MH+ Ep.19 : 'No Bad Bonds, Just Bad Prices' Kev Catches Up With Harley Bassman

Hey folks, welcome to the market huddle plus episode, where we get a previous guest back on the show. For a quick update, I'm Kevin M and this week we welcome back Harley Bassman from simplify Asset Management. It's our Show more

pleasure to welcome back to the show Harley Bassman, the managing partner at simplify asset management and the originator of the move index. Harley, thanks for making time for us today, thank you. Thank you, I thought you were gonna add convexity Maven also, but that's okay, I'll be today. We be modest, it only goes. Two titles, okay, um, first of all, before we start, we're going to talk about, uh, two new strategies that you have, uh, the uh Tua and the MBTA. Uh, but before we do, I just want to kind of give you a huge plug for your pfix and, for those who don't know, this was the product that was, in essence, buying a swaption on 20 year, uh, 20 seven-year option on 20-year swaps, and, and it was, in essence, betting on higher 20year rates. And you, you kind of brought this out last year, or maybe it was two years ago, and it was an absolutely stunning trade. It went from $50 to $110 and, uh, just hats off to you. It was well done, thank you. Thank you, I mean, I mean it. It was a, a seven-year swaption into a 20-year payer. Uh, if you want to bleed it down, though, for Simplicity, it was a seven-year put on the 30-year treasury. That's the think about it there: a seven-year put with a 30-year treasury bond. Um, and, and yes, it was a, a winner last year, I think, up 92%, because we brought it at 50. It promptly went to 37 at the end of 2021. You can't get it perfect time them all right now. And then Jay Powell- I, I will. Jay Powell gets all the credit. He took this thing from uh 37 up to 114 last month, so that it did what it was supposed to to do: a, a, a, a, a positively convex way to get Negative duration well, and I think it one on two ways: one on the Delta, meaning that the interest rates went up, but it also went, one on the fact that volatility increased. Oh, yeah, I, I mean easily 10 points of that was V because, uh, you were also buying this thing when the move was at 60, uh, before it went to like 140. So, yeah, you, you, you, you, you made money on both sides of the trade. You lost money on the curve, you lost money on the curve, um, but we may made up for it everywhere else. So, that's okay, I, I'll, I'll take a winner, Show more

okay, so that one was a long, uh, convexity trade, and you have the new one that you're coming out with, the MBTA, and this is a strategy where you're going to buy um mortgage back Securities, and it's a little unusual for you because usually you know, you mentioned that you're the long convexity Maven and this trade is actually shorting ball. Can you tell us a little bit about this strategy? Well, it, it, it, it, it would seem oxymoronic, except for the small detail that I ran mortgage trading at mirl Lynch, so I am a, so you're always short, uh, I, I am a mortgage guy by training, um, here's what. So I write a commentary: uh, it's free, um, I post every four to six, eight weeks. You can find it at convexity mavencom. My email is there. If you want to get added to the list, just ping me and I will add you. It's free, no cost. And my last two commentaries have gone through kind of the math of what's happening in the mortgage market and what you've seen in the mortgage Market. You could think of a mortgage as being a byright, but a big fat, juicy byright. So not buying a security and selling a one or three-month call. This is like buying a 10-year Treasury and selling a three-year call against it. Okay, why don't you explain to people why? That is just like what, the, the kind of the, why a mortgage is different than a regular Bond. So only in the US, us and in Denmark- but we'll ignore them- can a consumer, homeowner, ordinary, civilian, take out a 30-year loan where the rate is fixed for 30 years but at any time they want they could prepay it for no cost. Um, that's a gigantic, Mammoth option, a 30-year option. It's a very powerful option, um. And therefore what that means is if you take out a loan, a, if some takes out a mortgage of 5% and rates go to six, well, he's go. You know he'll keep his 5% loan R go to four, he's going to refinance if you own that Bond. So what happens is the big mortgage companies are no longer Banks, but they're like rocket mortgage or Quicken. Those are the guys who do all Show more

