A Closer Look Into Buffett's Bond Comments

Includes: BRK.A, BRK.B
by: Charles Margolis

This morning I read the headlines Warren Buffett, CEO of Berkshire Hathaway (NYSE:BRK.A), made at his annual shareholder meeting. Headlines such as "bonds 'terrible' investment,"

and "Buffett: I feel sorry for fixed income investors."

You see, for the past few weeks I had my eye on a very long-term bond, with a top credit rating, with a low 4.69% coupon. This morning the bond, Bowdoin College's century bond traded above par, and this afternoon it dipped below par, and I bought it; regardless of Warren Buffett's sage advice.

In ten years one Bowdoin College century bond should generate $469 in taxable income, whereas $1,000 of stock could return more, or less. I should add, I also invest in Berkshire Hathaway's class B stock and Berkshire Hathaway corporate bonds. I find Berkshire's corporate bonds to offer competitive yields, and I presume Mr. Buffett stated his beliefs accurately. Though, as one of the greatest investors of all time, I believe he realizes there are some benefits to issuing bonds, since Berkshire refinanced its own debt recently by issuing new bonds.

I presume Mr. Buffett would feel a lot more sorry for investors who lost a great deal of their wealth, by investing in companies that failed; than investors whose bonds are generating continuous streams of cash. The fact is not every company is run with the same brilliance Mr. Buffett has lent Berkshire Hathaway (and the companies he invests in.) Certainly, many investors for one reason or another have not been able to turn their original investments into fortunes, as Mr. Buffett was able to.

What Matters Most

Let's say one investor has $100,000 in stocks, another investor has $100,000 in bonds and another investor has $100,000 in a mix of stocks and bonds. We know interest rates will probably go up sooner or later, and we know the stock market is near all-time highs; it could continue to soar, it could correct.

Let's presume our investors have been reading some quality finance articles and have been consulting financial advisers. The first investor has 10 stocks, including dividend champions, the second investor has 10 corporate bonds yielding an average of 5% (choosing bonds closer to par and focusing on investment grade) and the third investor has a mix of stocks and bonds of their choosing. Each investor has a strategy to deploy dividends and income continuously, by adding to their investments periodically.

Whether you are an individual investor, represent a town or city's finance department, or manage a mutual fund; the fundamentals of the example are simple. You could choose to be invested completely in equity, completely in fixed income or in a mix. Take a look at the holdings of Vanguard Wellington Fund (VWELX), which is open to Vanguard retail investors, compared to Vanguard Wellesley Income Fund (VWINX). Both funds are rated 5 stars by Morningstar, Wellington is composed of 65% equity and 32% bonds, Wellesley Income has 37% in stocks and 60% in bonds.

The investors who are only in stocks, or only in bonds could not invest in either fund. The investor who chooses to be in stocks and bonds could pick whichever fund they prefer; either one weighted towards stocks, or one weighted towards bonds. Additionally they could attempt to satisfy Warren Buffett's investment advice, by allocating income to equity continuously; while leaving their stocks to reinvest.

What matters most is not whether there is exposure to some fixed income, it is the usage of the income to increase overall yield. For instance what is most important to me is not the $1,000 I invested in the Bowdoin bond; I could use income generated from it and other bonds to go into Berkshire class B stock over time, or whatever seems like the best investment periodically, rather than guess at whether the market will go to 16,000 or down to 12,000 in the next few years.

A Closer Look Into Warren Buffett's Perspective

While I invested in the Bowdoin century bond today, I also invested in three stocks and one bond fund: Metropolitan West Total Return Bond Fund (MWTRX). I chose this fund because after reading the articles that went along with the headlines, I went to Morningstar, looked up Berkshire Hathaway shareholders and noticed this mutual fund recently picked up $51M worth of Berkshire bonds. The fund meets my additional criteria as it is rated 5 stars and has a reasonable 0.63% expense ratio.

