Lead-Lag Live
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Lead-Lag Live
Harley Bassman on Bond Market Dynamics, Derivative Strategies, and Long-Term Interest Rate Trends
Ever wondered how the dynamic world of bond markets can impact your investments? Join us as we engage with Harley Bassman, a Wall Street veteran, to uncover the intricate relationship between Fed funds rates, two-year notes, and their broader implications for inflation and long-term bonds. Harley's extensive career, from Merrill Lynch to Simplify Asset Management, provides a unique lens through which we explore the future of interest rates and market stability.
We then shift our focus to the innovative strategies of Simplify Asset Management and their groundbreaking use of derivatives within ETFs. Discover how these professional tools, traditionally exclusive to seasoned investors, are now accessible to everyday traders, potentially outperforming hedge funds through reduced fees and smart structuring. Despite the benefits, we address the prevalent misconceptions about derivatives and the cautious stance often adopted by financial advisors.
Our conversation also spans leverage funds, mortgage rates, and the potential for a steepening yield curve. By dissecting long-term interest rate trends and inflation expectations, we explore their impact on housing and mortgage bonds. Moreover, we discuss the broader economic outlook and the possibility of a hard landing, all while appreciating Harley's insightful perspectives. This episode promises to equip you with a deeper understanding of market dynamics and innovative investment strategies.
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traditionally Fed funds to two-year notes is 50 basis points, half a percent. So if I'm at 2% inflation. I got two and a half funds. I'm at 3%. Two-year Two is 10. Traditionally 175, somewhere there. That puts the 10-year to 75,. 4%, 10 right now. We're what? 365, 370?. We're there, man, we're done, it's over. The back end is not going down unless all hell breaks loose and we go into a hard landing. Or as my colleague, personal friend, Michael Green, who says that funds are going to half a percent.
Speaker 2:Okay, If that's the case then yeah, we can go a lot more in the back end.
Speaker 1:But if you believe the Fed that their target to their Fed funds is two and a half, the back end is done. It's going nowhere.
Speaker 2:This will be a phenomenal conversation with Mr Harley Baskin, who had quite a moment with a lot of things in his career. We'll talk about some of his successes and things that he's learned over time.
Speaker 2:So those that are watching this live do me a favor, if you want to engage while we're live, I can see your comments on X, linkedin, youtube, which means if you want to ask a question, put it in whatever platform you're watching this on, I'll be able to see it. I'll bring it up live. Let's make this as often as I can. This is one of three for the day, so it's going to be a busy Monday to start the week.
Speaker 2:So, with all that said, my name is Michael Guy, a publisher of the Lee Lagerhorne, jimmy Flaura, harley Bassman the convexity of even, as he likes to call himself, harley. You and I did a space as a year and a half two years ago. It's been a while. For those who are not familiar with your background, talk about who you are, what you accomplished throughout your career and where you grew up. God, that's a lot. I like to keep it simple to begin with. Thank you for the invitation to be here.
Speaker 1:So you know I'm an old Wall Street buzzard. I was at Merrill's 26 years. At various times I ran the option business, the mortgage business. I was out of the mortgage business before we blew up so I guess I feel good about that. Went to Credit Suisse went to PIMCO and now I work for the managing partner at Simplify Asset Management.
Speaker 2:This is a very clever firm. It got me out of retirement to go join them.
Speaker 1:What we do is we put derivatives into ETFs. This is a relatively new idea. It was only SEC changed the rules two years ago to allow this. This is a relatively new idea. It was only SEC changed the rules two years ago to allow this and it basically gives civilians non-professionals the ability to go and access professional tools and we put out a number of products where we do this and we do it at a very low fee. So it's kind of almost cutting up the hedge funds. Because hedge funds are professionals, we're basically getting between the wall of wallpaper with them and charging vastly lower fees and, more importantly, it's listed. You can get out whenever you want. It's not a lock-up kind of investment where you're trapped there for, you know, three, four, five months you use the term clever firm and I think actually that's one thing that does come to mind, as I myself have started doing some work with you guys.
Speaker 2:I interviewed michael green a few times, got to know Brian Keller Before we get into the markets and bonds in general, I'm just curious how do you get to a? Place, from a culture perspective, where you're working with a bunch of people that are also as smart, if not smarter, than you are, and everybody gets along, because, let's face it, when you're intelligent, when you're clever, everyone likes to be the one that everyone else turns to I guess not having an office might help.
Speaker 2:You know, we, we, we are the zoom child, this firm does not exist without you know, covet and zoom you got a lot of people kind of my age or a little younger to go join the firm.
Speaker 1:um, you know specialists in various fields and there's no way we're all going to go to new york city or somewhere else to go in and be in office, and so we're like in 10 different cities we use. You know, all the stuff that a lot of like me is ever familiar with.
Speaker 1:like you know Slack and other things like that, but it does bring us together and we all have a common purpose in the sense that we're a startup. I mean, I was employed over nine over here and it's kind of exciting. And we're also kind of plowing new ground, which is very interesting. And also, when you affirm our size, you can move the needle Any one of us can actually go and do something that advances the cause. You're a black rocker, band rocker.
