Tony Crescenzi, Executive Vice President, Market Strategist, and General Portfolio Manager for PIMCO in New York, discusses the role of bonds in an investor’s portfolio and their place in the investment universe. He is hosted by Interactive Brokers’ Andrew Wilkinson, Head of Investor Education, and Steve Sosnick, Chief Strategist.
Note: Any performance figures mentioned in this podcast are as of the date of recording (March 15, 2023).
Summary – IBKR Podcasts Ep. 66
The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.
Welcome to another weekly episode of IBKR Podcasts. My name is Andrew Wilkinson. Today’s guest is Tony Crescenzi from the New York office of PIMCO. Tony is an executive vice president, market strategist and general portfolio manager for PIMCO, and he’s also an accomplished author about fixed income and all things related to money and bond markets. Welcome Tony, I’m delighted that you could join us.
Thanks so much.
I’m also joined by Interactive Brokers’ Chief Strategist Steve Sosnick. Steve, for the sake of putting today’s recording in context, can you describe some of the turmoil in the market as background to today’s recording?
Yes, just because I don’t know when listeners will be hearing this, it’s Wednesday, March 15th that we’re taping this. Markets are wrestling with the news that the largest shareholder of Credit Suisse, the Saudis, are not putting any more money in. It’s the latest in a string of bad news about banks and potential bank troubles as opposed to Silicon Valley Bank, you know which was a fairly fast-moving decline and Signature Bank, which happened over the weekend when people didn’t even notice until Monday really. This has been going on for quite some time, but it’s much larger and much more systemically important. And so as we’re taping this, we’re seeing S&P down by about 1 3/4%. We’re seeing two-year notes well below 4% at the moment and basically commodities falling and a wide range of dislocations in the market today.
Nice color, Tony. Let me turn back the clock to a piece that you wrote in January of this year, which at the time I felt perfectly described the landscape for bonds. Let’s say well into the monetary tightening cycle, you said, “the repricing of yields has vastly improved the allure of bonds, which in 2023 seemed likely to provide investors with the traditional benefits of diversification and capital preservation”. That was from your Strategic Bond Investor on January the 18th, 2023. Can you elaborate on that great quote and bring investors up to date?
Thank you, Andrew, and thank you for having me. And as Steve just referred to a few areas of tension in the stock market that would lead to the problems in the banking system, and we can bring that right back into the points about the bond market in the sense that we can contrast the reaction of late in the bond market to the stock market to 2022, when everything went down. Of late, we’ve seen better correlation as it’s put typically of course, when stock prices fall, bond prices rise and vice versa, at least historically. That wasn’t the case in 2022. Last year, 2022, probably could be seen as an anomaly of sorts with the repricing related to the removal of near $19 trillion dollars of bonds globally from negative yielding status. Think of the German bund 10-year bund at minus 50 basis points. What investor will want to own a bond yielding minus 50 basis points? Again, given the deep negative returns, they experienced. Today though, and this is part of the point about the return of income, there is income to offset the potential for losses and prices and rising yields and therefore a better climate for investors. To sum up, though, in looking at the recent data on where yields are and they’re swinging around in a great movement, the Bloomberg aggregate, which is one way to look at the bond market in aggregate, because it’s a compilation of treasuries and mortgages and corporate bonds and asset backed securities. It had been in the mid to high 4% area relative to history, that’s pretty good and it’s also higher than what markets think the future inflation rate will be, which is somewhere in the twos, and it’s also pretty good relative to typical volatility in the bond market, call it five, six percent. So, if you compare the near 5% yield that existed recently to the 5% volatility, you get a good ratio. Contrast that further to the stock market where returns tend to be mid-to-high single digits but with volatility in the teens. And so, the risk reward story looks pretty good for bonds today.
I’m going to throw the next question. Over to Steve.
That segues into to the next question. Which would be to define the aims of investing in bonds and you know a lot of our listeners tend to be equity focused, please explain to them what an investor should be looking for in bonds as opposed to equities and you mentioned the risk reward trade off before but other objectives that someone might have in bond investing?
Today I’m thinking of one of my favorite movies, It’s a Wonderful Life with Jimmy Stewart, which has a scene in the movie critical to the outcome where there’s a run on the bank, the Bailey Building and Loan.
If I may interrupt for one second, I literally linked to that clip in the current piece I wrote.