the mortgages now, not the banks. They will do, let's say, 10,000 loans and they'll give them to Fanny May, who will look at them, stamp them, give them back as a single pool with a diversified group of five- 10,000 mortgages in it. Those mortgages will all be prime, which means 720 FICO or higher doesn't really matter, because Fanny May then stands behind that and guarantees the timely payment of principal interest. Okay, so when you buy this Bond, um, if rates go up, it will go down, like any bond would. It can go down five, 10, 20, 30 points. As a matter of fact, we have bonds right now. They're down 30 points. You know, Fanny, Fanny, two and a halfs, twos are down by that much. Right, but it really can't go up much above 105 because once he gets to that level, the underlying mortgage will be about 100 basis points in the money and the homeowner will refinance and you'll get paid back at par um, and so it's negatively convex. Remember what is convexity? Convexity simply means you have a nonlinear payoff profile. So if I have anything, any asset or a bet, where I could make a point or lose a point for equal changes in the underlying something, that's no convexity, it's linear return. If I could make two points and lose one point, positive convexity. If I could lose three and make two, negative convexity. That's it, nothing more, nothing less. If the up and down is not the same, it has convexity. And if you make more you lose, or vice versa. That's the number now the reason why we hired all these rocket scientists in the 90s on Wall Street was to try and figure out what that option is worth. And uh, for mortgage bonds it tends to be worth about three qus of a point. So if Treasures are trading at five, mortgage bonds trade at 575 and of course, okay, the underlying mortgage inside of it will be at 650 to 7%. Somewhere in there you'll, the underlying mortgage will be usually- let's call it- one point higher. That's because, if take all the fees and the processing for it, Show more

okay, right now we're trading about 175 basis points over the curve. That's insane. And and and while I have made a career of being long convexity, as we say on the street: no bad bonds, just bad prices. Oh, that's a great line. There is a price I will sell convexity at, and we're at that price right now. So, all right, so what? So let's talk about why this exists right now. Why is that spread at? You know, record whites? Uh, I will give a, an easy reason and a hard reason. Okay, easy reason is that volatility has basically doubled. The move was at 60, now it's at 125. And you're- since you're selling a three-year option, not a three-month option- that Vega, that the, the, the value of taking V up by a point or two or three on a three-year option is really big. And so the mortgage spread is widened, because the mortgage spread is just simply the value of the option. Fanny, BR, Jenny, bonds are basically full faith and credit of the US government. They will not default. If you think F was default, you should get can of tuna, small, small token, gold coins and a gun, because that's what will happen to the world if Fanny and Freddy default: it'll be the end of civilization. So it's not happening. So therefore, the only difference between Treasury and a mortgage is the value of that call option. And the call option is G, up in value because balls have doubled the other. So that's easy. That's the easy reason. What's the hard reason? Hard one is: you have to go to my prior commentary called the center cut, issued on November 1st. Go to page eight and read that. What it simply says is: as the yield curve has inverted, the call option has become plumper, has become up as value. I'm not going to detail why. Okay, it's murder, but so. But the but? That is a key concept here. Because if that option is plumped up because the curve inverted, what will happen when the curve steepens? The value of the option will go down right. That's really interesting with this ETF here is that by buying um, Show more

buying it, you have an embedded yield curve steepener. Okay. Now one of the problems with um people going out and just saying, oh great, that's a great trade, I'm going to go buy mortgage back Securities, is that there's different tranches or issues of these. Why don't you explain to people why it's important that you get the right group of MBS Securities? Okay civilians, you will never buy a trunch. That's for a CMO. What you're gonna, what you're gonna look at buying, is a regular plain vanilla mortgage back security. That's the whole Bond. Now you're not going to buy it. You can't buy. Well, if you, if you have enough money, you could buy it, but even then you probably don't want to. Generally, civilians cannot buy mortgage bonds. You think you can when you see Fanny or Freddy or federal Home Loan, Bank or or or Farm Credit, those are the gs's issuing Securities. Those are not the actual mortgage back Securities. Mortgage back bonds are hard to buy because the street does not want to sell them to you because they're just dirty animals. And they're dirty because they give you a monthly principle and interest, just like when you take out a loan and you pay 2,000 bucks a month for your loan and some goes to principal, some goes to interest. When you're the owner of the mortgage security, you receive that and the accounting for principal is bothersome, to say the least. You will get a1099 in February. You get 1099 supplemental in May. You're not going to like it. So, in general, Wall Street does not want to sell you these bonds. What I've given you is basically the only way to buy a specific mortgage Bond, which is right now Fanny sixes. You can buy them with the mortgage index Investments, either mutual fund form or the biggest one out there, the mortgage index ETF. Who's ticker, I can't say, but you can, okay. Um, here's the problem with that. 72% of all mortgage bonds have a coupon between two and three and a half the okay. So explain to people what that means. When the FED took rates down, everybody Show more

