, you know, how you get your money back. Uh, you know, this is probably the best way to describe it would be, you know, how maybe even from a, if you get your money back and when you get it back changes with interest rates, right? If you have, think the easiest way to explain how you get your money back is, you know, a mortgage and you know, you can buy securities that are tied to mortgages. And if I own a, if I own a security that's tied to a mortgage that somebody has, interest rates fall, that person is going to prepay their mortgage is going to give me back my money. Right when I don't want it to quite frankly, because I want to lock in the rate as rates fall. And if interest rates are going up, you know, I want them, they're going to pay it less quickly, delay their prepayments back to me. But in reality, rates are going up, so I want to get the money quickly back so I can reinvest it in higher rates. So that's a different risk. Again, it's probably a little bit harder for people to understand. But I think if you tie it back to any sort of mortgage loan, whatever that is, that's a really interesting. It's a really good way to think about that risk. And you can get paid for that. You can get paid really well for that. There's different times when taking that risk maybe spreads out mortgages versus corporates are really attractive. Then maybe you should allocate to more mortgages versus. creditors. I think that's kind the environment we're in today. speaker-1: would be the, I mean we're saying all these things that all sounds positive, what would be the downside of prepayment risk? I guess people prepaying their mortgages a little faster. speaker-0: Well, again, so let's say you buy a bond that's, you think it's going to have a seven year maturity and you've locked in 5%, 6%, whatever the number is. Interest rates fall and they pay back your money tomorrow. So I haven't locked up that money for seven years. Right. I've only locked it up for a year, a year. Now I got my money back now and rates are lower. So my reinvestment is a lot lower. So it kind of comes back to. speaker-1: So, that's speaker-0: combining when you get your money back and how. And there's a little bit of credit risk associated with that and then sometimes as well. So it's ⁓ probably the least understood one, I would say, if I'm just your typical advisor investor. It's kind of hard to understand what that means. you can get compensated for that. You get paid to take on that risk. And that's just another source of return. investor could earn some income on speaker-1: But I think it's important, mean, the way you're linking these, mean, all three of these so far seem very interconnected. And I think that will probably lead you into, I guess, what we're talking about, our fourth risk. speaker-0: Yeah, it's converting your money to cash, right? And maybe there's maybe two kind of embedded thoughts within that. It's maybe the bid ask spread, if you will, so what I can buy a bond at versus what I can sell a bond at. But it's also the vehicle structure. So ETFs, mutual funds, have different liquidity structures than more of a private, you know, private credit fund might with redemption caps. So, you know, it's, just how quickly and, and, and how efficiently with little price impact, can convert whatever your investment is to cash in your checking account. Right. I think that's, that's something that, you know, people probably don't really think about. They just see the, the yield and They don't think about, well, how do I monetize that yield I've had? And now people are kind of understanding. OK, so that was when I was investing in private credit. Yes, I was taking, if you get your money, credit risk. was taking other risks. But another big one I was probably taking on that I'm not aware of was getting my money back in my pocket. And so I think every once in a while, it's good for individuals to understand the risk that you were taking on. speaker-1: Absolutely. I mean, I think it's definitely tough for, I don't even think people think about those four risks even linking together. So I think that's a good point. So I guess I got to put you on the spot for a second, Mike. So out of all of these, I know we listed four things and we know they're interconnected. Which do you feel I think is the most important in this current environment? speaker-0: Yeah, I think it's probably credit risk, but, you know, given what energy prices have done recently and, uh, did, know, changing thoughts on the fed policy over the next, you know, six to 12 months, you know, you could argue that, you know, when you get your money back, you know, interest rate risk is another one. But I would say if I was looking at a risk that, you you're probably not getting compensated enough for at the moment, I would say it's credit now. There's old bonds saying there's no bad bonds, just bad bond prices. And so when you think about spreads over treasuries and how that prices into a bond, how that moves to bond prices, ⁓ there's, would say, not a lot of ⁓ bad outcomes getting priced into the credit markets. Their spreads are tight. Not to say that names are going to default, but you're going to probably have spreads move. wider at some point in time just because they're so tight. There's not a lot of bad outcomes priced in. I like not to get too much in the nerdy weeds, but I think it's important to everybody to think about investing in a distribution. There's possible outcomes across the board, right? A recession, solid growth, and then there's the middle. Well, things spreads and all these risks. You have to look at it on a ⁓ distribution basis where spreads that are really tight levels. That means that there's a, the market's pricing in a low probability of bad outcomes happening to the economy or whatever it may be. so I don't think you're getting compensated a ton for that risk. That's to say you shouldn't own corporate bonds, but you got to make sure you know what you own right now versus kind of, you know, jumping in to the deep end of the pool, if you will, and buying, you know, lower quality for that little extra yield. Because again, you're not getting compensated a ton for taking a little bit more credit risk, or a lot more credit risk, just getting a little bit more yield. And so just be just be aware of that. I think right now is probably something that would would would probably fall. speaker-1: That kind of leads me to my next point is I think what you have summed up here and I think what the audience needs to understand is that the important thing is probably not to start with yield, but rather these four basic risks, which is again, like when, how, if, and then again, the conversion into cash, then look at yield. And hopefully I think when you look at that, you can begin to implement the concepts in a way into your new portfolio management approach. I think that's a great point and I think, shoot, I think we've talked everybody's ear off and it's a good place to start. What do you think? speaker-0: Yep, I would agree. speaker-1: Overwhelm them too early. Yeah. So hopefully, I guess, if I, if I can say this, hopefully you've been able to take something away from this other than our love for the asset class. So if you want to hear more or see our disclosures, visit madisoninvestments.com. Thanks again for tuning in to the issue at hand. Look forward to seeing you next time. Take care.