Podcast Summary: Excess Returns – "The Bond Risk Investors Miss | Nancy Davis on Inflation and Building Robust Portfolios"

Episode Overview In this episode of Excess Returns (October 28, 2025), hosts Jack Forehand and colleagues are joined by Nancy Davis, founder and CIO of Quadratic Capital Management. The conversation focuses on risks often overlooked by bond investors, especially the hidden role of optionality and convexity in bonds, the importance of inflation-hedging, persistent misconceptions around portfolio construction, and the innovative structure of ETFs like IVOL and BNDD. Davis advocates for a robust understanding of volatility and inflation risk and suggests ways investors can enhance portfolio resiliency in today’s market.

Key Discussion Points & Insights

1. Short Volatility: The Risk Lurking in Bond Portfolios

• Prevalence of Short Option Positions

  • Davis highlights that most investors are "short volatility" in their portfolios, often without realizing it, mainly due to widespread passive investing and mortgage exposure.
  • Quote: "The whole world right now is selling options… we think a really unique alpha is actually using the options as part of the portfolio… when you're short options, you're short volatility."
    • [00:00 - 02:15] Nancy Davis

• Mortgage Risk and Negative Convexity

  • Many investors have significant exposure to negative convexity due to mortgage-backed securities in indexes like the Bloomberg Agg.
  • Quote: "Mortgages are, you know, have negative convexity... You as the debt owner are short the option. And when you're short the option you have a negatively convex profile."
    • [05:03] Nancy Davis

2. Understanding Convexity and Its Role

• Explanation of Convexity and Gamma
  • Davis demystifies jargon: Convexity (fixed income) is analogous to gamma (options), describing sensitivity to interest rate changes.
  • Quote: "Convexity is kind of the same thing as gamma. It's just a different, different jargon term depending on which asset class you're [in]."
    • [05:03] Nancy Davis

3. Quadratic’s Approach: Long Optionality/Positive Convexity

• Alpha via Long Options
  • Davis explains why Quadratic ETFs (IVOL and BNDD) maintain long optionality, providing positive convexity rather than being structurally short volatility like most passive bond products.
  • Portfolio structure: 80% Treasuries/Cash + positively convex options.
  • Quote: "Everything is positively convex, meaning we are—it's treasury obligations…"
    • [09:38 - 10:13] Nancy Davis

4. The Indexing Trap: Why Most Investors Are Short Inflation

• Structural Short Inflation

  • Davis argues that passive bond indexes lack inflation protection, exposing investors to real-world, unappreciated risks.
  • Quote: "Everybody, no matter what industry you're in... your goal is to be able to retire and live off the income from your savings... and people's big risk is inflation."
    • [11:21 – 12:48] Nancy Davis

• Inflation Protection Myths

  • Traditional “hedges” (e.g., gold, commodities, TIPS) are often misunderstood; CPI isn’t the only or best inflation metric, and backtesting the '70s is limited since inflation-linked products did not exist.
  • Quote: "It's crazy that people are using this one index to calculate inflation. Especially after hearing from the Fed for years that they don't even use the CPI."
    • [13:33 – 15:18] Nancy Davis

5. Yield Curve and Inflation Expectations

• Yield Curve as Inflation Proxy
  • Davis describes using the steepening of the yield curve (specifically, the SOFR twos-tens curve) as a better measure and hedge for inflation risk than simply tracking CPI.
  • Quote: "We essentially own call options... to express a steeper yield curve, which to me is a really nice other index to measure inflation expectations."
    • **[18:01 – 19:10] Nancy Davis
  • The potential for mean-reversion after an unusually long yield curve inversion offers a rare value opportunity.

6. Explaining IVOL and BNDD ETFs

• IVOL ETF

  • Combines TIPS and long options to fix deficiencies in traditional inflation protection.
  • Offers unique, cost-effective access to interest rate volatility and yield curve steepening.

• BNDD ETF

  • Focused on nominal (non-inflation indexed) Treasuries with a “turbocharged” long-duration, positive convexity approach—benefits if long rates fall or Fed doesn’t cut as expected.
  • Quote: "It's more like espresso to coffee... super long duration nominal Treasuries plus the kicker of... 30 year yields moving lower."
    • [31:05] Nancy Davis

Memorable Quotes & Moments

• On Hidden Risks:
  "I feel like right now, especially in the credit markets, it's very much like what we were looking at ED in 2001, where a lot of investors are hanging out in short duration credit thinking it's safe. And it feels very much like kind of deja vu to me."
  – [04:10] Nancy Davis

• On Conventional Inflation Hedges:
  "Gold is a great psychology trade... it's not necessarily a great inflation trade because it doesn't pay a coupon... It's just drives me crazy because people look at the 70s and they do all their back testing and I'm like, you're missing the whole obvious market, which is the inflation markets, which are newer and TIPS are not a great product on their own."
  – [16:13] Nancy Davis

• On Portfolio Construction:
  "Most people just use it [IVOL] as a compliment to what they already have... I think about people, people have the Agg because it says core fixed income. But how can you be core fixed income if you don't have any inflation protection... and you're only short optionality?"
  – [28:58] Nancy Davis

Timestamps for Noteworthy Segments

• 00:00 – 02:15: Introduction to Nancy Davis & principal risk themes
• 04:40 – 06:33: Convexity explained and why most portfolios are short volatility
• 10:25 – 13:13: Inflation as a hidden real-world risk
• 13:33 – 17:04: Critique of traditional inflation hedges
• 18:01 – 22:44: Yield curve steepeners and market opportunity
• 26:22 – 27:55: Difference between stock vs bond vol & their correlation implications
• 31:05 – 32:01: The structure and strategy of BNDD
• 36:01 – 36:51: Contrarian view on using options as portfolio core
• 36:57 – 38:43: The risk of selling options vs collecting income

Actionable Insights

• Understand Your Hidden Risks:
  Many core bond allocations come with embedded option selling (negative convexity, short volatility); don't assume these exposures are “safe.”

• Inflation Protection Needs a Rethink:
  Relying solely on gold, commodities, or CPI-benchmarked TIPS is insufficient or potentially misguided.

• Yield Curve Steepening Offers Opportunity:
  With the current curve just coming out of an extreme inversion, there may be attractive risk/reward in products positioned for a steepening.

• Positive Convexity is Undervalued:
  When volatility (specifically interest rate volatility) is cheap, optionality can be used for asymmetric, risk-defined trades—unlike traditional "income" strategies that sell options and risk larger losses.

Conclusion

Nancy Davis urges investors to look beyond conventional portfolio practices—recognizing the often overlooked risks associated with negative convexity, the shortcomings of traditional inflation hedges, and the timely opportunities in the current interest rate regime. The Quadratic ETFs offer innovative ways to address these issues, combining transparency, positive convexity, and inflation protection—vital components in bolstering long-term investment resilience against inflation shocks and interest rate volatility.

For further reading and white papers:
Contact Quadratic Capital, or reach out via podcast host channels for Nancy’s research on inflation hedges and historical yield curve data.

Notable Quote to Remember:
"Selling options is not income. It's selling options...you are taking on negative convexity." – Nancy Davis [36:57]