COLLIN MARTIN: I'm Collin Martin.

LIZ ANN SONDERS: And I'm Liz Ann Sonders.

COLLIN: And this is On Investing, an original podcast from Charles Schwab. Every week we analyze what's happening in the markets and discuss how it might affect your investments.

Well, hi, Liz Ann. You know, I was looking at the calendar. It's kind of hard to believe that it's now mid-October. So we're into the fourth quarter right now. And I initially thought we'd talk about earnings season because that kicks off this week, but this morning we also got a very important inflation report, the Consumer Price Index. And that's driving the markets right now as we're recording. So let's focus there first. And you know, what are your thoughts and what's it doing to the markets?

LIZ ANN: Yeah, so it was an upside surprise at the core level to the Consumer Price Index. So that's the ex-food and energy category. The headline inclusive of food and energy, that was in line with expectations. So the month-over-month increase in core CPI was, to be precise, because these days rounding matters, 0.33%, which was higher than the 0.24% gain that I think was the consensus, I believe.

What I found most interesting, and I'm certainly going to ask your thoughts on this, is actually the breadth of categories. And I always do, I put it on my X feed this morning, looking at all the select categories, and pretty hefty chunk of them are not only running hotter than the Fed's 2% target, but about two-thirds of them are running above 3%. So that, I think, is something that we need to continue to focus on is not just the initial print at the headline and core level, but what is the breadth of the underlying components, to get a sense of how broad-based this inflation problem is and how it's not limited to just oil prices driven by the war. Tariffs work their way in here. I think diesel prices are starting to work their way, component prices, the higher cost of the build-out of AI, and we are starting to see that in the data.

Oh, and I should say that, well, this is your world, but I noticed that a quick doubling in probabilities for a rate hike at the October meeting. I looked at that on the CME FedWatch tool, and we went from, I think, 22% yesterday probability to 44% today, meaning the day CPI released as you and I are recording this. So what are your thoughts in terms of impact? We certainly did see a move in yields up and down the maturity spectrum. What are your thoughts as to the reaction function on the part of the Fed?

COLLIN: Yeah, certainly an impact, but we're not sure if this reading alone is necessarily going to move the needle for another rate hike later this month. It certainly supports the case for one later this year, in our view. You know, you mentioned the move in in Treasury yields and implied probabilities. That was the very kind of knee-jerk reaction following the release because a few of the numbers did come in hotter than expected, and that's kind of what we're looking for.

Now, if things come in line, meeting expectations is generally enough to keep the markets relatively calm. It's those upside surprises that can spook the markets. And I think that, you know, what I was focusing on was that core CPI monthly increase of 0.3%. You alluded to the rounded and unrounded. On a rounded basis, it's the second straight month of rising at a 0.3% rate, and the three-month annualized change ticked up to 3.4%. So moving in the wrong direction. And that's something that we focus on. I'm sure I sound like a broken record right now for anyone who tunes into our podcast every week, but those core monthly readings matter because it's something that one of the main decision makers focuses on.

So New York Fed President John Williams, who is the vice chair of the Federal Open Market Committee, he has singled out those core inflation prints that he wants to see increases of 0.2% or less to be confident that inflation is moving in the right direction. Now that's two months in a row that it's come in a little bit above that. Now, the Fed prefers the Personal Consumption Expenditures index, not just the CPI, but I think they all matter to a degree. And it's funny, Liz Ann, because Williams just this week gave a speech, and he didn't seem too concerned about the inflation outlook. I think he said, you know, one rate hike seems appropriate by the end of this year, and then he expects a pause. So I wonder if this slightly hotter than expected reading will change his view a little bit.

And then as you mentioned, breadth. I think that matters too, because we know that's what Fed chair Kevin Warsh is looking at, the share of components rising at that 3% or more rate. So we're going to be focusing there. We saw that knee-jerk reaction. So the two-year Treasury yield moved up very sharply. The two-year Treasury yield is much more influenced by expectations of Fed policy in the here-and-now, where things like the 10-year Treasury yield … more based on long-term expectations. We saw the 10-year Treasury yield move up also, though. It went above 5.3%, has since settled down a little bit. We think we'll probably be range-bound for a little bit here, in terms of very short-term yields, unless the outlook changes, you know, markedly where we're expect … significantly more rate hikes than we're expecting. We think an additional two kind of seems the most likely path right now as we look into 2027. Unless that changes, and we start to see inflation really reaccelerating, as opposed to just, you know, I think time is a factor, unless that happens, I don't think there's too much upside with short- and intermediate-term Treasury yields from here. And with that outlook though, we still kind of like short and intermediate maturities, durations, or what we call as a below benchmark preferred duration. We look at the Bloomberg Aggregate Bond Index as our benchmark, as a duration of around six. So slightly below that is our preferred avenue right now.