refinanced. So people who had, who took out a loan at two, at two and three quarters, that loan would get put into a Fanny May, two okay, and and so on and so forth. Most of the mortgages in the US- three4 of them- got refinanced into very low coupon mortgages. That then got put into very low coupon mortgage back Securities. These bonds are not well, they're not very good for anything. Truth be told, they traded a very so. So, Fanny, a fanny 3, a 3% mortgage Bond basically mimics the mortgage index. It's trading now about $83 price. The problem is, at that $83 price and a 3% coupon, your, your dividend, your payout, is only 3.6%, despite the fact that mortgage bonds are trading at six. So you're supposed to make back this. You know 17 points over the next, you know 30 years, which is suspect to say the least. Um, these are not great bonds. Moreover, these bonds have very long durations. Fanny twos and two and a halfs have longer durations than the 10e note. And what you've done to make your measly yield on these things is you've sold a very far out of the money call. Remember the strike price I said was 105. When you create a mortgage Bond, it can look like buying a treasury at par at 100. It's like a three-year call struck at 105. The fny 3 still has a call struck at 105, but the bonds trade at 83. So you're 22 points away from being at the money you're selling, basically selling an option for a tail, option for pennies. You don't sell options for pennies. Okay, if you're gonna sell an option, I'm G say you should. If you're going to you, sell it closer to the money so you can get some some meat in it. You know, get, take some income into it. Selling off the tail is ous. So the mortgage index is basically a lousy investment right now and what I'm proposing is you sell the mortgage index, which looks like a 3% Bond, and buy my new ETF that only owns 6% bonds issued this year. I'm skimming off all the bonds issued in 2020 to 22, which is most of the index, and only letting you invest. Well, I'm offering you Show more

the ability to invest in new bonds that have been Meed this year and they trade with a much higher yield, a much higher coupon, also a much shorter duration, which we could talk about in a second, sure. So why don't we do it? Why don't you explain to people what you mean by that? Well, the fanny 3 trades like a 10e because the option so far out to the money, it's basically worthless, right? So it's like a 10e note of sorts. Um, a fanny six trades at 99 and a half. So you know a little. You, we move 50- 60 basis points from here to get in that thing near the, near the call level. So it has a duration of more like a four, like a fiveyear note maybe even less. Um, you're getting a lot more yield for it because you're selling a big fat juicy option. If you think the Market's going to stay in the range for the next you know while- and by range I mean up and down, 50, 75- then this is a great ticket. You're gonna get a lot more yield, um, and a lot short, less volatility. If you're concerned about there being being rates being a lot lower, what I would do is actually sell the mortgage index security, buy my new ETF and then go and buy back some duration. You can buy back one of two ways. One is to buy, uh, the, the, the 20-year treasury ETF, which is fine. The other is to go and buy a levered 2-year ETF, which we have produced, we, we, we. We've created an ETF that offers a 5 to1 leverage on the two-year note. So basically the same duration as the 10-year, but based upon the two-year yield, not the 10-year yield. Harley, you're just Harley, you're such a pro I don't even need to do the segue. Okay, so we're going to go from uh, talking about mtba, which is the simplify MBS ETF with these new mbss in there, to the Tua, and this strategy is buying 2-year levered, uh kind of Futures in essence. And why don't you explain to people why? Why this trade might be more attractive than just going out and buying a 10year or a 30-year Bond. Uh, this is our biggest ETF right now, very popular. We were a little early Show more

