By Heather Bell
Ron Ryan is the CEO and founder of Ryan ALM Inc., an asset management firm that is focuses primarily on asset/liability management. He has been developing fixed income indexes for more than 30 years. Recently, IndexUniverse.com assistant editor Heather Bell spoke with him about fixed income markets and other related topics.
Index Universe [IU]: Why should investors use a bond ETF when they could just buy bonds directly?
Ron Ryan [Ryan]: At the moment an ETF is an index fund, which means you know what you're getting. It has a pretty definite set of rules; it has usually a pretty long historical risk reward behavior, so you understand exactly what you're buying. As a portfolio of bonds, you certainly have portfolio diversification as well. I would think it would also save you money because to try and buy a lot of bonds as a portfolio is somewhat time-consuming and it could be somewhat costly, especially for individuals. But the idea is that you are trying to capture the risk/reward of, hopefully, an index and that's what an ETF is so good at. You have an instant portfolio.
IU: Where should investors position themselves on the yield curve today? Could you give an example of a scenario?
Ryan: Sure. A pension fund, for example, would most probably want to buy bonds that best behave like some part of their liabilities. That could be the entire yield curve or a certain part of it. Foundations and endowments maybe want to do only the short area because that tends to fit their time horizon. But apart from that, the shape of the yield curve today is very positive sloping, one of the highest, widest yield spreads in modern history, suggesting that you do get paid to extend.
If you think of a skier, they want to go find the best slope on the hill so they can slide down. It's the same thing here. Mathematically through time the maturity you buy in will become shorter, and if the shape of the yield curve stays the same, then you will invest into a rally, so to speak. The shape of the yield curve suggests that you want to extend, if you can, and it depends on your objective. But even on the short area you want to buy the longest maturity in the short area. At the moment that's what the shape of the yield curve is suggesting you should do: Take advantage of rolling down the yield curve.
IU: How much of an impact will the continuing credit crisis have on very short duration funds?
Ryan: The Fed guides short-term interest rates, and we have short-term interest rates now at very low levels. Today's yields levels are around 50 basis points away from the lowest yields in modern history. Our data goes back to the birth of the Treasury auctions on a continuous series, basically to 1973. For the two-year Treasury, for example, the lowest yield that we found was 1.073 and today it's in the neighborhood of 1.50, so we're 50 basis points away from the lowest yields of all time. That certainly plays havoc with money market funds, because after fees they struggle to show a yield or a return. You would think that would be temporary, but at the moment they certainly are doing damage to money market funds I should say. I don't know how much further they can go. They're already close to the lowest levels in modern history.
IU: Did the subprime mortgage crisis hit every aspect of the fixed income market? Did it hurt certain areas more than others?
Ryan: It certainly widens the spreads between Treasuries and corporate bonds - particularly mortgage banks. That's where the damage is done. It also has created some liquidity concerns.
Here's the thing you might want to think about: Low interest rates were sort of the cause of the mortgage problem, so how could low interest rates be the cure? That one's a real tough scenario. I don't think lowering interest rates is the cure here. It certainly hurt the mortgage area and it certainly hurts pensions - which nobody seems to talk about - because the liabilities of pensions behave like bonds.
When you lower interest rates, the present value of liabilities goes up just like for a bond. That could hurt the funded ratio, or assets versus liabilities. If the funded ratio gets hurt, then usually the pension fund has to put up more money in the form of a contribution. That's what has happened throughout America. We have a budget crisis among cities and states that have to put up a lot more money, and they don't know how they're going to do it. As a result, they are selling assets like toll ways and bridges, convention centers; they're borrowing money. They really are in a budget crunch.
IU: Is this something that has been exacerbated by recent events?
Ryan: It's a long story, but bad rules lead to bad decisions. Because pensions never priced their liabilities at the market value - instead, it's some accounting rule that smoothed or amortized or created some actuarial value instead of a market value - the client never really knew the true valuation of their liabilities. In some cases, they didn't even know the valuation for the assets, because the assets tended to be smoothed. Imagine a bank that can't tell you your current balance but can tell you the average balance for the last five years. I don't think that would help you write a check. It's the same thing here: We have a problem with the clarity of values. Most pension funds really are confused as to the true valuation of their assets and liabilities so they don't know the true funded ratio. If somebody told you that you had a deficit, hopefully you would behave differently than if you had a surplus.
Here's a cute story: When the stock market was going crazy in the late 1990s and having 20% to 30% returns almost every year, Greenspan saw this overvaluation and he disclosed the Fed model for the stock market, which compared the S&P 500 to the ten-year Treasury and showed that it was about 62% overvalued on a 40- or 50-year basis. Well, guess what the stock market did: It tanked. He didn't want it to go down too fast; he just wanted it to correct itself. So as the stock market was going down too fast, what did he do? He decided to lower the interest rate, and he lowered it and lowered it and lowered it for three years to help the stock market not crash but come to a safe landing. It really didn't work, but it killed pensions.