LIZ ANN: And you know, Collin, I'm glad you mentioned you went beyond just saying "Maybe another two hikes, contingent on...." And then you laid out the differential between if inflation stays relatively flat versus continues to accelerate, because I find that there are too many prognosticators who want to put their stamp on Fed policy expectations without any "because," just, "I think there's going to be another three or four." And there's no there's no sort of meat behind that view of "because we think the combination of inflation metrics are going to move higher or lower." So I'm glad you mentioned that.

It's also the case that and as you and I are taping this, CPI has been released, but Producer Price Index has not. And once we have both the CPI and the PPI, that's when the economists start to map to the core Personal Consumption's Expenditure deflator, which is the Fed's preferred measure. If you take just the CPI components that map over to PCE, that's kind of tracking at a rebound in PCE, as well. The kind of the annualized rate maybe popping up to the high twos from only around 2% in August and the annual rate picking back up to a little more than 3%. But again, we still have to see the PPI data coming in. But I think there always needs to be an explanation or a qualifier or scenario analysis for a view on what the Fed is going to do, say, out the course of the next year.

COLLIN: Yeah, and we try to follow that approach. Listen, we're all human, Liz Ann, right? We have a view. We hope it's right, but you never know. And you know, we have a reason behind what we're thinking, but there's different scenarios that are out there. And I think that's important to acknowledge. If we're wrong and inflation, you know, does become much more of an issue than we expect, then we'd likely see the Fed act more aggressively than we expect. And probably what a lot of the officials are kind of hinting at right now. But that's not their view, either. You know, one thing though, that when we get this inflation data, so we also figure out, "Well, how is that impacting us and consumers?" And once we got the CPI print this morning, we got to look at real weekly earnings, both on a year-over-year basis from a weekly and hourly. And you can see that high prices are taking a bite out of incomes, if inflation's rising more than income. So we might get to a point where, OK, inflation's rising, but what is that doing to, you know, consumption for us? But so far it doesn't seem like we're seeing that in the data just yet.

LIZ ANN: You know, another thing, you got a little more specific on the fixed income side in terms of the implications of where we are in this rate-hike cycle. Let me do the same thing on the equity side. As many of our regular listeners know, I'm a big fan of factor-based investing, either as an overlay to more monolithic sector-based investing or something that is relatively standalone, and that just simply means investing based on characteristics as opposed to just honing in on a particular sector in a broad-based way.

And the implications of higher yields across the maturity spectrum is being seen inside the market, maybe not purely at the index level, where you look at the resilience of a cap-weighted index like the S&P, but under the surface in terms of what's working and not working. And on the not-working side, it's more of the interest-sensitive segments of the market. But from a factor standpoint, what has been working, particularly down the size spectrum when you go into small caps, are factors like high-interest coverage, profit-margin stability, forward-positive revisions in terms of earnings, reasonable valuations. So it's kind of a little … it may sound like a hodgepodge, but it's GARPy, if anybody remembers, I think the acronym that was popularized in the 1990s, "growth at a reasonable price," where you look for that combination of growth characteristics and value characteristics.

But then I think it's important to add in that interest-rate sensitivity with factors like high-interest coverage and, you know, lower debt, the ability to fund operations out of … or at least pay interest on the debt out of cash flows. And that's one of the reasons why in the small-cap space, using the Russell 2000, profitable Russell 2000 stocks have doubled the performance of non-profitable Russell 2000 stocks. Now that may seem intuitive, like that should always happen. Why wouldn't the profitable stocks do better? But not always. And there are times where market leadership becomes a little junkier. And that was the case last year where the non-profitable Russell 2000 stocks outperformed the profitable ones two to one. And now it's essentially the opposite. And I think that that is reflective of the need to stay up in quality in a rising interest rate environment, especially when you … for investors that want to go down out of the mega-cap stocks.

COLLIN: Yeah, we're seeing that in the bond market. I'm sure I've mentioned this before, but just like small-cap stocks, when you think about the bond market, there's going to be, or specifically the corporate-bond market, there's going to be some issuers that are impacted more than others, right? If interest rates rise, how well can those companies handle that rise in interest rates? And what we've seen so far based on … we look at spread data as kind of a market, it's a market-based, I guess, indicator of risk is what is one way to describe it. But it's how much additional yield we as investors demand to lend to companies of various credit ratings. And for the most part, credit spreads remain pretty low. They've ticked up a little bit recently.

Except if we look at the absolute lowest rung of the credit rating spectrum, so the CCC-rated bonds, that's the lowest rung of the high-yield bond spectrum, their spreads have risen sharply year-to-date. The index we track, the Bloomberg High Yield CCC Corporate Bond index, the average spread is up 4.5 percentage points year-to-date. Much, much smaller move with BBs and single Bs.