Note the Metropolitan West Total Return Bond Fund has a lower minimum investment level for retirement accounts, which is where I invested in the fund. In order to understand why I allocated further to Berkshire bonds after reading the headlines: "bonds 'terrible' investments" and Warren Buffett "feels sorry for fixed income investors," -- it goes to my interpretation of the content of his message. Basically, in addition to direct exposure to Berkshire equity, I believe the company is properly managed, and I hope it continues to be properly managed. Therefore I believe income from Berkshire represents quality, keep in mind I allocated an amount that I do not mind losing in the short-term, in the event rates go up dramatically, in fact my plan would be to allocate more to the fund.

To understand my thought process, take a look at the exchange between Mr. Buffett and Squawk Box host Becky Quick:

Warren Buffett: ... I like owning stocks, I do not like owning bonds now. There could be conditions under which we would like it; we would own bonds, they are conditions far different from what exist now.

Becky Quick: ... Joe (Kernen) went in not long ago and talked to a retirement specialist who told him "you should be 40% in bonds." I just wonder if this is a very different time?

Warren Buffett: No, no you shouldn't be 40% in bonds, my family, anybody I have advised, and a lot of them are just typical people, they aren't super wealthy or anything of the sort; bear in mind they have the proper attitude, if stocks go down 20% in the next month they are not going to be bothered… I would have them having enough cash on hand so they feel comfortable, and then the rest of it in equities. Or if they are farmers, or they could own apartment houses or other things, I would have productive assets, I would favor those enormously over fixed dollar investments now and I think it's silly to have some ratio like 30 or 40 or 50% in bonds, they are terrible investments now.

Becky Quick: So now, this is not your life long look on it, this is particularly to what's happening right now.

Warren Buffett: No, it's now. I bought bonds back in the early 80s, we made a lot of money, we bought zero coupon bonds, I bought them personally. The price of everything determines its attractiveness, and when the price of stocks were way down a few years ago the news was terrible, but stocks were cheap. The news is better now, stocks are higher they are still not ridiculously high at all. Bonds are priced artificially, you've got some guy buying $85 billion a month, and that will change at some point and when it changes people could lose a lot of money if they are in long-term bonds. (timecode minutes: 07:00 to 09:00 CNBC Squawk Box May 6, 2013)

The Squawk Box host picked up on a very important part of Mr. Buffett's statement; the word "now." This interview occurred subsequent to the earlier declaration that Mr. Buffett "feels sorry for people that have clung to fixed-dollar investments."

The fact of the matter is some major, multi-billion dollar portfolios divested from bonds in the past couple years. They probably worried about rising interest rates, and while it is true, the stock market has rallied; so have bond prices. Those multi-billion dollar portfolios lost out on millions in fixed income and millions in profit from the appreciation of bond prices.

Mr. Buffett emphasizes the fact that when rates do go up "people could lose a lot of money if they are in long-term bonds." Though investing strategists and major financial institutions who allocate properly are able to deploy the cash generated from bonds to build portfolios. To put this in the simplest terms possible, remember that a 5% yield should generate 100% in 20 years (barring a default) a 3% yield should generate about 90% in 30 years, so there is a big difference. Some junk bonds currently yield well over 5%, of course they would yield a lot more if higher rated treasuries rebounded. Additionally, by the time interest rates go up inflation will likely cause the yield to differ further; this is one reason to consider a conservative allocation to quality and yield, in order to build an income stream sufficient to buy higher coupon bonds in the future, presuming conditions become more favorable.

Berkshire Hathaway has one phenomenally successful way of doing business. To the greatest stock picker of all time, currently, bonds may seem like an anchor; to investors who use a strategy to deploy cash generated from bonds effectively, bonds have a place. So long as investors weigh all the factors, including Mr. Buffett's wisdom, which may be greater than any one headline can summarize adequately.

Disclosure: I am long BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long Berkshire Hathaway corporate bonds, Metropolitan West Total Return Bond Fund, Vanguard Wellington and Vanguard Wellesley. This article is not a recommendation to buy or sell, please consult a financial adviser to determine proper allocations for your personal objectives.

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