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Page 3 of 4
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.
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