What's interesting, though, is that even with that spread increase, and because spread is a component of yield, so when spreads rise, the value of a bond should fall relative to Treasuries, because those CCCs offer very high-income payments, the total returns actually haven't been that bad. They're negative year-to-date, but because they have such high income payments to help offset that. Now, that's not a suggestion that we think investors should focus on CCCs. We actually are very cautious there. But that's the beautiful thing about bonds in general. If you're earning income payments, and we're seeing higher income payments today, that means that's higher income to help potential, to help offset some potential price declines, if we see yields move up a little bit more and prices decline a little bit.

Liz Ann, let's focus a little bit. You were talking about growth before. Let's focus on earnings because it is the beginning of earnings season. What are we looking for? I mean, I know the earnings have been very strong. I think they're expected to be strong. So what are you looking for?

LIZ ANN: Yeah, so the expectation for third-quarter growth for the S&P is 30%. And that has the potential to move higher, assuming we see somewhat of a repeat of what we saw last quarter, where last quarter the consensus was about 24% as you went into second quarter reporting season. When all was said and done, it bested that by about thirty percentage points, a low-50% range.

I'm not sure we have that same kind of spread that we're going to see this time, but it's too early in earnings season to start putting any meaningful numbers on it. But let me just share what I'll be paying most close attention to. Less about what the companies report for the third quarter. That's largely obviously in the rearview mirror, but anything AI-related on the spend, any potential disruptions to the trajectory of capital spending, whether that's because of pricing issues, the cost of that, supply constraints, and getting the equipment and the hardware that is needed, and whether at some point we have to start to ratchet down broad capex, AI-related capex, assumptions.

But also related to that is listening to the adopters of AI and trying to quantify, and I think analysts will be starting to ask more pointed questions of the leaders of the companies that they follow in terms of, "What is your spend to bring AI in? What is the spread between the cost of capital and the return on invested capital? What are the cost pressures?" Because we are starting to see more than just anecdotes of companies.

Some companies saying they have decided to rein in the spending a little bit because the cost of that spend was going up without being able to precisely quantify from a productivity or a profit-margin standpoint. But I think we're at that point where analysts are going to attempt to try to extract that more precise information from companies. So that's essentially … I'm going to be at least as focused on the adopters of AI as the enablers of AI.

All right, so Collin, this week you're in the hot seat interviewing our guest. So tell us about him.

COLLIN: Yeah, that's right. This week our guest is Bryan Whalen. He is the chief investment officer and a generalist portfolio manager at TCW's Fixed Income Group. He runs a team that oversees over $160 billion in fixed income assets, including one of the largest actively managed bond funds in the world. And he currently serves on the board of the TCW Group Inc.

Prior to joining TCW, he was a partner at Metropolitan West Asset Management and co-head of its securitized products division. And prior to joining MetWest in 2004, he was a director in the fixed income department at Credit Suisse First Boston in New York. He earned a BA in economics from Yale University and is a Chartered Financial Analyst charterholder.

Hi, Bryan, thanks so much for joining the podcast.

BRYAN: It's my pleasure. Thanks for having me.

COLLIN: I'm really excited about this because we met a few weeks or months ago at, I think it was the Bloomberg Studios, and you had just some really interesting comments on specifically the AI data-center hyperscaler build-out and what it meant for the corporate bond market. And I thought that you'd make a great podcast guest. So I'm glad we're here today. And I want to focus there first. I know we hear about this all the time.

But the idea of this hyperscaler data-center build-out, I think let let's kind of start at the top, like the projects themselves. What do they look like? Because I hear about, you know, a big issuer. OK, they're, you know, issuing 25 billion to build a, you know, data center. What does that mean in practice, though, in terms of how's the debt structured, the idea that there's construction companies involved? Like let's start there.

BRYAN: Yeah, it's AI and the data center's been everything in 2026. It's where the conversation has revolved around not just in in corporate bonds, but across the capital market. So I would say first of all, data center is something new, on these podcasts and in the kind of the broader market, but I'll say it's not new to those of us kind of, you know, in the nitty gritty of it, you know, doing this day-to-day for, you know, 30 years now, you know, data centers, not just data center, but data-center finance has been around for a long time, you know, for decades.

But traditionally it's been done in kind of smaller scale, you know, and the data centers have typically been, you know, as you would expect because AI is brand new, it hasn't been there to kind of support the compute or the language models. But what we've seen over the past literally 24 months is probably the biggest boom in capital spending we have ever seen in, not just our lifetimes, but they'll call it in the last 100 years.

You know, you can look at canals or railways or maybe something more modern what we've all experienced was the fiber layout, you know, for the internet boom and all of that. They all had kind of their own unique characteristics, but they all rhymed in this way, which was this was kind of an inflection point in whether it's industry or technology, and you know, the expectations was that was going to change the way we lived our lives, and we were right, all of those things, but they also had this, they shared this aspect, which was effectively an overspend.