Speaker 1:No one's going to go. One person's never going to change anything there. That's kind of fun, but also the whole concept of what we're doing. You mark my words. This company is basically PIMCO Junior.
Speaker 1:What PIMCO did in the 80s was they were the first company to put derivatives, futures and options into 40x mutual funds A third of our people are ex-PIMCO people because we have the same kind of construct of taking derivatives not crazy stuff, not crazy leverage, just access to professional tools like long-dated options, total return swaps, futures and put them into ETFs. And this is genius for what it does, because ordinary civilians just really can't access these products, either because they're not allowed to or because the process is just so complicated it's not worthwhile doing, and we're slowly developing this whole menu of products so you can go and get access to these things as a civilian on a listed platform where you can go to Robinhood and buy it.
Speaker 2:Yeah, and the democratization of all that is obviously the big thing, certainly cutting the fees to your point being against the hedge fund space. Speaking about the hedge fund space, as you and I both know the hedge fund, space has been struggling for the better part of a decade, plus I mean one could argue the alpha largely had gone away post-GFC when you look aggregate at the hedge fund alternative end of things.
Speaker 1:Is there something unique about this?
Speaker 2:cycle that maybe makes products like what Sipfly puts out there. On the derivative end had Alpha.
Speaker 1:I mean, has the Alpha largely gone away on the hedge?
Speaker 2:fund side because of the fees, and that's where the real opportunity comes in.
Speaker 1:Well, I mean, the whole line is a hedge fund as a fee structure acting as an asset class. What we can do over here is reduce the fees by a lot by how we're structured. I would not say that alpha is dead. But when you put on a 2 and 20 or a 10 and 15, fee structure it does change a lot, but really a lot of. What we do is taking advantage of internal Wall Street stuff.
Speaker 2:So for example we have a fund.
Speaker 1:I think I can't mention tickers here, but you can, I can't. That replicates the high yield index, but what it does is, instead of buying you know the index for, like that, for cash, where we put a suitcase of money and get you know junk bonds, we go to a total return swap with Wall Street. There's a long story why this exists, but in a nutshell, they give us the total return of the junk bond index and we give them back treasuries minus 50 basis points.
Speaker 1:We then take our cash and invest in treasuries and what you end up with is basically junk bonds plus a half percent period, zero, nothing else to do. We just beat the index by half a percent, because what we're doing is we're selling our balance sheet. Balance sheet is very, very expensive for commercial banks, for the big banks, so they will pay money. They'll pay us a half percent, so we'll give them a bucket of cash instead of just buying the bonds directly.
Speaker 1:There's a number of funds where we go and do this or we can basically make no change at all to the return profile, except for adding 10, 20, 30, 50 basis points and adding liquidity to it.
Speaker 2:That's pretty clever.
Speaker 1:And ordinary civilians can't do that.
Speaker 2:But we can because we have all the documentation with the major Wall Street firms.
Speaker 1:One of our trades you're familiar with. We bought a seven year put option on the 30 year treasury. We put this trade out a few years ago. I think it was the number one returning ETF last year. The year before that, up 91%.
Speaker 2:This was no genius of structure. It was the Fed.
Speaker 1:High trades by 500 basis points and you could buy a seven-year option. There's no way you can get a seven-year option unless you're a professional. You can go out maybe three to six months.
Speaker 2:But those are very expensive stuff you bought puts on some of the big ETFs out there. You'd never make any money on the darn thing You'd just burn your theta away.
Speaker 1:A seven-year option doesn't decay. Really, we offer those kinds of abilities. There's lots of things that we do that are very clever. Of course, the word derives is in the product and that, of course, scares people. And yeah, derives can be dangerous. Usually, derives are dangerous when you use them to gain excessive leverage. That's how they usually blow up on you. But if you use derives in a very low-leverage manner and most of our funds have no leverage they're just accessing the same return in a different way and allowing you to go and get a better return.
Speaker 2:So that's kind of the gig, don't be?
Speaker 1:scared, but I know you will be.
Speaker 2:You went to where I wanted to go, which is that you've had you call yourself a startup and you've got 6 billion in assets, so that's a hell of a startup. Yeah, I know how hard this investment industry is from an asset gathering perspective and I assume, as you talk to, or as your people talk to, financial advisors there, is that concern around that word derivative right, Because it's exactly right the mind automatically goes towards leverage.
Speaker 2:Do you find that the advisor community has gotten better at understanding the nuances of derivatives as something that can enhance output versus just something that can blow up?
Speaker 1:Look the big advisors. They're smart as I am. Okay, when these guys are running X billion dollars they could be on Wall Street, you know, on the trading desk. So I mean that's the thing. But the problem is actually not the advisors and their IQ and their abilities, it's Wall Street's fear of litigation, which is why so many advisors hug the index. They want to go into this math set index because that way they can't be wrong If this goes down by 100. And they're down by 100 or down by 95, they're heroes, I suppose. Once you go off index, well then you got to go just explaining if you're above or below that profile.
Speaker 2:Everyone wants to go.