Those three years, 2000 to 2002, it's amazing what happened to pensions, and we had a rash of bankruptcies in corporations, most of which most people never heard of, where they turned over their pensions to the Pension Benefit Guaranty Corporation [PBGC]. Greenspan also created this budget crisis for cities and states, and because they amortized over 30 years, this thing is really out of whack. It's the big thing you're going to be hearing about, that cities and states have this humongous budget explosion mainly due to pensions and they don't know what to do about it. So they're selling assets and borrowing money. They're trying everything under the sun not to tax people, and it's kind of scary.
Lowering interest rates dramatically, I believe, is the cause of the pension crisis and the cause of the market's problem, where people went and bought inflated houses at supposedly cheap money, but since it was an adjustable rate when those things reset they got clobbered. So they're just buying time, but they still have the problem of buying an inflated house at a mortgage that they can't afford.
IU: How is the practice of amortizing adding to the problem?
Ryan: That's what the public side does - they amortize everything over 30 years. They stretch it out, which kind of buys time, but what it means is their contributions will be going up for 30 years unless they can find a miracle solution. If lower interest rates cause the problem, you would think that higher interest rates would be the solution, but that's not what they're doing. They're reaching out to find assets that can give them better returns. So they're going into assets and strategies that they never did before --- very risky assets, very risky strategies to try and enhance their returns --- alternative investments, leverage, 130/30 strategies and the like. That was never allowed in pensions. So now we have this new wave of strategies that are very risky to supposedly get a better return. It might work, but the better solution is that interest rates need to go up.
The Fed is the major operator of the yield curve on the short end. You can see the long end doesn't believe it, so the long end hasn't gone down in yield like the short end, and it has created this tremendous slope. At the same time inflation looks like it's becoming more pronounced, so we just need interest rates to go up gradually, nothing dramatic. If they would go up gradually for the next five years, then pension funds could get out of their hole. It's hard to say about mortgages, but if inflation and interest rates go up, usually the value of your house goes up. That might help housing. You just need a gradual movement here.
IU: Wouldn't raising interest rates be an unpopular decision?
Ryan: I just see it as a solution to the pension problem and you've got to rank priorities, which can be very difficult. It's pretty obvious that the banks didn't go to America for their financing. They went elsewhere, and look what Citicorp and others paid for their financing. They didn't pay American interest rates. Citicorp I believe borrowed money at something like 11%. So don't think that America's interest rates are what the rates are when you're desperate and need money. You'll pay almost anything.
We need an orderly market, and we don't have one right now. We have great volatility, which the traders love, and if you're quick and nimble that can work, but for most investors they need something that they can live with for a long time.
IU: How should an investor chose between the bond funds based on your indexes and the funds offered by the others?
Ryan: Notre Dame did a study a while back that proved my whole point that interest rate risk is the dominant risk in bonds, what you call systematic risk or market risk. They looked at the major bond indices of Lehman Brothers, Merrill Lynch and Salomon Brothers in those days and showed that interest rate risk was 95% to 98% of these bond indices. Well, the way you measure and understand interest rate risk is the Treasury yield curve. That is the best expression of interest rate risk. To say it differently, maturity and duration dictate interest rate risk.
What you want is something that is very clear on its interest rate risk. If you have a product or an index that is not clear on its interest rate risk, then you're going to have a problem. The best expression of interest rate risk is the Treasury yield curve, so the ETFs that we produce are all very clear expressions of interest rate risk. You know what you're getting; they're constant maturities, with basically no drift. These big bond indices, even the one- to three-year bond indices, are basically a garbage can of anything that fits in that area - they own them all.
As you can imagine, in a one- to three-year index you've generally got bonds coming in and going out. Every three years you've got 100% turnover, so you're never quite sure which way it's going to lean. It could lean to the three year and then it could lean to the one year, or it could lean to the middle. It's not clear the interest rate risk you're going to get. There is a big difference between 1.5% and 2.5%. If bonds are 95% or 98% interest rate risk, then you want the best measure that tells you what that interest rate risk is. That would be our ETFs that have these constant maturities: no drift, no surprises. You know what you're getting, and that's how you want to play the game.
IU: How do laddering strategies fit into the picture?
Ryan: One of the PowerShares ETFs is based on one of our laddered indices. With that kind of index you do not have any interest rate direction - you want to be interest rate neutral, and that's when you buy them all.
Our whole spectrum of ETFs gives you all the opportunities. You can pick the constant maturity that you want or you can buy them all.
IU: Is the Lehman Aggregate the best measure of the bond market?
Ryan: Absolutely not. This harks back to the Notre Dame study I was talking about. The bond market is interest rate risk. That's what it's all about. It's 95% to 98% of the ballgame, and if you miss out on that one, then you don't have a good measurement of the bond market.