So something new, revolutionary, and you know, you got to love mankind, we are greedy, you know, we see an opportunity, we all want to run in, partake, and take the lead. And this has been no different. But yeah, I think what it's been really exponential is that the capital spend's like nothing we've ever seen. Even if you kind of present value dollars going back over 100 years, the rate of capital spend has been unprecedented. So kind of kind of back to your question, you know, let me just give you kind of an easy stat to kind of wrap this up.

You know, last year in 2025, net issuance in the investment grade corporate bond market was about a half a trillion dollars or $500 billion. Today, this year it's expected to double. And I would say almost the entirety of that doubling of issuance has been in the AI/data-center required capital spend because even though, you know, three years ago these hyperscalers had over $250 billion of free cash flow, collectively this year they're negative, and we expect they'll be negative the next year. So they've used all that free cash flow to build these data centers and buy the chips, etc., and pay for the power, but that hasn't been enough. And so they've come to the capital markets to borrow in all sorts of shapes and sizes.

COLLIN: So you mentioned free cash flow there and kind of those fundamentals. So that's a big question I have is, just the kind of fundamental outlook here, the profitability outlook, the staggering number of debt we're seeing. Is there enough money being earned here? So what kind of risk are we seeing there? And then let me add one more point. You know, a lot of times I hear about these big companies that, hey, they're big companies. They have high credit ratings. They are cash flow positive, have strong earnings. But how do you consider, say, the fundamentals of these big issuers?

BRYAN: Great question. so let's start with kind of putting this in perspective. We talked about issuance in the corporate bond market. Let's talk about capital spend. You know, the numbers vary, but let's say expectations on capital spend on data-center build outs, about $800 billion for this year. Roughly half of it will be financed through the capital markets here, most of that coming from the corporate-bond market.

The market quickly found that the asset-backed securities market and the commercial mortgage-backed securities market just isn't broad or deep enough to basically fund that amount of borrowing. So you have to go to the traditional corporate-bond market. There's a conversation here about the way they've done it, and we should talk about these structured deals, but like let's talk about the fundamentals. You know, it's interesting. The way I would break this out is kind of like the equity markets, you know, we're using the term FOMO. And there's a lot of excitement and euphoria and just like the, you know, in the equity markets, the debt markets are generally approaching this with everybody's-going-to-win mentality, basically expecting that, over the next couple of years, all this capital spend will not be an overspend. We're going to need all these data centers, and the earnings and the cash flow generated from this AI investment are going to reap the rewards that everyone's expecting.

And our concern is that, similar to other points in history, we're not questioning the revolutionary aspect of this technology and that it's going to change the way we live our lives. We're just kind of taking a pause and saying, like, "What if this AI journey just takes an unexpected twist?" And I'm not going to say we have any insight into telling you what that's going to be, but you know, just for the sake of conversation, let's throw out a few possibilities, and that's the way it always works. I'm going to throw out a few things, and it's probably something I don't mention. But as long as it takes the, you know, the unexpected twist, I think that's the most important point.

And so, you know, we're reading every day now about security concerns, you know, about breaches and AI, these agents doing things differently than even their creators expected them to do. Historically, we've seen concerns about power generation and the cost of that compute and what it's doing to utility bills to the consumer. We've seen, you know, concerns about what's going to happen to jobs, you know, creative destruction, you know, it may be a great place 10 years from now, and none of us have to work, and we've got agents running around doing all our personal and professional things for us, but somewhere along that journey, there's going to be a lot of jobs lost until we get to that next great place. So, you know, that's a concern. So you know … or what if just simply the adoption of AI isn't as broad and deep as people are expecting? Or very likely it just is a lot cheaper than everyone's expecting.

You know, maybe China comes up with the next type of model, language model, and they offered it at a fraction of the cost. So all of these things could prevent kind of a twist. And to your question on the fundamentals, let's break this ecosystem into two pieces. Let's call it the technology companies that have large, robust, proven non-AI businesses. And, you know, in this world we call them the hyperscalers, you know. It's your Microsofts and your Amazons and your Metas and your Googles, and people like to throw Oracle in there, although they got a little bit of different capital structure. But you know, it's these big, still pristine balance sheets, although they looked a lot stronger a couple of years ago, but their metrics still look incredibly sound. Then there's the other part of the AI journey. So you've got this giant AI ecosystem, picture these hyperscalers as like these strong foundational buildings within this ecosystem.

And obviously you've got NVIDIA in there too, I should mention them. And then all circling, you have hundreds of companies that really don't have non-AI businesses. And there are also a lot of self-financing going on within this. You know, NVIDIA, I think at this point is financing over 200 different companies, you know, that effectively buy their products. And you know, that might remind some of us of the technology bubble, you know, that we had in the late '90s going into 2000 and 2001. And so our concern is that when there is a lot of optimism in the market and particularly in this sector, when it's in a … it's a generational change in the way we're going to live our lives, but the journey's unproven.