on it. But whatever you can't, you can't pick the bottom. So why is the yield curve inverted? That's that's the question you got to ask, like: why would someone want to go and take less yield for a riskier bond at one point? Why was the tenure yielding a 100 basis points less than the two-year? The reason why is people want duration, they want G, they want some ammo if rates go down. They want to make some money. Okay, a 10 year will make about eight points. Rates go from five to four. That 10 year bond will go about eight points. A 30-year Bond will go by about 17 points. A two-year Bond will go by about 1.8. That's nothing. It's a nice yield, but you know you're you're not getting any, any ammo for it. So people kind of have to battle back and forth. I think we're going to a recession. Think F going to cut rates. Think R: all rat are going to go down. I want to go make some money. Two years is for babies, um. By the way, I never traded the front end because this for babies, um. So what do you do? Well, what you could do is what we've offered and said. You know what. We'll give you the two-year, but we're gonna do it by doing it in Futures at a ratio of five to one, more or less. So when you buy that two-year ETF, there's five Futures in there for every dollar you invest. So it moves like a 10year has a duration of about eight and change. That's very interesting. And the reason why you like that is when the FED Cuts, they will cut. Uh, I disagree with my partner, Mike Green about when that will be. Uh, I think it's not till next year, later, but they will cut. They they're slamming on the brakes and um, eventually they'll SL the economy down and they'll cut rates. When they do that, they cut the front end, they don't cut the back end. Here's how it's all going to play out in my prediction. Their inflation Target is 2%. They're going to want a 50 basis point real rate, so that puts funds at 250. The historical relationship of fed funds to the two-year is 50 bips, so that Show more

put two years at 3%. Historical relationship of twos to tens is 100, 100 bips, that's 4%. What's going to happen is that twoyear not is going to go from five to 250, but the 10 is going to go where? From 450 to four. It's not going to move that much. The real ammo is going to be at this front end. But owning, owning an unlevered two-year, you'll make nothing. Right, five to un levered- well, now you're really making something. This, this, this levered twoyear is is going to move 20 odd points now when. Sorry, I didn't mean to interrupt. First of all, I I just want to kind of reiterate one of the things that that Alex gervich says. He says that easing is steepening, and I think that's one of the things that people don't understand is we could have a situation where the FED actually eases and you've kind of crafted a scenario where the tenure it actually goes down in yield. But you could also make the case that it's going to the, the yield curve might steepen and or sorry, the yield curve might steepen enough that it actually means that the tenure doesn't go, not only doesn't go down, it could go up yeld. Oh, I have no problem with that at all. I have zero problem with that, right? Um, I'm just trying to be generous here, right, and I, I think that's what people kind of mistake. They think: oh, I'm, I'm, I think that the economy is in trouble. I'm going to go buy 30-year bonds because they're going to move the most when interest rates move. But the trouble is that if the, if the interest rates at the front end are where the real juice is, then you're not going to actually benefit as much from owning the 30 and it actually might be a losing trade. I can assure you this. Do not buy 30-year zeros. That's a suicide trade, because 30-year zeros trade negative to the 30-year treasury bond. I'm not g to tell you why, I'll just say it's the case. Please do not buy La at zeros. That's that's. That's suicide. Okay, now one of the things that you mentioned is that, uh, when they cut, they cut hard and I just Show more