Speaker 1:And you can see. You know my partner, mike Green, all the time talks about passive investing based upon index investing. How much of new money goes into the index investing profile? There's pros and cons and dangers to that. But ignoring that concept entirely is once an advisor goes off index he has, I guess, career risk to himself, whereas it's much safer to go and say look guys, I'm going to give me your money, I'm going to manage it.
Speaker 2:You give me a half percent or a percent running and you're safe, ain't going to blow up.
Speaker 1:No made-offs, no, nothing I'll give you the market return and, truth be told, most RIAs, it's not about stock picking. It's about do I trust you with my money? Because most people out there ain't Wall Street pros like us. Okay, they are civilians who made their money in some other way. Wall Street investing is not their gig.
Speaker 2:This one, someone who's not going to go and lose the money and they're not wrong, you know. They're just not wrong about that.
Speaker 1:So the effort really is not to risk.
Speaker 2:It's to go off index, which which is possible. There's, I mean, and there's great reasons for it to do that, but but that's that's the real challenge is going off index, not going into the ribs yeah, that fear relegation as an industry person is so spot on in terms of the way that you said it, because you're exactly right.
Speaker 2:It's like why bother, why take the risk right, why have the career element, especially when you're in this cycle? It's really been there. You you can argue since, like 2011, 2012, where it's been a game of just passive large cap market cap waiting. Small caps don't work, international doesn't work. Nothing else works except US large cap tech.
Speaker 1:Well, that's a true story. So in 94, this is probably before most of you were born, but nonetheless Merrill Lynch was selling lumber derivatives to Orange County Pension Fund. This guy was reasonably intelligent and he wanted to buy these things. And our head of risk management top of the firm goes out and says hey man these things are a little risky over here.
Speaker 1:We kind of think you maybe should not buy any more. In fact you might even want to sell a few of them. The guy says I know what I'm doing. It's my money. I'm very smart with this stuff, I'm going to buy it, and if you want to sell to me, Merrill Lynch, then I'll buy it from Goldman and Morgan Stanley and he's like okay okay, fine, got it. Will you please put it in writing and he writes it out and the email comes and it's now posted and framed on the.
Speaker 1:Hennepin's wall. Well, the thing is a surprise raid hike in 1994, and everything goes, you know, asunder, and Orange County goes bankrupt and we get sued because the you know, the firemen and the teachers and the police when their pension funds now kind of bust big bad. Merrill Lynch is the bully here and we pull a little you know.
Speaker 2:Sign out and said hey, the guy knew what he was doing.
Speaker 1:He said so, right here and he says, yeah, but we're going to sue you anyways and, as Merrill Lynch would go to court against the policemen and firemen workers, no, we're not. Two are a check for $400 million. That's what you're dealing with here. It's not a matter of right and wrong. It's just how the world works, and so when these large firms are concerned about this, I can't say they're crazy. So that's the challenge for all of us here is to help people take reasonable risks and manage them properly, and not be surprised.
Speaker 2:Speaking of surprise, have you been surprised by the proliferation of some of these covered coal type of funds that are just juicing yield by selling options?
Speaker 1:I mean, it seems like everywhere.
Speaker 2:I look as far as the asset growth in the ETF space. It's really gone there as far as the stuff that Vanguard and BlackRock really won't touch.
Speaker 1:Let me take a little diversion over here. In Bondland, not Stockland. In Bondland you have three risks, three vectors you can play with Duration, credit convexity. Duration is when you get money back. It's like a two-year or a 30-year Credit is if you get it back so Apple or Carvana Convexity is how you get it back.
Speaker 1:In theory, the super AI computer will look at all three of these vectors and say which runoff is the best risk return and the money will flow around accordingly, and so my moniker of Convexity Maven is that I specialize in this convexity swimming pool. I look at that risk and kind of advise and consider ways to deal with it and so covered calls. That's basically a convex kind of idea.
Speaker 2:Is it worthwhile doing it?
Speaker 1:Well, it depends upon your view of the market, it depends upon the price level of the stuff. But, most importantly, when you get involved in a covered call, especially for stocks, a covered call strategy what you're doing there is you're converting capital gains, long-term capital gains, into short-term income. It's a bond-like concept.
Speaker 2:Is that a good idea?
Speaker 1:Bravely, I'm not the biggest lover of that. You buy equities because they have the unlimited return. A stock is a call option in a company where the strike price is the value of the bonds, because the bond was going to get paid first right, and you get all the excess above that. That's why all the really rich people in the world, it's always from promoting stock owning equity in their company.
Speaker 1:It's never from W-2, because you have an unlimited upside when you do a covered call strategy, you're selling off this unlimited upside for short term income.
Speaker 2:Why are you doing?
Speaker 1:that I mean you own the stock for a reason. If you really want to do what you should be doing, if you want to do covered calls, you probably should go reduce your equity exposure and increase your bond exposure and go directly to the income profile, as opposed to creating this kind of weird animal of a synthetic bond.
Speaker 2:That said, there are plenty of times when covered call strategies are really good, depending upon the world, and I say right now in the fixed income world.
Speaker 1:a covered call strategy is the best thing you're going to get, so we're going to get into your thoughts on the bond market.
