Bonds: Follow Bill Gross, Not Warren Buffett

 |  Includes: HYS, TLT
by: David Fabian

As a follow-up to the Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) investment conference this year, CNBC did a lengthy interview with Warren Buffett and asked him about his opinion on the bond market. To which he replied that bonds are "a terrible investment" right now. While I have always respected the Warren Buffett's stock picking prowess, I am hesitant to get behind this sweeping proclamation that all bonds are bad for several reasons:

1. Rising rates are not here yet. While I believe that ultimately we are going to see a return of sharply rising interest rates, the current uptrend in bonds is still intact. Therefore it makes sense to continue to profit from a bull market even if you feel that it is in its mature stages.

Whether you agree with the actions of the Federal Reserve to purchase $85 billion a month in fixed-income securities or not, you still have to respect the strategy has worked to lift nearly all asset prices. This has been of benefit to both stock and bond investors over the last four years.

The ultimate cost of quantitative easing may still come back to haunt us, but for now the trend is our friend, and I'm not going to fight it.

2. Not all bonds are created equal. The bond market is so diverse among different types of credit quality, duration, sector exposure, countries, and other factors that it is reckless to declare "all bonds are bad". Even when we do enter a new phase of strongly rising interest rates, there are going to be areas of the bond market that outperform based on their risk individual characteristics.

Right now there are areas of the bond market that are showing signs of weakness such as the iShares 20+ Treasury Bond Fund (NYSEARCA:TLT) which just pulled back to its 200-day moving average.

However, there are also areas of strength such as the Pimco 0-5 Year High Yield Corporate Bond Fund (NYSEARCA:HYS).

These trends can also very quickly reverse if we start to see a flight to quality out of stocks and other risk assets that flow back into safer Treasury bonds.

3. Warren is talking his book. Let's face it, Warren Buffett made his name in the world by being an unbelievable stock picker and long-term value seeker. He is motivated through his ownership stake in numerous publicly traded companies to keep praising the stock market and continuing to reap the rewards of higher equity prices.

I would say the same thing if I were him, and so would you.

A Message from the Bond King

While reading the May 2013 market commentary from PIMCO's founder Bill Gross, I was struck by two things:

1. The first 90% of his commentary can be difficult to understand if you aren't used to following his thought process. A lot of it is over my head.

2. His comments under the last section titled Investment Strategy are some of the most balanced and logical that I have seen in the stocks vs. bonds debate.

Bill states that "PIMCO's advice is to continue to participate in an obviously central-bank-generated bubble but to gradually reduce risk positions in 2013 and perhaps beyond. While this Outlook has indeed claimed that Treasuries are money good but not "good money," they are better than the alternative (CASH) as long as central banks and dollar reserve countries (China, Japan) continue to participate."

The last sentence of his commentary goes on to recommend "Gradually reduce duration, risk positions and "carry" as the year proceeds".

Final Thoughts

I believe that the concept of moderately reducing your holdings in both stocks and long duration bonds as a mechanism to manage risk in an actively managed portfolio makes the most sense. That is not to say that you need to sell everything right here, but profit taking on the highs is a prudent exercise for those that are interested in sidestepping the next downturn. While there is nothing that says the Dow can't hit 16,000 before year end, I am still of the opinion that we will see at least a modest pull back this year that can be used as an opportunistic entry point for new money into stocks.

If you are overweight stocks or high yield investments you may want to consider pairing back at least a portion of these holdings into strength to rebalance your portfolio. Despite Warren Buffett's belief that stocks represent good value here (at all-time highs), I am waiting for a better buying opportunity down the road.

While I don't believe that bonds represent an excellent long-term value proposition at these levels either, they are still appropriate for investors seeking income with the right balance between high quality and high yield. By pairing back on your duration you can lower the risk of rising interest rates on your portfolio as well. The key to successfully navigating these waters is to be vigilant to changing conditions and have a risk management plan in place for both rising interest rates and falling stock prices.

Disclosure: I am long HYS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. David Fabian, Fabian Capital Management, and/or its clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.