And so our concern is that if we get a change in the path of this journey and there's a disruption, and the capital markets maybe push down equity valuations or push up the cost of capital. We're not concerned about these hyperscalers. These business are going to be fine, even with higher amounts of leverage. They have a strong, robust non-AI business to handle a disruption in the AI journey, but it's the non-AI companies that we think are going to suffer. And at the end of the day, what I would tell you is that is just not priced into the ecosystem right now. And so, you know, our viewpoint is basically it's kind of we have a kind of a value discipline in terms of investing, and we sit back and we basically, you know, put forward the simple notion. There's nothing wrong with risk. We love risk, particularly when you're getting compensated for it. And we step back and we look at this ecosystem, generally speaking, you're not being compensated to take the risk that we see within the ecosystem. We are starting to be intrigued at the unsecured debt levels of some of these hyperscalers because they have underperformed, because they've been issuing so much debt, and there's so much supply. But by and large, outside of that, we've been moving forward very cautiously.

COLLIN: I have a ton of follow ups, but that was going to be one of my main ones. You know, how do you as a manager kind of approach this? So it sounds like if you're not being compensated well enough, are you just being very selective in how you kind of view this ecosystem right now?

BRYAN: Yeah, I'll give you … let's call it we think of an overweight risk budget. And you know, how much doesn't … let's just say, you know, you think of it you're either underweight, you're neutral, or you're overweight. So we're roughly neutral right now in kind of exposure to the broad AI ecosystem. And you know, we're kind of stepping toward and thinking about getting about one third of the way to what we think about as a maximum overweight.

And so we're kind of … we're just starting to put our toe in the water here. And I'll tell you how we're thinking about this, which is we're going to break the, you know, the way to approach the AI business from a debt lens into two pieces. Traditional corporate bonds, which these, you know, our big hyperscalers have been issuing in large quantities, and now remember, a few years ago, when they were $250 billion or more of combined free cash flow, these hyperscalers, your Amazons, your Googles, your Metas, they had the most pristine balance sheets in the world. And, you know, a lot cleaner than Uncle Sam. A lot cleaner than Uncle Sam. You know, the highest ratings out there. And as you would expect, their debt, you know, the spreads over Treasuries traded very tight. Very minimal amount of extra yield to invest in these companies' unsecured debt versus Uncle Sam and well less than what you would find in your average kind of corporate bond market.

Now, I would tell you because of this issuance, mostly a supply story and a little bit of extra leverage on the balance sheets, the debt of these companies trades wider than your average corporate bond. So if your average corporate bond's around 75 basis points, 0.75% over Treasuries, you're going to find … you're going to buy hyperscaler, unsecured debt somewhere between, you know, 110 or 130 basis points over Treasuries. So 1.2% more than Treasuries versus 0.75% more.

And that's interesting to us. Now I'll tell you what we're thinking. You know, that may not change anytime soon, because it looks like at least for the next 12 months, these hyperscalers continue to borrow and borrow money. So it just looks like an attractive yield and carry play. And so that's really where we're dipping our toe in the water.

The second way to get exposure is through the debt markets to this AI and data center ecosystem is through these really interesting structured transactions. And let me give you a kind of a brief description of how these things work. So unsecured debt, you lend money, you basically you buy a bond from Microsoft, and they say, "In 10 years, we're going to pay it all back to you, and we're going to, you know, we're going to pay you a 6.25% interest rate." Fine. Clean, simple, easy to understand. These structured deals work like this. Some entity you've never heard of, lately I've been using French pastry names like "Beignet" and "Sopapilla." That's your borrower and this shell, this structure, basically has … think of it as two components. The timeline and the component, while they borrow your money to build that data center, because it isn't built yet. And it's going to take somewhere between 12 and 24 months on this journey to build this thing. Now, during that period of time, for the most part, effectively your borrower, like who you're looking to for the risk, is either the owner of this property, who you've probably never heard of before, or some big construction company that's put the shovels in the ground and is connecting you to the power supply. And maybe you've heard of them, maybe you haven't.

But this is not hyperscaler risk. However, the reason investors are thinking about it as hyperscaler risk is because once that data center is finished and ready to go, most of these deals then have a lessee. And that lessee is often one of your hyperscalers. So it's Meta or it's Google or it's Amazon, who is guaranteeing payments over the life stream that they're going to be in this data center. And those lease payments are effectively promised to the trust, your French pastry, that owes you your money. And so what I would tell you is these are … I'm simplifying. There's a lot of bells and whistles, and things can go wrong, cost overruns, it might take too long, force majeure, like, there's a lot of details here that I think … it's not rocket science, but it just takes time and it takes a team of people to underwrite it and understand it. And the risk, the primary risk, at least in our minds, is that during this time period, before you have your Amazons or your Metas or Googles on the hook for their lease payments, over the next one to two years, while they're building this data center, what happens, again, what happens if the AI journey gets a curveball thrown at it, right?