Speaker 2:I call this. You know bonds are cooked based on what you put on the email there. But let's go to the audience for some questions here.
Speaker 1:I think it's good to kind of have these kind of conversations you mentioned derivatives and people associated with leverage, so this is from Danny, who's watching this live. Thank you for this interview.
Speaker 2:Is there an additional risk to the initial investment in buying a leveraged ETF? None of this, by the way, is financial advice, folks, but I think this is an interesting educational conversation. Ecf None of this, by the way, is financial advice, folks, but I think this is an interesting educational conversation, maybe a little bit more simplistic view of the universe. Let's talk about leverage funds. You can argue these are kind of the first real derivative ways of using derivatives within ECFs, these leverage fund products, any thoughts on these sort of daily reset type of vehicles.
Speaker 1:Yeah, those products are interesting, but let's be clear they are short-term investment vehicles.
Speaker 2:They are not long-term because people like this you buy a stock, you buy anything. It goes down 10% and you lose. It goes up the next day to get back to even it has to go up by 11.
Speaker 1:So when you buy these levered products that are structured on a daily reset, you're basically short a massive embedded option, because each time it goes up or down it's got to go make or lose more just to get even. And so I mean they're fine for a short-term play. They're great for a short-term play. You want to own them for?
Speaker 2:a week. God bless you, man.
Speaker 1:It's okay, do not use them for longer-term exposure.
Speaker 2:Leverage in general, leverage is fine, if you know what you're doing If you're watching this show I'm pretty sure you probably do.
Speaker 1:Most important is to know just when you allocate your risk that you understand what you're doing and you either have a stop or you've sized it appropriately. So if it goes to zero, you're not going to be you know, you know sitting in a slush church in the street.
Speaker 2:Let's play with that term. Know what you're doing, because I think this is a nice thing with towards the Fed and the bond market. I put out that post last week. I said I think the reaction is wrong. 50 basis points is more of a move around panic, which a lot of people liked, and we posted that wording went viral.
Speaker 1:I think several thousand views I would go back to the Fed is like everybody else.
Speaker 2:They don't know what tomorrow brings. They can have the brightest people in the world. Nobody can get that much insight on the unknowable future. But let's talk about the bond market's perception of the future. Do you guys sense that the bond market has things in quotes right about inflation? And is there opportunity?
Speaker 1:Okay, look last week's Fed move. Who gives a damn really? I mean zero to 250,.
Speaker 2:I don't care the anchors, the media loves it, come on.
Speaker 1:You know what the pundits have to go and fill airtime constantly. I guess you are too right now with me, but let's profile out two to three years. That's what we care about here. What is the profile? Look forward.
Speaker 2:And, if you look at it, fed is 7.12%. Will they get that?
Speaker 1:Maybe Not tomorrow, but maybe.
Speaker 2:I'm not a believer.
Speaker 1:They're going to get it anytime soon, but it doesn't matter. They want 2%. They're going to put the Fed funds rate at 50 basis points, so half a percent real return and they've said that that and they're dots. Their long-term strategy is like 250, 260, 270. That's the big dots out there and the market's basically priced out you know that number in the futures contracts Okay, that's good, traditionally Fed funds to two-year notes is 50 basis points half a percent.
Speaker 2:So if I'm at 2% inflation, I got two and a half funds. I'm at 3% two-year.
Speaker 1:Two is 10. Traditionally 175, somewhere there. That puts a 10-year 375, 4% 10. Right now. What 365, 370? Like we're there, man, we're done, it's over the back is not going down unless all hell breaks loose and we go into a hard landing.
Speaker 2:Or, as my colleague, personal friend Michael Green, who says that funds are going to half a percent. Okay, if that's the case, then yeah, we can go a lot more in the back end.
Speaker 1:But if you believe the Fed, that that's their target too and their Fed funds is two and a half the back end is done.
Speaker 2:It's going nowhere. The front end can't come down.
Speaker 1:It will come down. Will'll come down as fast as the market's suggesting? Probably not. Will twos get to three percent in a year or six months? Probably not. We'll get there in a year and a half yeah, maybe that's the whole thing is to really look out there at the longer term, and so I'm very suspect of of the back end actually going down and, truth be told, I kind of think back end rates probably go up so the curve's going to steepen by a full twist not just the back end rising or the front end coming down by itself.
Speaker 2:What's the implication on that for housing, for mortgages that 10 years? What are they spaced off of?
Speaker 1:Right now mortgage rates can come down. There's two mortgage rates out there. They are always confused. Okay, one is like the Freddie Mac rate of where homeowners borrow money to buy a house. That's important. If you're a civilian buying a house, that's the most important thing out there. The other is the one I care about which is the mortgage bond rate. So remember what happens here is someone borrows money rate.
Speaker 2:So remember what happens here is someone borrows money, that loan goes into the pipeline it gets chopped up, goes to Fannie and Freddie, blah, blah, blah and ends up in the mortgage market. Usually that spread is about 75 basis points. Right now it's about 100, but about 75 basis points and that 75 cents is the cost of ensuring that the mortgage doesn't go bankrupt.