Apropos, because there are so many photos like that, if not fiction, but real, including one in 1907, anyone can Google this. The banking panic of 1907, lots of people on the streets standing in front of Federal Hall, which of course is where George Washington was inaugurated across the street from the New York Stock Exchange. A big run on the bank that ultimately led to the creation of the Federal Reserve in 1913. So how does all of this relate to your question? Well, in terms of the aims of investing in bonds, one doesn’t want to be stuck in that crowd trying to get his or her money back. And so investing in bonds today, especially in the context of the recent banking stress, means protecting capital especially for individuals with money that exceeds what’s currently insured in the banking system. Of course, the FDIC insurance is only at, I say only because there are lots of deposits above these levels, $250,000 and one quick statistic: There’s one FDIC, the insurance corporation, of course, that supplies insurance to depositors has about $130 billion in hand from money that’s collected over time. But there’s $10 trillion of insured deposits. And so that math doesn’t work so well, unless, of course, there’s a blanket guarantee. That would take an act of Congress. And so rather than get up, caught up in all that in the crowds that amass in times of stress, an investor seeks out the safety of bonds because the odds of getting money back eventually are high. One quick footnote: Consider, for example, Triple B rated bond, which is the lowest rated investment grade bond. There is AAA, AA single A then triple B. Historically, according to Moody’s, the default rate is 0.1%, meaning that in any given year an investor on average in a triple B rated bond will have a 99.9% chance of getting his or her money back. And so for many investors, especially today, with the older society on average than in the past, investors want to go up in the capital structure, as they say up, where there’s more safety. In that sense, especially in a time of stress, as markets and the public is going through currently.
Tony, not all bonds are the same. What are some characteristics that investors should consider looking at?
The easiest one, Andrew to point to is of course the maturity. Different maturities behave differently in different times, but your listeners are pretty sophisticated and understand that a longer-term dated bond will tend to move faster in price than a shorter-dated bond. That’s the so-called duration risk. So the duration on a 10-year note will tend to be around 10 and a two year note around 2. That means if the yields move a percentage point, the 10-year price has the potential to move 10%. We all saw that last year. So there’s potential for a lot of movement, whereas the two year would move a lot less in price. But that’s the easy one to look at. And, of course, you want to consider where the US is in the economic cycle when deciding on which security to invest. Investors in the past week or so, in the time of stress related to banking sector stress have been choosing the two-year note, which has had wild swings. For example, just recently that two-year Treasury was yielding 5.1%, but it’s fallen down to 4.1%. That yield decline is far greater than the yield decline that has been seen in the 10 year. Now the price movement is far smaller. As I mentioned, there is a duration element there. But there has been significant outperformance and that outperformance relates to something called convexity. Convexity, meaning, what’s the second order of movement when there is movement, certain things certain bonds will move faster than others when prices are moving. A major example and an important asset for fixed income investors is agency mortgage-backed securities, which have the implicit guarantee of the US government: Highly liquid, high-quality securities therefore. But they can be highly difficult to predict in terms of movement and because of that, when interest rates are volatile, they’ve been volatile the past year, agency mortgage-backed securities might underperform treasuries and they did last year, for example, agency MBS yielded 2 points more than treasuries, and typical spread is under one point – today it’s about 1:50. So there was significant underperformance related to convexity, which is to say investors didn’t / couldn’t predict how many Americans would refinance their mortgages, buy and sell homes to get rid of mortgages that are in existence. And there’s a cost to that so-called convexity cost that affected how they performed. Now takes a lot of sophistication to understand how they will, even I don’t totally understand. But even I, in the bond market for decades, but I still can’t fully grasp mathematically how they will move. So one will have to rely upon experts, typically those who have expertise in the mortgage realm. And I do have the luxury of leaning on my colleagues for that. About sixty of them. But the investors generally should be thinking about going to specialists in different areas that could bring municipal bonds, et cetera, when looking for help in terms of understanding these little details. One final, final note in the next cycle, meaning when interest rates decline, one key characteristic of a bond to consider is whether a bond has a call feature. Just an illustration of how there’s so many complexities call feature, meaning if yields declined, will company XYZ decide, “Hmm, well, this investor has a bond that we issued at 6% and now it can issue bonds at 4%. I’m going to call them away. I’m going to get rid of those bonds, pay these investors back and refinance”. So those call features can be detrimental when yields are declining. So lots of little details on bonds that require lots of attention. Final, final, final note: it means also having benchmark awareness. Meaning what benchmark is being used in the bond fund that I’m in? Investors should be thinking about that because these benchmarks have lots of different characteristics themselves.
By the way, just as a segue, thank you. Thank you, Tony. But just one thing for those of you who are who might be more familiar with options than bonds, the way I like to talk about duration and convexity is, duration is your delta and convexity is your gamma, the duration being the change in price to a change in the yield and whereas convexity is the change in duration that can occur over time. So, they’re not exactly perfect, but that’s an analogy for those of you who might be less familiar with bonds might find helpful.