What if this data center isn't needed? What if something happened with… there's a fire or a flood, or who knows what could happen? But basically, what happens if your obligor is not necessarily a hyperscaler or some… or rather it's going to be a much lower-credit quality borrower. If something goes wrong, the price at which these bonds, these structured bonds trade at is going to drop tremendously. And by the way, I'll add one more thing here. These are not small transactions.

These transactions on average, and they've been over 30 of them, are about $15 billion in size. And so there's been a lot of investors. They've bought a lot of these bonds. And if something kind of takes a twist or a turn, you're going to see a lot of selling of this paper. And so for us, look, you know, these investments very well could be money good, although their price could take a really wild journey.

And just given the amount of excitement and euphoria and very little pricing for something that might go wrong, we're kind of keeping our powder dry in most of these investments and waiting for a better entry point.

COLLIN: I love the analogy of the French pastry of … you know, these kind of the projects before the big companies take over the leases. Kind of like a technical question, so those project bonds debt, are those index-eligible bonds? Meaning if you're an investor, you know, in a fund tracking an index, I assume those are probably not really held there. Is that right?

BRYAN: Correct, because actually most of them actually have, even though you have the hyperscalers and lessee, the rating agencies rate them to typically like one of the obligors, the owner of the property, the construction company. So actually most of these deals have a below-investment-grade rating. They're not in the index. Down the road they might be, but typically they're also done as privates. So more likely than not, you're talking about 30 times $15 billion a pop of volume that's not index eligible, and I think you're going in the right direction, which is, you know, when spreads are tight and everything feels really good, investors are often willing to explore beyond the boundaries of index eligible. But you know, when things go bad and spreads are widening, you know, people start paying attention a little bit more to what's index eligible, and that will only further exacerbate the price volatility.

COLLIN: I want to touch on one thing I've heard you mention, with all this issuance from these big companies, that they are price insensitive, that they almost don't care, you know, what they're borrowing at. Can you kind of walk us through that a little bit?

BRYAN: Yeah, you know, in the good old days, you know, there was just a healthy check and balance in the bond market. Like any market out there, even French pastries. You know, too many croissants, you got to lower the price, and then the market comes into balance. So, you know, let's tie it to the bond market. You know, if a issuer like a company or an industry is going on this kind of capital-spending binge, and they're borrowing a lot of money, their debt levels start raising, and the profile there, of the credit quality of their profile, starts to deteriorate. And what does the bond market do? It says, "OK, you're getting … you're becoming a riskier credit. We're going to charge you a higher rate to borrow money. OK, you borrowed more money. We're going to charge you a higher rate."

And eventually what happens is the rate gets so high, you choke off the borrowing and the company, or the industry stops borrowing money because they can't afford it anymore. Now, let's go to our hyperscalers. Again, they started with the most pristine balance sheets literally, you know, in the world. And even after this borrowing, they're still relatively healthy balance sheets. In addition, what I would tell you is that, in their minds, they may not be right, but their expectations for what this capital that they're borrowing will do, the way when they … when they build these data centers, and they buy these chips, and they basically create this compute. Their expectations of what that investment's going to do for their earnings and therefore their equity valuations is so optimistic. If they're correct, it's going to make the difference between borrowing at 6% or 7% or quite honestly 8%, literally a rounding error in the math. Basically the equity, the multiples of the equity valuation return will basically dwarf and make that extra cost of capital, again, it seemed like a no-brainer, you know, in hindsight.

And so basically what I'm telling you is, you know, you pick your name, but I'll just say, you know, Mark Zuckerberg, he does not seem concerned whether he borrows at 6%, 7%, or 8%. It's not the cost of capital; it's just getting the capital.

COLLIN: Let's kind of look at the broader credit markets, the broader corporate bond markets, because you mentioned supply and demand, and that matters whether it's French pastries or whether you're issuing debt. So how is the rest of the market holding up? You also alluded to before just the depth and breadth of the corporate bond markets. Have they been received OK? But what sort of negative impact, if at all, are they having with all the non-, say, hyperscaler issuers?

BRYAN: Things are starting to crack. I'm going to give you two reasons why that's happening. The first one is the … actually it's what we were all talking about back in January and February, which is "Oh my goodness, AI is going to make industries obsolete, right?" It was software, it was insurance brokers, and you know, the list went on and on. It was like "We don't need these industries because AI is going to do it for us."

And so first of all, so that's like a true, fundamental, disruptive way to think about credit risk, and it's true and we don't have the answers, but the market was, I think, doing a healthy thing of trying to re-underrate and calibrate, you know, what's going to go on, what's the life cycle of these businesses, can they pay back their debt? And who's going through that? So that continues to go on.

