Why Buffett Hates Bonds

| About: iShares 20+ (TLT)

A recent report described something interesting: bonds have outperformed stocks over the past 30 years.

Associates SBBI bond index has returned 11.03% a year on average over the past 30 years, edging out the 10.98% return of stocks.

Given investors' panic flight to bonds, it's not at all surprising that bonds have done pretty well in recent times.

Given the rally in bonds in 2011, it might not be surprising that the Ibbotson Associates SBBI bonds index, a broad bond measure, returned 28% last year, crushing the 2.1% return of the Standard & Poor's 500 including dividends.

In context of such figures, why does Warren Buffett hate bonds, calling them the "most dangerous of assets?"

It's fairly simple. Take a look at the chart below, which describes 30-year Treasury bond yields over time. (Note that the actual yield is a factor of 10 less.)

(click to enlarge. Source:FreeStockCharts.com)

30 years ago (roughly), 30-year T-bond yields were at 15%. This means that if you bought a freshly printed 30-year T-bond, you were guaranteed return of principal at the end of 30 years, along with yearly 15% coupon payments.

Since Treasury Bonds are backed by the full faith and credit of the US government, any investor who DIDN'T buy at least a few bonds at 15% interest is insane. Give me a guaranteed 15% return over 30 years, and I'll take you up on it any day of the week.

(It's important to note that yields spiked in 1982 because of inflation fears - at the time, inflation rates were in the double digits. Now, however, inflation expectations are hovering around 2-3%. See this table for historical inflation data.)

Unfortunately, this dream scenario is unlikely to repeat itself anytime in the near future. Anyone buying 30-year bonds right now is making a terrible decision. (See: The Impending Collapse of the Treasury Bond Bubble.)

Right now, yields on the 30 year bond are well under 3%. This means if you held the bond until maturity, you'd be satisfied with a 3% yield.

But it gets worse. Bond prices vary inversely with yields. Why? Well, if you've got a bond yielding 2%, that's obviously not as valuable as a bond yielding 3%. So if you bought a bond yielding 2%, and the interest rate rises to 3%, your bond is going to be worth a lot less than face value - because nobody will be interested in paying full price for a bond yielding 2% when they can go to the Treasury and grab one that yields 3%.

For the past 30 years, with declining bond yields, the price of long-term bonds has been going up sharply (see the 28% return quoted in the intro). But is this sustainable?

Absolutely not, and that's why Buffett hates bonds.

High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based investments - and indeed, rates in the early 1980s did that job nicely," Buffett wrote. "Current rates, however, do not come close to offsetting the purchasing-power risk that investors assume. Right now bonds should come with a warning label.

Even ignoring the huge interest rate risk currently accompanying long-term bonds, Buffett has more arguments against long-term bonds. Namely, that a 2-3% 30-year return is pathetic. (Especially in context of dividend yields from blue chips that exceed 3%.)

Buffett wrote an excellent piece on bonds. I encourage you to read it. Below is an excerpt with what I believe is the most critical message to take away:

Succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.

The dollar has fallen a staggering 86% in value since 1965. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as "income."

For taxpaying investors like you and me, the picture has been far worse. During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. This investor's visible income tax would have stripped him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining 4.3 points.

According to Buffett's logic, which I completely agree with, investors would need yields on T-bonds far higher than 5.7% to make any significant income. (So if 30-year yields hit 10-15% for some bizarre reason, count me in as a buyer.) But at current interest rates, investors are actually losing money to inflation and taxes. Not to mention, of course, that bonds have no upside - unlike stocks, they can't do anything to make themselves any more intrinsically valuable.

As I've established before, in the near term, the future is bleak for Treasury bonds. Thus, long-term bond funds like TLT should be avoided like the plague. Much better opportunities are available to investors - to name a few, domestic stocks and high yield bonds.

So if you want to invest like Buffett, choose stocks over bonds. (Especially because the US is at the cusp of the next great secular bull market.)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.