Tony, I want to skip down the question list a little bit here. Your opinion on corporate credit spreads, do you see them widening as rates increase? And this is great timing in the context of what’s happening in the market today with yields coming down, so what’s likely to happen with corporate credit spreads now?
One of the most important things to be thinking out in the post-GFC era (global financial crisis era) is the change in business models that has occurred amongst intermediaries, which is to say that the liquidity in corporate bonds has evaporated relative to the past. It was never high to begin with, and it’s gotten worse over time. The principal-agent model means where can investor XYZ can go to sell securities and who will buy from that investor, the intermediaries, the primary dealers. They are the ones, but they’ve decided to begin playing a game of hot potato in the sense that they’re no longer allowed or want to hold bonds in their inventory. Here’s a quick example and it can affect how they trade and or value, which is what I’m going to get at. In 2007, primary dealers, these are the major investment banks with big names that most of our listeners have heard of, they had $300 billion of corporate bonds in in their inventory. So, they were holding them for various reasons, not for an investment, but to trade. And hopefully, you know, buy and sell and make the price difference. Today that holding is down to $7 billion. $7 billion, even though the corporate bond markets doubled in size to $10 trillion. So, if an investor today wants to offload risk, in other words, says, “I don’t like the corporate bond market, get me out”, it’s not easy because there isn’t a willing buyer anymore to take the other side. The price that the investor gets could be far below the fair value, and that means one has to be very cautious about the liquidity aspect of it. Here is a really good example of that. In March 2020 Triple B rated securities, which I mentioned earlier, have had a long-term default rate of 0.1 percent. 99.9% chance of getting your money back, traded with an implied default rate, meaning where the price suggested it seemed to suggest that the default rate could rise. It was at 10 to 15%, substantially higher than the long-term default history. And of course, a lot higher than the actual occurrence in the aftermath, although some could say that was because of all the government support. But the fact is that these bonds many bonds can trade very poorly. So corporate bonds today, it’s not just a matter of default risk or what you think about company XYZ, what you think about the equity market in terms of deciding what the right price is. You have to also think about liquidity on the way out and whether in a recession or at a time of stress, as the markets have been going through lately because of the banking issue, how they’ll trade. It could be completely different from what company XYZ’s prospects are. And so the credit spreads are more likely to widen than contract in the time ahead because it looks like now, because of the banking story, that the recession odds have increased somewhat for all we know we’re reaching the point of a sudden stop – not saying that will happen – but meaning we could see many banks pull back on lending and affect the economy and it will slow down and so be cautious about the credit stay high in quality because the low-quality securities will get hurt the most.
As a quick follow up to that, that really sounds to me as though it’s very important for investors and bonds to do their best to match their assets to their liabilities. So, meaning that if they’ve got needs for the cash going forward, you know they should try to find fixed income investments that they’ll roughly match their anticipated liabilities. For example, you’ve got a kid going to college and in five years maybe that’s the part of the curve you should be looking for. Am I hearing that correctly, Tony?
Very wise, Steve. I think that’s a very good idea. We know that major companies do that with respect to the obligations they have to take a lesson there on pension funds, et cetera. Insurance companies expect to have certain liabilities at certain points in time, and they try to match those liabilities best they can and the flows this year by those entities have been towards buying these longer-dated bonds to maturities to match the liabilities. It’s a great way to think and avoid the headache, if you will, stomach ache, choose your poison, in times of stress, and just simply weigh that weight and hold to maturity (HTM).
Tony, I wanted to ask you about your views on the yield curve and my original question was going to be, do you expect it to normalize when the Fed kind of gets somewhere close to finishing its tightening cycle? But just tell us what you’ve got at this point. Where do you see the curve now and where is it likely to head under the current volatile circumstances?
