Bonds Supporting Padawan Attacks Jedi Master Buffett - No Contest

Includes: DBL, PFN, SPSB, VCSH
by: Gary Bourgeault

Bonds supporters aren't happy with Warren Buffett, as the Oracle of Omaha has let it be publicly known that at the yields offered, along with the growing risk, he isn't interested in buying any bonds. He even went so far as to say "bonds really should come with a warning label."

One of the premiere experts in bonds - Pacific Investment Management Co.'s Bill Gross - in January, raised his holdings in Treasuries to the highest level since summer 2010, rebalancing the portfolio.

Citing the fact that liquidity is a priority for the investment strategy of Berkshire Hathaway (NYSE:BRK.A), Buffett said in that regard the company primarily holds U.S. Treasury Bills because they "can be counted on for liquidity under the most chaotic of economic conditions."

After Buffett communicated these things, the predictable response by investors was immediate: many got completely out of bonds. Bond supporters predictably attempted to castigate Buffett.

This is the story of one of those that recently blasted Buffett for his remarks, calling him arrogant, irresponsible, reckless, and accusing him of possibly breaking securities laws. All of that from Buffett saying bonds are a terrible investment option.

The reason for this article is that those holding bonds are in fact participating in a very risky investment vehicle at this time, and some of the points made by a writer attacking Buffett need to be addressed; just in case they may be believed by some.

Ad Hominem Response to Buffett's Bond Comments

The article I'm referring to was by a writer for TheStreet, who unfortunately started ad hominem attacks on Buffett and his holding company Berkshire Hathaway.

He starts the article off, referring to the annual shareholder meeting as the "Berkshire Hathaway Annual Carnival, er, Meeting."

Concerning Buffett personally, he was referred to as being arrogant because he made such a sweeping statement about bonds, which this portfolio manager didn't believe was appropriate for everyone.

Buffett is also alluded to as an elitist who is out of touch with the normal person on the street with an investment portfolio.

Finally, he is negatively equated with talking heads at CNBC, attempting to drag Buffett down to the level of being not much more than a financial reporter.

The point is, when a person starts off with ad hominem attacks, it almost always means it has become too personal to them, and the following verbiage will lack any significant rebuttal to the person they disagree with. That's the case here for sure. The problem is it never really addresses the economic circumstances we now face.

Did Buffett Break Securities Laws?

According to the writer, Buffett broke securities laws for making his general comment about bonds, even if it was unintentional. Why bring that up in a conversation about bonds? Again, I say it's because what Buffett said is true, and if personal attacks on Buffett don't work, then suggesting he broke the law is an attempt to personally discredit him; a different form of personal attack.

Here's what is said to be a breaking of the securities law concerning something Buffett wrote: "Anybody I would [advise], I would have them having enough cash on hand so they would feel comfortable, and then the rest in equities."

This is of course silliness. Buffett was simply saying if he were a financial advisor, his advice would be to have cash on hand and put the rest in equities. How did that become an actual recommendation for individual investors?

Sure, the argument could be made that what Buffett says influences people, but since when does that break the law? Creating a scenario that doesn't exist for the purpose of illustrating a point could never be considered breaking the law. It makes no sense at all.

What's the Argument for Bonds?

Now that we're past the smoke screens, let's get into the actual advice offered by this writer concerning bonds.

His major argument is concerning whether or not bonds are suitable for a specific type of investor, as measured by age, net worth, and risk tolerance.

He even goes into the old "general rule of thumb" about the age of a person should reflect the percentage of holdings in fixed income investments. If you're 60, in this system, you should have approximately 60 percent of your capital in fixed-income vehicles. For many advisors this is the basic premise they work from.

Interestingly, he is making a broad, sweeping statement using this investment strategy, as much as he said Buffett did.

The idea is if equities go south and investors are all in, they could suffer up to 10 percent loss of capital - especially among older investors - because in the writer's view, this is the typical response by the elderly to a market correction.

In my opinion, the asset allocation disbursements advised in the pre-2008 period, no longer apply, if for no other reason than the policy of the Federal Reserve has forced people out of alleged safe investments if they want to make money.

To operate under the former ways of allocating capital no longer works in this economy and under the existing loose money policies. That doesn't even include what may and probably will happen when the Fed attempts to unwind all of this.

Bonds - Post 2008

While it's not necessarily a bad idea as to the investment suggestion above, it's just one of many ways to allocate capital. One major thing that must be taken into consideration is we no longer live in the economic world we lived in pre-2008. That makes all the difference in the world as to how a person should invest his or her capital.

Never in world history has there been a loose money policy as we see today with a number of central banks. The Federal Reserve is creating money out of thin air like it never has. We're completely in uncharted territory, with a lot of that having a direct impact on bonds and the new and greater risks associated with them.

Here's what is offered as a way to keep bonds relatively risk-free in a portfolio:

"Now, a bond portfolio should certainly be designed sensibly. With rates so low, the danger, of course, is an eventual rise that would decrease principal values. But I personally believe that issue is manageable - keep maturities short so that you can potentially reinvest in new bonds as rates rise."

What is wrong with the seemingly sound advice? It makes no sense for the reason there is nothing to be made by investing in short-term bonds. The rates are so low as to result in a loss of capital after taxes and inflation.