kind of I, I just- we're going to talk a little macro here for a quick second. I kind of went through and looked at 2000 and the 2000. We went from what? 6 and2 uh down to one and the meat of the move down to 1 and 3/4 was uh in about a year's time, then in 2008 or seven, sorry it started in 2007- we went from five and a quarter down to basically zero, and that all happened within the year as well. Um, one of the things that kind of strikes me is that people say, oh, the fed's going to cut 50 basis points next year according to the curve. Isn't the curve actually incorporating, uh, different probabilities of either like zero or 200 basis points? Okay? Number one: I have never said that fed's gonna do a hard cut overnight. I've never said that. No, no, fair enough, I'm just. I'm just kind of saying: in the past, this is what is happened. Yep, so what you're looking at is this: if you look at the current oneyear rate versus the oneye rate, onee forward, which is like down 100 basis points from here, that's where people are kind of jinning up this notion that we're going to see that the feds, the Market's predicting, um, a big cut in interest rates. Um, so right now, the one-year rate is 5.2. I'm looking at Bloomberg right now, live, and the onee forward sofa rate is 4.1. Okay, so that in one might say the Market's predicting that we're looking for 110 basis point fed funds cut over the next year. Got it? Number one: forward rates are not a prediction. Never say that to me. I might hit you forward rates forward. It angers me greatly. Okay, they're not a prediction. Forward rates are simply the mathematical Break Even of an Arbitrage free condition. That's all it is. Now, when you have an inverted curve, that, why is the curve inverted? One could say, well, that is telling you something, it's true, but it's not a prediction, but it's, it's. It's. It's somewhere in between this 110 basis point spread between the current one-year rate and the onee forward one-year rate. Here's my pet Theory, which I've stated Show more

many times in the past. The Market's not saying we're going down by 1% or 1.1%. What it's saying is there's a 90% chance rates will be unchanged and a 10% chance rates will be down by, you know, 400. Ah, there will be power windows down, hard landing, hard crash, fed Cuts back to zero again. If you add up 85% times 5.2 and 15% times 1, well, there you go. That's how you get your 4.1% forward rate. It's not really a prediction per se. I think it's a massive bodal distribution right of either a- we're unchanged- or B- we crash and burn, and and and that gives the. The average of that is 4.1 or 100 basis points. But that's where I think is going on here. I and my guess is the Fed doesn't cut till third quarter next year. Okay, so can we talk about that? Why do you feel that way? And if so, then uh, it's, it's, it's still too early for the Tua. Let's talk about Humanity, okay. Okay, we read the Greek tragedies from 2500 years ago. We read Shakespeare from 500 years ago. Why do we read these things still? Because they've captured the essence of humanity, which is that the great failing is always hubris. It's always ego. And I don't got to go too far in our current politics to go and point to: yeah, it's kind of all ego. Um, without scratching too hard. J Powell is worth a lot of money, or so I've been told. I'm quite certain has a lovely wife and kids, nice house. What left for the guy his legacy? Does he want to be known as Arthur Burns, who people spit on as they walk by his grave because he, you know, did not kill inflation when he could have? Or Paul vulker, who is a modern-day hero? I'm gonna guess it's vulker, which means he is not cutting rates till he knows inflation is dead in the ground, with a stake in its heart. Um, and that's not going to happen until he has court pce with a two handle for six months, or he has un employment, 42 to 45, that's a good take. He's not re reversing early. He will take no risk. His legacy is tarnished by him releasing too early. It's not economics, it's not math, Money, Show more

numbers. I'm talking his pure ego of what he wants to do for his legacy and that's it okay. And so if that's the case, that means the FED stays, uh, tighter for longer, uh, probably means there's more pressure on financial conditions. If, if it, if we have to assume that they put us into a kind of a tightening a point where we're restrictive and um it, it also probably means the yield curve inverts more, doesn't it? Um, not necessarily. It is very it depend when the yield curve inverts. There's ordinary civilians who own 10 years versus six-month bills. They're giving up 100 basis points in yield. That's not a cost, well. Well, it's an opportunity cost. It's not out of your pocket dollar cost. Now, all the hedge funds, all the levered money, they actually are writing a check of negative carry right. So the question is: how long can they carry a trade? For I will tell you, it's a lot shorter than what you know, a civilian Canon, and so that's. So that's what kind of drives this thing is. Is levered money. How long can they hold the trade? Now, if you go look at my uh levered twoyear ETF, this is actually a long convexity, long Theta trade, because we go out there and buy five Futures contracts. Those Futures, I'll save you the math- they yield negative half a percent. Okay, forget why. So I got five of them. That's negative two and a half. I'm making what? 540 on three Monon paper, right, so I'm actually making like a 2 point. Uh, 2.4%, sorry, is that right? 2.9% yield on this puppy. So I'm earning 2.9, almost 3% on this levered 2-year ETF. And what's convexity? Convexity, again, is relative up and down. Do I think rates can go higher? Unlikely, but okay, maybe, maybe a 100 higher. Okay, maybe 100 higher. Take fed funds at six and a half downside. I just told you they could probably go to go to two and a half likely. So you could, you know, lose one, make three. I call that positive convexity. Can I measure the value? Not particularly, but on its face, that is long convexity and you're earning almost Show more

