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.

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