The second thing is interesting, which is you have this AI ecosystem and these hyperscalers, which as we've discussed, are price insensitive. So as both interest rates on Treasuries has gone higher this year and the spreads has widened out, we haven't seen them deterred by higher rates. They continue to march forward. However, there is a large non-AI part of our economy, right? A lot of small and mid-sized businesses, a lot of consumers who are price sensitive. You know, the cost of capital actually really matters to them. The difference between borrowing a car loan at 7% versus 8% may mean not getting the car. And it makes, you know, investing interesting and challenging right now. I think it makes being a member on the FOMC really interesting and challenging right now, is that you almost have two neutral rates. You have maybe a neutral rate you need to apply to the AI ecosystem to slow them down. And you know, I've got bad news for the FOMC. That's probably hundreds of basis points higher from where we are today.

And then you've got an, you know, a part of the economy that, you know, whose neutral rate is probably lower than where we are today. They're already, you know … they came into the year already at rates that are too high, which is why the market expected when the year started lower interest rates, you know, over the next 12 to 24 months. And nothing's changed there. So they have been suffering. They continue to suffer. And so we have this kind of, you know, it's two economies, a hyper-bifurcated economy, one that's marching to its own beat and really is interest rate insensitive and one that had already was suffering when we started the year, and it's only gotten worse. And so it's a difficult situation for an FOMC member. Do I raise rates? Because it may not affect these AI companies, but it's hurting the rest of the economy, but I have to deal with inflation. And then as an investor, you know, you have to deal with the same challenges.

COLLIN: Well, I'm glad you mentioned the Fed there because I wanted to touch on that real quickly because I think a lot of what we've been talking about is a driver. We're seeing a ton of capex going on. It's helping the economy stay resilient. So what is your outlook for Federal Reserve policy? They hiked rates last month. Markets are expecting a few more. What's your view?

BRYAN: We don't think the Fed's going to go as much as the market's pricing in right now. So you know the Fed's hiked once, and the market's got three more priced in basically over the next 12 months, or four. So they'll probably go one more time, but we really don't think they'll go the final two times for basically the reason you would expect, because I kind of already I hinted at it, which is that we had a supply shock with regards to oil. We're not in an economy like, let's say, 2022, where rates started very low, and you've had a huge flush of fiscal stimulus into literally consumers, you know, savings accounts or checking accounts and that they in turn have spent. You know, we're at a point in time now where rates, while higher, we're still started the year at least a more elevated rate than where we were in 2022. Not a lot of fiscal stimulus in this system. We were already seeing parts of the non-AI economy come under some pressure.

And so in our view, these higher energy costs will not be passed through to broader parts of the economy. It will not unanchor inflation expectations. And as the fourth quarter kind of unfolds here, I think we're going to start to see a lot of hints that small and mid-sized companies are under pressure, that the bottom half of the U.S. consumer is under pressure. And I think the Fed's going to see in the data that it doesn't have an inflation problem.

And once we kind of see that and we digest that, I think the markets will start to price out at least two of these hikes that are priced in, and what you should see is a bull market, rates coming down in bonds, particularly led by the front-end of the curve, like in the two- and the 5-year part of the U.S. Treasury curve.

COLLIN: Yeah, our house view, we're somewhere in the middle. We expect two more hikes, but we're kind of in the same boat that we don't think inflation is necessarily running out of control. There's parts of the economy that aren't doing too well. And a lot of it I think comes down to just the timeliness of getting inflation down as opposed to a potential reacceleration. You also mentioned Treasury yields before. This has been a hot topic. We've seen Treasury yields of all maturities increase pretty sharply lately. Tends to make a lot of negative headlines about the why, what does this mean? What's your view? What do you think the key drivers of the move up lately have been?

BRYAN: You know, I don't think it's one answer. I think it's a little bit of everything. Let's go where it started. The journey began with the war and the pop in oil prices. And it's not just gasoline, obviously, it's diesel and other kind of refined materials. And that's an issue. It started there. However, that's been magnified by the ongoing conflict in Ukraine and Russia, and particularly on the refinery side there. And so that's been a supply issue. That's where it started.

I would tell you the fact that, so far, the economy has held up and been resistant. And so the market's interpreting that as an economy that's able to withstand higher rates. I would tell you, you could see our belief is that only part of the economy can withstand higher rates, but you know, time will tell. And then finally, it's been supply, you know, and it's come from all corners. You know, we already talked about the increase in corporate bond supply, but, you know, obviously, this rise in interest rates, it's not just a U.S. issue. It's a global kind of developed market issue. And where I'm going right now is in terms of government borrowing. You know, the government, generally most governments around the world, you know, have been on a spending spree. They have not kind of reined in their budget deficits after COVID, you know, in that spend they kind of kept them up particularly high, and you got to fund that. And you've been issuing debt, and it seems … the time, it seems to be coming to a head here where the bond market is going to impose fiscal discipline on some of the largest developed countries around the world. And so, you know, that's basically it. It's the shock in energy prices. It is the resilience so far of most economies around the world, and then just the outright sheer amount of debt that's been issued. And you know, when you put a lot of supply out there, rates are going to go up and the bond market's going to charge you for more of that.