a 3% yield while you're long. This convex profile, I think it's a pretty good deal. Yeah, and when I was doing the math and chatting with you, with you about this before the show, I was thinking about it like a hedgy and thinking to myself: okay, well, if you're levered long F, twos, the, the overnight, the repo is trading at 540 or whatever and twos are yielding whatever they are and it's negative. And then you reminded me the fact is that, no, there's the money that is sitting in the ETF that is actually earning that interest. So I guess it is. It is the opportunity cost of owning just a straight two, uh, which would earn you 5% or whatever it is, versus the owning this, which has less of a of a current yield. But then, if we do get a situation where rates go down a lot, it cleans up. Well, let's put pencil to paper. If I have rates down by 250 basis points on the on, on the two-year, so from five to 250, as I, as I, as I, or five, sorry, five, five to to to three, let's say that's 16 points, right, eight, an eight duration times 200 bips, that's 16. The 10 year is going to move 50 in my scenario. That's four. Right, I can make 16 points with, with, with, with, with the front end, four with the owning the cash tenure. So I think I like, I like this profile a lot better. And not only that. As we've said, easing is steepening and there's a chance that even with the FED lowering rates, that you're not actually going to win at the tenure. And if we do go hard Landing twos are going below three, right, okay. So so I mean, it's a, it's a very timely trade. It's a. It's a. It's a. It's probably the best hedge out there now for a recession, I think. And this is a trade that has been kind of Old As Time amongst the hedgies, right, like our, our mutual friend, Morris Sachs. He talks about how he did this trade with Paul tutor Jones and he did it with fives back in 1987. But this is this is a trade that is kind of when people want to express kind of worry about the system and the potential that Show more

there's a financial accident and the FED has to go cut rates. This is the way to do it. Well, like. I don't know him personally, but I did see a tweet that said that um, duam Miller, uh, came out and said he is massively levered long to. Yes, he is well. So if you want to go and pretend you're him, but you're a civilian with just a Robin Hood account, this is how you do it. Well, 5 to1 leverage. You're telling me he doesn't own Tua. That'd be nice. Listen, Harley, it's always great to have you on the show. Why don't you tell people where they can find more about you? You did it early on, but just why don't we remind everyone one more time where they can chat with you and find out more about you and your great products? Um, so I'm the convexity maven, convex mavencom. You could find me there. I 'll add you to my list, uh, and our products are all at simplify do us, simplify, do us. Has all our products there. Um, they're very clever and- and just to remind you what I mean, I came out of retirement to join this firm because what happened is there was a rule change at the SEC a number of years ago where, all of a sudden, you could put derivatives, Futures options, swaps, all these nice professional tools. You put them into ETFs. You couldn't do it before, you could do it now, and so we started a company where we put professional investment tools into ETFs so civilians can trade like professionals at a very low fee. Yeah, no, it's absolutely fantastic. And if you think about the strategies that you've introduced: the first one, you needed an isda to do with the piix. This one, the Tua, you need to. You need to use leverage, which a lot of people don't want to do and they don't want to be rolling and taking care of all that. And then, finally, with the, your Show more

new MBS, you know almost nobody, except somebody that uh used to work as the head of maril Lynch's mortgage back Securities, can buy those things, and so I just want to thank you, because I think it's a the great, uh, a great sweet products that you've offered for everybody. Thank you very much, thanks Harley. Thank you for tuning in this market huddle plus episode and don't forget that our regular full length show airs every second weekend this Friday. We're looking forward to chatting with Peter bvar about the challenging macro environment. In the meantime, you can check out my partner's website at bigp pictur tradingcom and, if you want to see what I'm up to, go to the macr touristcom until next time. I'm Kevin M, and thanks for listening Show more