Speaker 1:right, Fannie and Freddie will guarantee that you get paid collecting the money, paying out the money, all the other stuff that goes on. So I look at the mortgage bond rate, the MBS rate, that rate is still relatively high versus other stuff.
Speaker 1:Right now, that mortgage bond, the mortgage security rate, is about 110 basis points over treasuries. That number should come down to about 75 cents in the next time and it will do that as volatility, the move index comes down and as the yield curve steepens. We can get into the math of that if you care to, maybe not. So you're going to see mortgage bond yields come down relative to everything else and you're then going to probably see that spread between the retail bond rate, retail mortgage rate and the institutional bond rate that's going to come in also. So I do expect that you're going to see retail borrowing rates decline in the next year, which is a good public policy outcome.
Speaker 2:But why does that spread exist and what's causing that clear history to be that outsized?
Speaker 1:Okay, so we're asking about the mortgage bond, which is now 110, which, by the way, was like 160, 170 six months ago when I started pounding the table about this being just crazy, the wrong price and why we came up with our ETF to go and take advantage of that. A mortgage bond sounds crazy, but it's not. It's just a giant covered call. When a homeowner borrows money, at some rate that becomes a bond.
Speaker 2:They say I'm going to pay $3,000 a month for the next 30 years and that $3,000 a month fees some interest and some principal okay, that homeowner has the right, owns the option to pay off that loan early.
Speaker 1:So when you're the buyer of the mortgage bond, you buy a 60% mortgage bond. You might have that bond for three or four months, but have it for 30 years. You're short a call on that. We know, already know the payment stream of $3,000 a month, how it's going to come in the amortization of that loan and it's basically full faith in the US government. Fannie and Freddie are not going down. I think there's a risk of that. You should buy guns and cans of tuna and then move to a cave, because that's what's going to be the case if Fannie and Freddie go bankrupt.
Speaker 1:So it's basically a treasury with what, as you can model it up like a three-year call against it. That's kind of how it looks if you do your bond. Math, geeky stuff.
Speaker 2:And so I can say I buy a treasury at 100.
Speaker 1:I sell the call option for six points. So I'm now basically buying this package, this covered call package, at 94. The way the mortgage bond tightens gets a lower yield versus everything else. All equal is that call option going from six points to four points. And that call option will go down from six points to four points as volatility comes down and as the yield curve steepens which is a much harder concept and you can go to my website, convexdbmcom, where I explain this in a number of ways and when the yield curve is very inverted and vols were very high the move was at 140, 150, and the curve was like negative 70,.
Speaker 1:That's when you had mortgage bonds trading at like 160 over the curve, because the embedded options were like 8 points a few months ago. It's now kind of coming to six points, it's going to four points and that's what's going to play out.
Speaker 2:Do you find that mortgage-backed?
Speaker 1:securities are hard to get retail to pay attention to, because maybe they've got some their mind goes to GFC.
Speaker 2:I mean talk about sort of the type of audience that MBS attracts.
Speaker 1:First off, anybody listening to this podcast. Unless you're a Wall Street professional, you can't trade mortgage securities.
Speaker 2:Okay, you just can't when you go to your Fidelity account and you look up Fannie or Freddie those are agency debentures.
Speaker 1:Those are not mortgage-backed securities. It is almost impossible to buy a regular mortgage-backed security unless you're an institutional player.
Speaker 1:And if, per chance, you're an ultra-high net worth individual and you do want to buy a million dollar minimum mortgage bond from Merrill Roy Stanley JP Morgan, if you couldn't do it. You don't want to do it Because what happens is this Remember that Mortgage bond is a pass-through they're called pass-through securities from the homeowner, just $3,000 a month coming to you. What you're getting is some interest and some principal, because that mortgage bond is going to pay down to zero over 30 years.
Speaker 2:That means that you have to go and take that principal you're getting refunded to you and reinvest it every month. Well, you're not going to do that because you're lazy, it's a small number.
Speaker 1:You wait two or three months to go. Do that, so you earn a lousy yield on that money coming in and it's brain damage to have to go and do it. And then number two, which is even worse, is when you buy this mortgage bond at any price. It's not 100.
Speaker 2:So you buy it, let's say, at 95.
Speaker 1:Every time that money gets returned to you, the principal part, not the interest part. The principal part, that's a little miniature capital gain. Because you bought the bond at 95, you're getting back 100. So you have a small little five-point profit on that small amount of principal you got back. So what? Will happen is, you'll get a 1099, or your accountant will, your broker will in January, march, stating how much you earned in interest on the mortgage bond.
Speaker 2:Then two months later, in May, you get what's called 1099 supplemental where they figure out how much your capital gains are, those refile your taxes and everything else.
Speaker 1:You just don't want to do this stuff, so really there's no way for civilians to buy mortgage securities except through some ETF or mutual fund. And that's why people really have no basic touch and feel of the product, despite the fact that the mortgage market is the second biggest bond asset class out there. You have treasuries, you have mortgages, then you have, you know, corporates and junk funds and everything else. Second biggest asset class out there but no one else touches them, for good reason.
Speaker 2:What's the historical correlation look like against equities, against other bonds, when you look at MBS.
