The Issue at Hand by Madison Investments
Most clients have a solid understanding of stock investing–you invest in equity ownership shares of a company for the potential of price appreciation or dividends. When the conversation turns to fixed income, investors and advisors have a harder time grasping the nuances.
In our first episode, we break down the four key risks that shape fixed income outcomes: when you get your money back, if you get it back, how you get it back, and how easily you can convert it to cash. We also discuss why today’s environment requires a more thoughtful approach to credit risk. Using this framework, you can navigate client conversations with confidence.
Key Takeaways
- Fixed income returns are driven by four core risks: maturity (when), credit (if), structure (how), and liquidity (conversion to cash)
- These risks are interconnected and should be evaluated together
- Starting with yield alone may overlook important risks in a portfolio
- In the current environment, credit risk may not be adequately compensated
- A more effective approach is to frame fixed income decisions around risk first, then yield
The Discussion
Chris Aleman: Hi there, welcome to Madison’s inaugural podcast, The Issue at Hand. I’m Chris Aleman, an Investment Director here at Madison, and here with me is Mike Sanders, Head of Fixed Income and Portfolio Manager. How you doing, man?
Mike Sanders: Doing well, doing well.
Chris Aleman: The plan of this podcast is to launch a new episode the first Tuesday of every month, and 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, with that, let’s get started. Mike, I think one of the things that we want to tackle on is what we consider fixed income basics – fixed income risk. Let me turn it over to you. Why don’t you set the stage for us?
Mike Sanders: When you look at investing in fixed income, I think a really good place to start, to your point, is just looking at the risks involved in where you’re earning 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. And I think to set the stage, like you said, in terms of looking at those risks, defining them, and understanding what they mean, I think would be a good place to start and get a baseline understanding for everybody.
Chris Aleman: 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 their money, you need to recognize that you’re helping them manage a lot of risk simultaneously. And I think that’s a big deal, and I think that leads to a valuable relationship. So, I think, with that said, let’s set the stage. So, Mike, how should people frame risks in fixed income for their clients?
Mike Sanders: When I think about risks in fixed income, I think of really four different buckets of risk. 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 other risks. 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 the 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 maybe the performance going forward – how much duration, how much maturity risk you’re taking, and then how that influences your coupon clipping or total return opportunities. I would say the next one, it would be if you get your money back.
Chris Aleman: 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 in the – I guess that takes me back – what is 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 is another thing I wanted to hit on. So, sorry, I interrupted, you were saying?
Mike Sanders: I mean that exactly it, it’s Fed moving up, Fed moving down, QE, QT. 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 determining what maturity makes the most sense for your client or your own personal goals and whatnot.
If we go to the if you get your money back, that’s credit risk. That’s, “I buy a corporate bond, I’m going to earn a little bit of income, and I want that money given back to me in five or 10 years”. Bonds are unique in the sense that there’s really a capped upside, right? Unlike equities, which, in theory, have infinite upside potential, a bond –
Chris Aleman: We’re not talking about equities here, now, come on.
Mike Sanders: We don’t talk about equities. Everybody wants to talk about equities – bonds are much more important.
I 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 cents on the dollar par, but if they don’t pay me back, it’s a lot less. And so 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.
Chris Aleman: Well, I think it’s also important to know how fast, I think, that can turn, too. 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. I mean, it can happen that quickly. So, I agree with you. I 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?
Mike Sanders: Yeah, no, 100%. It builds up, and then it escalates very, very, very quickly. And 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. And that’s a pretty important 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 how you get your money back – probably the best way to describe it would be: how – maybe even from if you get your money back and when you get it back, it changes with interest rates. I think the easiest way to explain how you get your money back is a mortgage, and you can buy securities that are tied to mortgages. And if I own a security that’s tied to a mortgage that somebody has – if interest rates fall, that person is going to prepay their mortgage, it’s 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, 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 at 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 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 on mortgages versus corporates are really attractive – then maybe you should allocate to more mortgages versus credit risk. I think that’s kind of the environment we’re in today.
Chris Aleman: We’re saying all these things that all sounds positive. What would be the downside of prepayment risk? If people are pre-paying their mortgages a little faster?
Mike Sanders: Well, let’s say you buy a bond that you think is going to have a seven-year maturity, and you’ve locked in 5% or 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 – I’ve only locked it up for a year. Now I got my money back now, and rates are lower, so my reinvestment is a lot less. So, that kind of comes back to combining, when you get your money back and how, and there’s a little bit of credit risk associated with that in there sometimes as well. 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. But you can get compensated for that – you get paid to take on that risk. And you know, that’s just another source of return an investor could earn some income on.
Chris Aleman: I think it’s important, the way you’re linking these. All three of these so far seem very interconnected, and I think that will probably lead you into what we’re talking about – our fourth risk.
Mike Sanders: It’s converting your money to cash. Maybe there’s two kinds of embedded thoughts within that. It’s maybe the bid-ask spread, if you will. What I can buy a bond at, versus what I can sell a bond at. But it’s also the vehicle structure. ETFs/mutual funds have different liquidity structures than more of a private credit fund might with redemption caps. It’s just how quickly and how efficiently, with little price impact you can convert whatever your investment is, to cash in your checking account. I think that’s something that people probably don’t really think about. They just see 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, “oh, wait, okay, so that was when I was investing in private credit, yes, I was taking if you get your money – credit risk, I 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 are taking on.
Chris Aleman: 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. I got to put you on the spot for a second, Mike. Out of all of these – I know we listed four things and we know they’re interconnected – which do you feel is the most important in this current environment?
Mike Sanders: I think it’s probably credit risk. But given what energy prices have done recently, and changing thoughts on Fed policy over the next 6-12 months, you could argue that when you get your money back – interest rate risk, is another one. But I would say, if I was looking at a risk, that you’re probably not getting compensated enough for at the moment, I would say it’s credit. Now, there’s an old bonds saying, “there’s no bad bonds, just bad bond prices”. And so, when you think about spreads over treasuries, and that how that prices into a bond, how that moves to bond prices. There’s 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. Not to get too much in the nerdy weeds – but, I think it’s important for everybody to think about investing in a distribution. There’s possible outcomes across the board. A recession, solid growth, and then there’s the middle. I think spreads and all these risks, you have to look at it on a distribution basis, where spreads that are at really tight levels – that means that the market’s pricing in a low probability of bad outcomes happening to the economy, or whatever it may be. I don’t think you’re getting compensated a ton for that risk. That’s not to say you shouldn’t own corporate bonds, but you got to make sure you know what you own right now, versus kind of jumping into the deep end of the pool and buying lower quality for that little extra yield. Because, again, you’re not getting compensated a ton for taking a lot more credit risk, and just getting a little bit more yield. And so, just be aware of that. I think right now it’s probably something that would fall under that category.
Chris Aleman: I think that kind of leads me to what 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, 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 that’s a great point. And I think we’ve talked everybody’s ear off, and that’s a good place to start. What do you think?
Mike Sanders: Yep, I would agree.
Chris Aleman: Don’t want to overwhelm them too early. So, hopefully you’ve been able to take something away from this, other than our love for the asset class. 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.