Harley Bassman on Why the Big Moves in the Bond Market Are Done

Episode Summary

Executive Summary: The episode explains fixed income through Harley Bassman’s framework of duration, credit, and convexity, arguing that current markets favor selling convexity, avoiding credit, and positioning for a yield-curve steepener. Bassman sees mortgage bonds as unusually attractive versus corporates, expects the Fed to cut less and later than markets price, and thinks inflation may stay stickier because of demographics and Fed ego/legacy concerns.

Main Topics: Why 2023 was unusual for bonds (Priority: 5/5): The hosts discuss how 10-year Treasury yields ended 2023 near where they began despite major volatility, framing the year as emblematic of a strange bond market cycle after decades of relative calm. Convexity explained in plain English (Priority: 5/5): Bassman defines convexity as non-linear payoff or 'unbalanced leverage,' contrasting positive and negative convexity and emphasizing that fixed income payoffs are path-dependent. The three fixed-income risks: duration, credit, convexity (Priority: 5/5): Bassman says bond investors really manage only three levers: when you get paid back, whether you get paid back, and how you get paid back; he argues convexity is currently the best risk to own/sell depending on expression. Why mortgages look attractive relative to corporates (Priority: 5/5): He argues near-par mortgage bonds offer government-like credit quality with better yield than investment-grade corporate credit, while incorporating valuable optionality and convexity characteristics. Fed outlook, inflation, and the yield curve (Priority: 4/5): Bassman expects fewer and later rate cuts than markets imply, believes inflation may remain sticky due to demographics and labor supply, and thinks the front end of the curve will matter most. How to express macro views through products and ETFs (Priority: 4/5): The conversation covers how Bassman packages complex institutional trades into retail-accessible ETFs like PFIX and TUA, allowing investors to express steepener or rate-risk views more directly. Market structure, zero-day options, and stock-bond correlation (Priority: 3/5): Bassman briefly addresses zero-day options and notes that stock-bond correlation depends on the inflation/rate regime, with higher rates and inflation tending to make the assets move together.

Key Arguments: 2023 bond market volatility was extreme, but the 10-year Treasury finished the year near its starting level, showing how chaotic the path was even if the endpoint looked unchanged. Convexity is simply non-linear payoff: favorable if you can make more than you lose on the upside/downside asymmetry; fixed income is fundamentally about managing that asymmetry. Bond investors should think in terms of duration, credit, and convexity; right now, duration is less attractive, credit spreads are too tight, and convexity is relatively expensive/important. Mortgage securities are effectively a 'covered call' on Treasuries: buyers give up some upside in exchange for yield, which makes them attractive when you want government-like credit and convexity exposure. Investment-grade and high-yield credit spreads are tight versus history, so taking additional credit risk does not look compelling relative to alternatives. Bassman believes the market is pricing too aggressive a path of Fed cuts; he expects fewer cuts, later cuts, and a slower normalization of rates. He thinks inflation may remain above the Fed’s 2% target because boomers have wealth and will keep spending while labor supply is constrained by demographics. The yield curve’s inversion is less about a precise recession forecast and more about markets buying insurance against tail-risk outcomes. The best current expression of his view is to favor short/medium-duration convexity exposure and position for curve steepening rather than making a simple directional rate call. Stock-bond correlation is regime-dependent; when inflation and rates are high, equities and bonds can fall together rather than hedge each other.

Data Points: 10-year Treasury yield: ~3.8% - Hosts note the 10-year ended 2023 roughly where it began. Investment-grade credit spread: 57 bps - Bassman says IG credit is tighter than its historical average of about 65-66 bps. High-yield credit spread: ~350-370 bps - Bassman compares junk bond spreads with a usual average around 440-460 bps. MOVE index: 120 - Bassman says bond volatility is elevated and compares MOVE to the VIX for bonds. Historical MOVE average: 90-100 - Used to show current convexity pricing is elevated relative to normal. Mortgage spread to Treasuries: ~150 bps - He cites current mortgage-bond spread versus a historical range around 70-75 bps. Historical mortgage spread: ~70-75 bps - Bassman says mortgage spreads were typically much tighter over decades. Par mortgage yield: ~5.5% - He says near-par mortgage bonds offer around this yield. 30-year mortgage spread to treasury: ~2.8% - Hosts mention the spread has eased from a peak but remains wide. Fed cuts priced by market: ~120 bps / 4-6 cuts - Bassman says futures imply multiple cuts in the next year. Potential mortgage-rate decline: ~100 bps - Bassman says mortgage rates could still fall another full percentage point eventually. PFIX performance: up 200% for a while - Bassman references the ETF’s strong performance when rates rose. PFIX distribution: $34 - He notes a large distribution distorted recent chart performance. Duration example moves: 2-year ~1.8 points; 10-year ~8 points; 30-year ~17 points - Bassman illustrates how longer-duration bonds are more sensitive to rate changes.

Pivotal Quotes: "Convexity just means that the payoff is not linear. It's not one-to-one." — Harley Bassman: Defines convexity in simple terms for the hosts. "When you're in the bond market, not equities, the bond market, you have three buttons you could push. That's it. Duration, credit, convexity." — Harley Bassman: Summarizes his framework for fixed-income portfolio construction. "The Fed wants a 2% inflation rate. They'll get it eventually, I presume. They're going to put the funds rate at two and a half... So now we're at three. Two is tens... So now we're at four." — Harley Bassman: Outlines his view that policy rates and longer yields will settle above current market expectations.

Implications: Investors should focus less on simple bond-versus-stock narratives and more on how rate, credit, and optionality risks are packaged. Bassman’s view implies favoring mortgage-backed convexity, being cautious on credit, and preparing for a slower Fed easing cycle and a steeper curve.