Speaker 1:Mortgage bonds typically trade 75,. Three quarters of a percentage point more than treasuries. They go up and down, depending upon stuff. Ig investment grade is probably 60, 65 over. The weird anomaly right now, dialing back to duration, credit convexity is the yield curve is still kind of flat. It's still inverted in derivative space. You are losing money, giving money to take more risk in duration. Right now the three-month bill is still higher than the 30-year bond, so you're giving yield to take more risk. That's kind of weird. Ig is trading 52 over.
Speaker 1:That is very close to its historic lows and if the Feds take a race down by 50 as opposed to 25, that kind of yeah, they're normalizing and recalibrating, but it kind of means they're a little worried about not being recalibrated in time when you go into a recession. I'm not saying we will, but ifgrade credit at the lower part of the spread spectrum.
Speaker 1:As the Fed's signaling, we're a little worried about this, and mortgage bonds are 110 over, so you clearly want to go and take convexity risk because you're paying for it versus the other two. So that's the general profile. Let's bring one more thing though Mortgage bonds. They are effectively a giant covered call strategy. So instead of selling a three-month call, you're selling a three-year call, so it's much less convex than an ordinary covered call strategy.
Speaker 2:But there's still things that affect you to it. If you think rates are going to drop by 100 next month, you don't buy mortgage bonds.
Speaker 1:Any mortgage bond Forget my product, which is current coupon stuff, the index, which is a lower coupon stuff. You don't buy that because you don't sell a call on something that's going to go explode at a much higher price. If you think we're going to crash in the economy and it's going to come down really hard, you buy a lot of recent treasuries. Okay, that's what you buy.
Speaker 1:Now, truth be told, I'd rather buy the seven-year sector of the market than the 20-year, Because, I already told you, I think the back end of the curve is kind of already cooked.
Speaker 2:So GLT is a little lukewarm on that.
Speaker 1:I'd rather buy by duration a little closer in, and we offer products where you can get levered exposure to that. We have a product where you get three times the seven-year, which is functionally equal in duration to the 20-year, so that's a much better way to get access to a 20-year duration is to do it three times a seven-year, so that's why we created the product.
Speaker 2:I don't think we're hard landing.
Speaker 1:And I don't think we're going to see rates drop 180 points in a month and I think because the back end is cooked and ball is still high, that near-par mortgage bonds are the best risk-adjusted return in the bond market.
Speaker 2:I don't want to expand on that hard-lending point, but talk about the speed with which you bring products out, because you're talking about something which is, for a moment in time, an anomaly weird extreme that you have a fund to try to take advantage of. You don't know how long that's going to last, but you want to create a fund around that and there's a long lead time to that. So I a fund around that and there's a long lead time to that. So inter, I'm just curious, mechanic wise and mechanics like internally and simplified, when somebody comes up with an idea based on some kind of outlier, that somebody's noticing how closely are you moving to try to create a fund to take advantage of it there's, you know, two kinds of funds.
Speaker 1:There's the tactical fund, as you're describing, my seven-year put option on 30-year bonds, kind of tactical. I mean rate for two percent of the time. So I mean it was kind of easy to go and figure that one out race is four percent, not quite as obvious best for a tactical trade. I will say this, though there's always a place for disaster insurance. So that product, which should have been a lot of your portfolio two years ago, should you sell it now?
Speaker 2:yeah, a lot of it.
Speaker 1:Not all of it, though. There's a reason to go have some back-end insurance, just in case and the severe option in interest rate. Space is still extraordinarily inexpensive, it just doesn't decay for a lot of reasons.
Speaker 2:So I kind of like that. But clearly that's a technical product. Our mortgage product, our synthetic junk bond product, those are lifetime products. You're going to own those forever. You're always going to have some allocation to junk bonds, Maybe usually it's 10%, 15%.
Speaker 1:You know, maybe now it should be 5% 7%. And if we get a recession it goes to 20%. But, being general, you're always going to have some exposure to credit. You're always going to have some exposure to mortgage market. I mean it's, you know, 22% of the whole bond market. You're not ever at a zero on that, and so these are basically forever products, and so we'll kind of create both Clearly we prefer to create the lifetime products as a profitable company because we earn money forever, whereas the tactical products.
Speaker 2:They go up and down.
Speaker 1:But I didn't try to offer both. It depends upon the environment and also there are some real niche-y things that are interesting. So we offer a product that offers access to Bitcoin combined with the general Y index.
Speaker 2:Is that a good idea?
Speaker 1:Yeah.
Speaker 2:If you want Bitcoin, this is a tremendous idea.
Speaker 1:In one little package you can go and buy you know, your broad market equity exposure and put a few Bitcoins on top of that.
Speaker 2:Then you go to the nuts. It's opening an account or something else like that. So, yeah, it's a great idea. What I recommend to someone like Bitcoin be my guest.
Speaker 1:I would jump to stuff. But I mean, you know there are guys clickers like Bitcoin. I prefer, you know, bars of gold. That's kind of an idea where it's niche, but there is critical mass of people who will want access to that. We're talking a country of 330 million people here. I don't think that many of a percent.