The yield curve will tend to steepen when the Federal Reserve cuts interest rates, meaning that short maturities will see a decline in yield that is faster than the decline in yield, if it is occurring in longer maturities. That’s what’s happened of late in response to the banking stress. That should be expected to continue if the Fed is set to cut interest rates. A big if. Who knows? None of us can predict where confidence will be and whether those lines will form outside of banks. It’s all a confidence game, but it’s possible that the Fed cuts rates in response to that stress. But what it’s faced with, of course today is a high inflation rate and has to tend to that well. So, Paul Volcker, the famous Fed chair from 1979 through ‘87, he wrote a book called, “Keeping at It”. Fed Chair Powell, the current Fed chair, said in August that the three lessons of history regarding fighting inflation, one take responsibility. Second, pay attention to how people feel about inflation, inflation expectations. And third, keep at it. He was quoting directly from Volcker. Keeping at it means keeping the funds rate up, don’t give in to pressure to cut rates, unless of course there is a major stress issue. We still don’t know, but if the Fed lets up too soon and these were errors in the 60s and 70s, two different times, 1969 the Fed in the mid-60s, the Fed cut rates too soon, had to go back at it and raise the policy rate to 9% by 1969. Then of course, made similar mistakes in the late 70s. Had to raise the policy rate to 20%. So the Fed would want to avoid that error, ensure that the bleeding is stopped, keep the finger on the gauze on the bleed and avoid the rate cuts. So that will limit any steepening perhaps, but so again, a lot depends on the banking story, but if the market believes that the Fed is going to cut rates by 100 basis points and that’s what it’s priced for as we speak. This year, 100 basis points. That then it was going to take a big stress point for that to happen. And I would wager against it, but ultimately the action of the past number of weeks is the future. You will see short maturities intermediate maturities outperforming longer ones when the cycle is over and the final word is: It’s clear from the breaking that the breakages that are occurring, that the breaking points are near for what the Fed need to do and accomplish. And so, the time to buy shorten intermediate maturities probably has arrived, although there’s some issues now with that discounting for rate cuts.
You know leading into that, Tony, one of my theses is that when you have short, when markets have real trouble pricing short-term assets, and I’ll point to the two-year as the poster child for this, if markets are having trouble pricing relatively risk free assets, what hope do we have to be able to avoid volatility in riskier assets? Do you follow that premise, either when it comes to bonds with some longer credit risk or longer duration or other asset classes?
It’s a great way to think about things. PIMCO’s had a framework since the early 2000s. It’s a graphic that we have called the concentric circles. It’s like a solar system and at the center rather than the sun are the risk-free assets, the treasuries and repo, et cetera. Those riskless, we think and hope, assets. At the perimeter, at the very end edge are the riskiest assets and you could imagine what those are, call them junk bonds, et cetera. Equities are somewhere out, they’re certainly not in the center because they’re not risk free. One could lose all of his or her money, so it’s really important to understand where the center of it all is. Certainly, the sun we’re having a problem. We couldn’t predict that on March 21st it starts to get warm. We need to know that this part of the solar system is going to be steady. Now heading into this year, it looked like that was going to be the case and probably will still be the case. And think about 2022, this core was unstable. The market thought 1% on the policy rate. It turned out to be 5%. But the market entered 2023 thinking 5%. And it’s turning out, it might be lower, but might be a touch higher. So the forecast miss 2023, is already shaping up to be significantly smaller than last year, meaning the core is probably stabilizing. Yes, within a mild range of late related to stress in the system, but bonds are doing what we’d expect them to do, which has run up in price to see decline in yield, which can be very big mitigant against stress at the perimeter. And so yes, it’s tough to make predictions on where the two-year will be day in, day out. We’ve seen 50 basis point swings in both directions. Highly unusual in fact going back 40 years in fact. But it’s still trending toward a lower level. And that’s good for the investor and equities and credit and everything else. It’s just the problem is the reason for this volatility relates to macro uncertainty. And one final point and it relates to this other thing called a Knightian uncertainty, which I’m sure you’ve heard of, Frank Knight in 1921 wrote a book on Risk, Profits and Uncertainty, and a phrase came from that called a Knightian Uncertainty and it’s where the risk is so great that they can’t be measured, and price discovery becomes impossible. That happened in 2008 for example, it’s happening in the way some banks are trading lately. People just don’t have enough information to make judgments. So, reaching points of Knightian uncertainty is causing lots of stress. So, we’ve got to get out of this. The central bank can help us, we hope, because it is the lender less resort with formidable tools. It’s hard to depend on that, you just simply have to be in high-quality assets and be a little bit closer to the core. Work your way out if you think the coast is clear.
I love that analogy of the solar system especially, you know, because we know risk-free rates are at the basis basically of every pricing model. And I feel that a lot of times when I’m talking to equity investors. You know they have, let’s say, a pre-Copernicus view of the solar of the investment solar system, thinking they’re at the center instead of one of the planets.
Thank you very much. Tony Crescenzi from PIMCO in the New York office where he’s the Executive Vice President, Market Strategist, and General Portfolio Manager, and a big thank you to Steve Sosnick for wandering into the office today and offering to sit and offer his insight. Thank you both gentlemen, and don’t forget folks, look out for more podcasts at IBKRCampus.com and also on ibkrpodcast.com. See you
Tony Crescenzi – The Strategic Bond Investor
Paul Volcker – Keeping at It
Frank Knight – Risk, Uncertainty and Profit
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