COLLIN: I like that you mentioned globally, because yeah, we're seeing this. It's a global issue, which I think is important to highlight right now. All right, one last question. This has been a great conversation, but just kind of summing it up, given everything we've talked about with the AI build-out, where spreads are, the move up in all yields, you know, where are a few areas that that you see opportunities today?

BRYAN: Well, we like interest rates here. We think they're attractive. I think, you know, I like to say the bonds can be bonds again. Basically, you're getting a really nice coupon. You're getting a nice yield. It gives you some cushion if rates go a little bit higher, but it also gives a great total rate of return potential on bonds if rates just come down a little bit more. You know, you buy a 5-year U.S. Treasury, you know, and route … and we just go back to where we were when we started the year in interest rates. Guess what? Your 12-month return on your 5-year Treasury is going to be 10%.

That sounds pretty good. And I do think Treasuries will give you that risk-off positive response if equities get a downdraft. And so they will kind of behave the way you would want them to in in a diversified portfolio context. We are very defensive on corporate bonds. I think that's a great trade right now. Wait for a better entry point for the reasons I already talked about, particularly with regards to AI. But there is some decent value out there in terms of spread, and that's in the securitized market.

And so agency mortgage-backed securities, some asset-backed securities, some commercial mortgage-backed securities. They offer similar, if not a little bit more, spread than corporate bonds, but they don't have that same type of AI-concentrated type of risk that we described already.

COLLIN: All right. Well thank you. That's a great summary. This has been a great discussion. So thank you so much for joining.

BRYAN: Great to be here. Thank you so much.

LIZ ANN: So Collin, it's time to look ahead to next week. What do you think matters the most? What's on your radar, and what should investors be watching?

COLLIN: Yeah, it's a relatively light week next week. We do get some housing data. And I think this is important because we have seen this big move up in mortgage rates. So next week we get housing starts, building permits, and pending home sales all for September. So it'll be interesting to see if it's starting to have even more of an impact than high mortgage rates have already had, given that we saw a jump last month. We get a few employment indicators. We get the ADP weekly employment change on Tuesday. Initial jobless claims on Thursday.

It looks like we're still in the low-fire, low-hire environment. So we'll be looking for any signs there that that's changed. We do get a few Treasury auctions next week. The 20-year Treasury auction is Wednesday. Now normally long-term bond auctions are highly scrutinized, but this one we kind of take with a grain of salt. The 20-year Treasury is a bit funky. It was just introduced a handful of years ago after being discontinued in 1986, and it's not the most liquid when you compare it to 10- and 30-year. So we're going to be watching it, but if it's a weak auction, we're not going to read too much into it because it is, you know, less liquid and less popular than the 10- and 30-year tenors.

And then finally we will not get any Fed communications next week because, beginning this weekend, the Fed blackout communications period begins. So following, you know, starting this Saturday, we won't hear from Fed officials about monetary policy or their views there until the FOMC meeting later this month. So what about you, Liz Ann? What are you going to be watching?

LIZ ANN: Yeah, just two other things beyond what you have mentioned. We get the S&P Global version of the Purchasing Managers' Indexes. Arguably the ISM version is still followed a little bit more, but I wouldn't dismiss S&P Global's. It does have a wider swath of companies that they survey that does veer into the rest of the world. So that's helpful. And then we get the University of Michigan data out, which includes consumer sentiment. See whether that's plumbing record lows as it has been. And then there's inflation expectation components to that, too. So that's what's on my radar.

So that's it for this episode. Thanks as always for listening. We really do appreciate it. And you can keep up with us in real time on social media. I am @LizAnnSonders on X and LinkedIn. Still have lots of imposters. Please make sure you're following the real me.

COLLIN: And I'm @CollinMartinCS on X and LinkedIn. The Collin is with two L's, and the CS is for Charles Schwab. You can find all of our written reports, not just for me and Liz Ann, but the rest of our team in the Schwab Center of Financial Research, they include lots of charts, tables, graphs, and you can find those at schwab.com/learn.

And if you haven't already, please consider leaving us a review on Apple Podcasts, a rating on Spotify, or feedback wherever you listen. It really does help us grow the show. So any of that feedback or reviews would be much appreciated. And we will be back with a new episode next week.

For important disclosures, see the show notes, or visit schwab.com/OnInvesting, where you can also find the transcript.

1. ^ Fear of missing out.
2. ^ An obligor is any individual, company, or entity that is legally or contractually bound to provide a payment, service, or benefit to another party (known as the obligee).
3. ^ The neutral rate of interest is the theoretical short-term interest rate at which monetary policy is neither restrictive nor accommodative.