Speaker 2:would like the idea to go and make the product work, the Bitcoin product is more niche.
Speaker 1:The credit brand mortgage stuff is more long term, forever, and then the interest rate hedge product is more tactical.
Speaker 2:Bar is the goal, because you want to simplify your life. I think is the way to think about it. Courtney Joe, the hard landing you said you're not in that camp. I feel like every single day there's some pundit going back to the earlier point, arguing for a hard landing, soft landing, no landing.
Speaker 1:I don't know what landing. What is your take on sort of where we are just picture-wise? I mean the bond market, I think, is the asset class closest to the real story behind the economy? There should be some real story that's being told now. As the saying goes, if it bleeds, it leaves. I mean, no one wants to hear happy stories as much as we'd like to in theory. We want to hear miserable stuff.
Speaker 1:So that's why the penitentiary is talking about a market crash and clearly, if you say market crash every day, you will be right at some point but it's kind of worthless to think about that Big picture view.
Speaker 2:This is where my friend and colleague Michael Green and I kind of pushed back and forth on each other.
Speaker 1:If you look at the 70s and the big inflation we had, what was going on? There was a massive demographic Pig in the python the baby boomers entering the workforce, getting married, having kids, buying a car, a washing machine, a baby carriage. You're demanding this big bulge, the labor force growth rate coming into the system demanding goods and services from the smaller World War II generation. Smaller because because one you depression babies and number two because they were killed in the war and so you have this mismatch of supply from a small demographic, demand from a big demographic and thus supply demand.
Speaker 1:You get your inflation and you can chart the labor force growth rate versus interest rates and I have this chart on many of my prior commentaries that are all on my space.
Speaker 1:What I propose is we're doing that again. We're doing it again for two reasons. One, the millennials are bigger than the boomers. There's more millennials than there are boomers. Now, the difference is that, as a percentage of the country, the millennials are smaller. It's a much bigger country, but there's still a huge group and these boomers and I got four of them okay, they're getting married later, they're having kids later. They're doing all this stuff later.
Speaker 1:If you look at, like the household formation service from a decade ago, everyone was crying their eyes out how the world's coming to an end and all the kids are in their basements playing video games, this and that, living with mom yeah, they were, but they did eventually get married and have kids and you can see what's happened is this household formation, which was way below the projected profile, has come back. Number two is that the boomers are retiring because we have all the money. Sorry, kids, but we took all your money. We have the houses because we have all the money. Sorry, kids, but we took all your money.
Speaker 1:We have the houses and we have all the stocks and the bonds, and the Fed, of course, pumped it all up with this massive money printing and so things you know kind of got rough during the COVID and then we didn't quit or this or that or went home. They're like you know what, let's go on vacation. Man who needs this crap? And so we have boomers who are the skillful, productive, efficient people retiring faster than their profile demographic. So I have the supply of stuff reducing, boomers leaving vastly affected and the millennials coming in and that's going to go create this kind of supply-demand equilibrium and kind of put a floor under inflation.
Speaker 2:So that's my inflation story, as well as, of course, immigration.
Speaker 1:Am I right? Who knows?
Speaker 2:It's a good story.
Speaker 1:But I mean just personally. I can see what my kids are doing. They're getting very much. I mean, I think San Fran first child average is age 32, now New York is age 31. I mean, this was five to six years younger, you know, which I already showed half ago. So when you get married you're going to go buy stuff.
Speaker 2:Comment off of YouTube. If the boomers went into the workforce, then would not the supply of goods and services increase in the areas they were hired?
Speaker 1:The boomers went back into the workforce?
Speaker 2:Yeah, exactly.
Speaker 1:I suppose. So yeah, sure why not All the stuff I've seen is net, net, net. They're retiring faster and they have, I mean, the bulk of the assets are in that. You know, age group. I think that part of the housing I guess I'll call it a bubble of sorts right now, but the housing richly in the housing market is the boomers having all this money or assets or whatever, and gives their kids I saw some number, like in california a year or two or three ago, that 40 of all closings were all cash.
Speaker 1:I can assure you that the people who are buying these houses were not. They didn't want the cash. They had their parents coming in and giving some kind of support to this thing. So I do think you're seeing this generational wealth transfer happening over time. You can't take it with you, man and the government taxes are pretty heavy. So why not go and do this? I kind of think that's supporting the housing market.
Speaker 2:I mean, can they drive the whole housing market?
Speaker 1:No, but on the margin. That's all you need.
Speaker 2:Okay, so since you mentioned that you kind of alluded to that, that maybe housing is a bubble or a bubble age or close to it. How does that impact MBS? How does that impact mortgage-backed securities?
Speaker 1:I mean you have fewer mortgage bonds created is what you have, but I mean you still have the general rotation of. You know mortgages are always shrinking because they're paying off. I don't think housing is a bubble. Oh, 405, that was a bubble man and we all knew it. A bubble. 0405, that was a bubble man and we all knew it. Everyone on the planet who was involved in that market, you know 405.
Speaker 1:knew we were in a bubble, but the question was how long it would take to pop the guys who made the big money like a Paulson or those elk. Their genius I'm going to kill for this their genius was they didn't figure out it was a bubble until 0607. All the guys, all the real pros, were already in the subprime trade no 4, no 5, and they got stopped out because it was a massive negative current trade.
