I am old enough to remember the E. F. Hutton ads that said, “When E. F. Hutton talks, people listen.” (It’s interesting to note that E. F. Hutton had a few scandals and, in 1988, they merged with Lehman – who is also now gone). The modern day ad would read, “When Warren Buffett talks, people listen.”
Earlier this month, Mr. Warren made the headlines by saying that bonds are a “terrible” investment at the moment and that owners of long-term bonds may see big losses when interest rates eventually rise.
So this seems like a good time to talk about bonds.
First – a few definitions. A bond is an investment where an investor loans money to an entity (a corporation or a government) for a defined period of time at a fixed interest rate. Bonds are commonly referred to as fixed income and, generally, bonds that have a duration of ten years or more are considered long term. The risk with a bond can come from a couple of places. First, the corporation or government that you loaned the money to may not be able to pay you back as originally agreed. Second, if you want to sell the bond before the end of the term, it may be worth less (or more) than you originally paid for it. Warren Buffett was referring to this second risk of the bonds being worth less than you paid for them.
Q – Are there any recent examples of bond values fluctuating up and down?
A – In 2008, the S&P 500 stock index dropped 37%. This caused many people to sell their stocks and purchase long-term government bonds (thinking they were safer). This led to a bond market increase of 25.7%. The next year, the S&P 500 advanced 26.5%, causing investors to sell out of bonds and repurchase stocks. This led to a decline in long term government bonds of 14.9%. While this is more extreme than normal, it is a recent example of large fluctuations in long-term bond values.
Q – What is our position on bonds and why do we have bonds in our portfolios?
A – First, we do not use long-term bonds as part of our portfolios. The research suggests to us that the risk of a long-term investment in bonds is not worth the reward. Second, the reason we use bonds is to reduce the volatility in the overall portfolio and to add income. In the example above, most people are not comfortable seeing their portfolio decline 37% in one year (which would have been the case if they were invested with a 100% allocation in the S&P 500 in 2008). A diversified portfolio that included some fixed income would not have been impacted so drastically.
Q – How are we managing the current bond environment that Warren Buffett was referring to?
A – The challenge today is that we need to stay short on the duration to minimize the risk of a decline in value when interest rates start to rise. However, the shorter we go, the less we will earn in today’s market. Our approach is to maintain the same strategy as we have in the past, however, we are being very diligent about keeping the fixed income short-term. We agree with Warren that long term bonds could be in for some declines when rates begin to rise, but we still value the benefit of having shorter-term fixed income as a part of your total portfolio.