You could put your money in a credit union and get a return just as high as bonds, and you have the added protection of having it insured by the government. The argument for short-term maturities as a bond strategy melts away in light of that argument.

His response:

"To the protestation that rates are so low that short-term bonds would lose out to inflation, I say that that's manageable, too. First of all, even if they did lose a point or so to inflation, that's better than experiencing a 10% correction in the stock market and then panicking out, as many people - especially older people - would do."

What isn't being said is the huge risk that accompanies bonds in the economic realities we now face. If a bond yield increases by 1 percent, the price of a bond would plunge, resulting in a similar situation that an equities investor getting caught in a correction would experience. If interest rates jump significantly, which is inevitable, it will crush holders of bonds, and that's what Buffett is referring to. He sees what lies ahead, and it's not pretty.

All of this for less than 2 percent returns? The risk isn't worth it.

Argument Against Bonds - Catalysts

We've already talked about the reason bonds are so risky at this time. Let's look briefly at catalysts.

There are three things that have pressured the interest rates of bonds down: the ongoing QE3 program of the Fed, banks not willing to lend, and borrowers' unwillingness to borrow.

When the lending and borrowing get going, that will be a key catalyst for bonds, whereby inflation will soon follow. If the economy ever gets real legs under it, it would also result in investors migrating from bonds even more and into equities.

Either way, bonds are facing a cataclysmic event, and Buffett is trying to warn investors before it happens. Buffett sees bond prices as being artificially high because of the loose money policy of the central bank.

Remember, inflation will raise rates, when rates rise it will lower the market price of bonds.

Buffett's Argument

Okay. Now what is it the writer, and other bond supporters, do not understand about Buffett's opposition to bonds, or chose to ignore? He is expressing his views mostly on the quantitative easing being implemented by the Federal Reserve and its impact on the bond market.

I say mostly because Buffett has never liked bonds, but he likes them even less in the far more risky economic environment they're part of now.

Buffett is making his declarations from a macro point of view, not simply based on bonds as standalone instruments. Buffett's argument must be understood at the macro level to understand the risk bondholders now face.

Asset allocation, safety, and yields no longer apply to bonds as they did in the past. That world, at least at this time, no longer exists.

Investment Implications

If you want to hold capital in a safe manner, there are much safer ways to do it than bonds, and they enjoy returns as good as bonds - as with the use of a credit union - which has already been mentioned.

Some bond funds, for what they are, haven't done too badly over the last year, such as the PIMCO Income Strategy Fund II (NYSE:PFN), which was up 7.71 percent for the year, although it stands virtually the same today as it stood on August 1, 2012. All the gains were dependent on whether or not an investor got in during June.

PIMCO Income Strategy Fund II

Another is DoubleLine Opportunistic Credit Fund (NYSE:DBL), which until about a week ago was up by over 7 percent, but has since crashed to about level to what it was a year ago.

DoubleLine Opportunistic Credit Fund

SPDR Barclays Capital Short Term Corp Bd (SCPB) has been trading level since August first as well, and is up for the year by 1.08 percent.

SPDR Barclays Capital Short Term Corp Bd

Finally, Vanguard Short-Term Corp Bd Idx ETF (NASDAQ:VCSH) has performed in a similar pattern, jumping in June and July, and leveling off in August through today. It's up 1.46 percent over the last 12 months.

Vanguard Short-Term Corp Bd Idx ETF

Other than PFN, all of these, at this time, have gone nowhere, and they're not likely to do so. And even if they do, what reason would there be to hold them at a time when bonds are so risky?

Pimco's Bill Gross recently said that the bull bond market is over, although he doesn't see the bear bond market kicking in just yet. This is why he bought more Treasuries in the interim.


Warren Buffett was making a macro, blanket statement concerning bonds, and he's totally right. That is also confirmed by probably the smartest bond man in the world - Bill Gross.

Why some bond supporters, like the writer I rebutted in this article, don't reach the correct outlook, is because they're operating from a pre-2008 worldview. That world, as it relates to central banks and the effects of their policies on bonds, no longer exists.

This is why the idea of asset allocation based on past models and assumptions is no longer appropriate to the conversation. We're living in an economic world flush with money that has been created from nothing, to an extent that has never happened before. That changes everything with our investment strategies, and those that don't understand this with bonds, and who think they are a safe investment, are in for a very rude awakening if they don't change their outlook and placement of capital. Don't be one of them.

As usual, we don't know the timing of all this, but the fact Bill Gross is shifting into Treasuries should be an alarm for bondholders. He has publicly stated things aren't looking good, and has backed that up with his actions. As we see the time approaching when it will all come down, watching Gross as a bellwether for the rest of the bond market would be a good strategy. He's going to continue to move out of bonds into other instruments as the time approaches when bonds will get slammed. It would be good to follow his example.

Many people attacking Warren Buffett because of his statements have a personal stake in the narrative, as evidenced by the writer mentioned, who obviously got crushed after the comments of Buffett. He says he offers, as an investment option to investors, "the Stable High Yield portfolio that I manage at Covestor." Not exactly an objective commentator.

With there being no real reward associated with the growing risk of holding bonds, it makes really no sense to keep holding them. Any past reasons have long been obliterated by low interest rates, upcoming inflation, and the approaching decimation of the sector.

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