Speaker 1:The guys who made the big money were the guys who didn't figure it out until late and got into the trade in 06 and 07. This is not a bubble. What we have right now is basically kind of a housing is expensive relative to income, so your index, your cost index, is high right now. Is it off the charts? Yeah, it's a little high, but I think it's manageable.
Speaker 2:It's not bubblicious like we had before, where you had, you know, cocktail witches in Las Vegas buying three homes and trying to go and run them.
Speaker 1:We don't have that right now. There's too many things going on to prevent that, namely that the banks have to go and prove the person has income before they can buy a house. You don't have 105% LTV loans anymore.
Speaker 2:I'll go back to duration, credit and convexity. Of those three, which is the most vulnerable to some kind of tail event? I mean, you can argue we already went through the duration tail event, at least from a cycle perspective. But is there a possibility that credit at some point explodes? I mean you mentioned it before. I must agree spreads are very tight. That's been, to me at least, a big surprise for this entire environment. I mean, where's the risk there?
Speaker 1:Credit is the wrong price, okay, but you're not going to blow up on it, okay, unless you do some kind of crazy derivative trade. Apple do some kind of crazy derivative trade. You know apple, microsoft, there's other, you know high-end companies. Fine, credit goes from 50 to 80. Okay, if you're in a derivative you get blown. But other than that, like if you're held to maturity, who cares? Now, junk bonds different story, because they can actually go bankrupt and your principal poof is gone. So that's a different story entirely so I'd be very cautious about.
Speaker 1:I'd be underweighting the high yield component right now of that business. Is duration the wrong price? Yeah, it is, but I'm not sure we're going to see a blowout in rates. Can rates go back to four and a half? Yeah, sure, but are they going to go to eight? I don't think so. So really, once again, as I say in all my commentaries, sizing is more important than entry level. You are never going to go and buy the bottom or sell the top. Let's do it by accident. Okay, this is not going to happen. What you want to do is look at the profile of the market, allocate money enough to an investment such that, if you're right, it'll make an impact.
Speaker 1:If you're wrong, you're not going to blow up, and if you do, that're not going to blow up, and if you do that you're going to be okay. So don't. I mean, everyone wants to go to a cocktail party and say they bought nvidia four years ago, which no one did, and if you didn't buy it.
Speaker 2:You know, at 10 bucks you sold it at 13 bucks and we're happy about it.
Speaker 1:But that's kind of kind of lesson over there. Um, I'll use the word always, but it's never always. But what always blows you up and I have a number of commentaries on this that you should go look at about it's always convexity. No one gets blown on duration or credit. Really you get blown up on convexity, short convexity. The reason why is the leverage against you is monumental. You think you have some certain kind of risk on. Against you is monumental. You think you have some certain kind of risk on and as the convexity goes against you, you tend to try and adjust your position and your adjustment makes it worse. Remember what is convexity all about. Convexity means unbalanced return.
Speaker 1:So, if I can make a bet, even money bet where if for a certain outcome, either way a coin flip for instance I could make a dollar or lose a dollar, that's zero convexity. If I make $2 and lose $1, positive convexity. If I lose $3 and make $2, negative convexity Stop.
Speaker 2:That's it. That's convexity. Don't think any harder. If you took ninth grade stat you could do my job.
Speaker 1:Okay, I'm returning that Problem with negative convexity. Big concept you buy an option, limited loss, unlimited gain. That's why equity is synthetically a call-up from a company. When you're short the option, you have limited gain, unlimited loss, Unlimited loss. Think about that.
Speaker 1:That's why it's always negative convexity that blows up. If you go look at the big market crashes in the past, it's all by people being short convexity in some manner, fashion or form. The GFC was really a giant short put trade on mortgage credit. You can model the trade up as short put option and that's why Merrill Lynch managed to lose $50 billion in short order, which they didn't think was even possible.
Speaker 2:As we wrap up here, harley, talk about your website, what kind of content you put out and other ways that people can reach out to you.
Speaker 1:So I publish a commentary every four, six, eight weeks whenever I'm in the mood. Whenever there's something that's interesting I'll talk about. If you want it, it's free, just send me an email. It's on my site, convexlymavencom. On my site I have all my past commentaries, going back to 06. I also have my library in there, which I've kind of curated. The under 10 or 20 commentaries that are not trade driven but basically forever self-describing convexity or other various forever ideas I have not there, so it's all free.
Speaker 1:I do publish also a song of the month, which tends to be more popular than my commentary, but I can't fight that.
Speaker 2:So if you add to my list.
Speaker 1:I'll add you to that also.
Speaker 2:Everybody. Please be sure you follow Arlie Bassman. I enjoyed this conversation. I'm a big fan of Simplifies, and I'm saying that not just because they're a client of mine, but because I think what you guys are doing anyway is very thoughtful regardless. Thank you, arlie, for the knowledge. Appreciate it.
Speaker 1:Thank you very much.
Speaker 2:Have a good day all Be careful, cheers everybody, thank you.