Yes, there is some credit risk in the bond market and other factors come into play, but it's interest rate risk that dominates. What you don't want is an index that skews the weights so you're leaning one way or the other. You'd like that interest rate risk to be smooth; with the Lehman Aggregate and any of those composite indexes that buy all the new issues that come in the door, depending upon the market, it could be leaning toward short maturities or long maturities.
Today, with the yield curve so positive sloping, you would think that corporations and the Treasury and the agency market would prefer to issue shorter bonds rather than longer because it's cheaper. That's probably not good for the client. If it's good for the issuer, you'd have to question if it's good for the investor. These composite indices that buy all new issues really are slanted to the issuer, not the investor. The real key here is interest rate risk. If you do not measure interest rate risk well, you don't have a very good bond index. The way you measure it well is by having either a constant maturity or a yield curve where the weights are smooth, without overweighting any particular maturity.
IU: Do investors need to diversify into overseas fixed income or international fixed income?
Ryan: It always depends on the objectives, but America is certainly the most liquid and best developed yield curve. When you go overseas, you now have new risk. You certainly have a currency risk, which has been a winner in the last five years or so, but that could turn around. And it's an added type of credit risk, so you better hope you get paid for it. When I ask people what their objective is, if the objective is denominated in dollars, you would think that the assets should be denominated in dollars, or you have more risk. If you think you're being paid for that risk, fine. But I would think that there's better ways to play risk than through international bonds.
IU: Does the average individual retail investor overlook the importance of fixed income?
Ryan: Yes. The way you should build your private portfolio is the way you would think a pension should build. You first look at the no-risk situation, where you have a known future value; you have no reinvestment risk, no credit risk, and based upon the time horizon you know exactly what you're going to get.
Let's take the example of somebody who's going to retire in 10 years or 20 years. They could buy a ten-year zero [a 10-year Treasury stripped of its interest payments] and know exactly what their portfolio is worth in ten years. With today's interest rates they may decide that's not good enough, so they decide to take risk and instead of buying the ten year zero, they go and buy a portfolio of equities and whatever. In order to understand the relative risk and the relative rewards that they gained or lost, they should compare to the ten-year Treasury zero, the risk free asset, and then they'll understand if they're winning or losing. But most people compare their equity investments to the equity market. Sure, that may tell you something, but it doesn't tell you if you're achieving your objective.
Over five years, if you had an equity portfolio and if it did well, you would compare it to the ten year zero, and then you would see how well you did or how much you lost.
IU: Are there areas of fixed income where active management actually does make more sense then index investing?
Ryan: I don't believe it. I wrote a research report called "There's no Alpha in Bonds," where I show with many examples that it's hard to beat a bond index. Every performance measurement report I've ever seen shows that active bond management has very little value added versus bond indices - in the neighborhood of 20 basis points for the median money manager versus the index, before fees. So after fees, you would think there's little or nothing. Then you throw on top of that that the Lehman Aggregate, which most of them use as their benchmark, loses to the Treasury yield curve. That's really hard to believe - that a five-year Treasury zero has outperformed the Lehman Aggregate by over 20 basis points a year for 20 years. So it's very hard to show that there's alpha in bonds.
So what good are bonds? To match liabilities. Fixed income should be the core. That's its real value, to let you sleep at night and to be the core of the portfolio. Almost everybody's objective is time sensitive, so it's back to the yield curve or these target maturities. You most probably have three or four different objectives and you have three or four different dates, and it's a question of how much Treasuries with those dates you're going to own versus other things, and it's based upon how much money you have, if you're ahead or behind.
IU: Are there any areas of fixed income that you think investors will be looking to next?
Ryan: That's a good question. The socially responsible area is getting larger. Pension funds are all passing rules and policies that say, "I will not invest in the following." And the trend may be growing at the individual level. We need a new breed of indices that do that for them. Socially responsible indices may be part of the future.
With this fundamental indexing craze that's going on in equities, you have to wonder why no one has done the same for bonds. Fundamental indexing, for the most part, is a game of weights. Which weights are the best? Basically 100% of the bond indices that are used out there are market weighted. But it is impossible to market weight a bond index. You need to know the amount outstanding, and as simple as that sounds we don't know the amount outstanding on Treasuries because they're stripped. Same thing for agencies, and if your index has mortgage-backed securities they all have prepayments, which is not known for usually 45 days after the end of the month. So there is no way to know the current amount outstanding at any particular moment.
Bond indices really need to be revamped and go back to the basics. For one thing, we've got to get the weights corrected. You cannot market weight a bond index correctly, so we equal weight it. Two, you've got to measure interest rate risk since it's so dominant. By not having constant maturities or very clear yield curves, you're overweighting parts of the yield curve all the time, and I don't think the clients understand what they are getting. So fundamental indexing for bonds to me is the new frontier.