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What Warren Buffett Thinks About Interest Rates

August 24, 2010 | About:
Josh Zachariah

Josh Zachariah

36 followers
In a news article a couple weeks ago Bloomberg reported that Berkshire Hathaway had been shortening the duration of their bond portfolio. Unlike maturity, duration considers the sensitivity of interest rates and expresses the effective time the bond will be paid back, inclusive of coupon payments (see a further explanation below*)

Bloomberg wrote that the holdings due to mature in less than a year were increased from 16% in 2009 to 21% this past quarter. Though not a significant increase, it was consistent in his Buffett's comments from late last year; "the United States is spewing a potentially damaging substance into our economy - greenback emissions, unchecked greenback emissions will certainly cause the purchasing power of currency to melt.”

Bonds have a precise inverse relationship with interest rates. An increase in interest rates will lead to a decrease in bond prices and vice versa. The logic is simpler than the mathematics. If the Treasury was issuing 3% 30 year T-bonds this year and interest rates shoot up to 6% next year, those holding the bonds paying 3% will be stuck with that coupon payment for the next 29 years. The new batch of T-bonds will be offered at the going rate; 6% and demand for 3% bonds will naturally decrease. So in Berkshire reducing the the duration of their bond portfolio, they reduce the risk that interest rates increase and they're left with holding longer dated bonds that would have diminished in value.

Buffett has mentioned the difficulty in predicting where interest rates will go. He mentioned much about this in the early 1980's annual reports. That may explain the relatively minor changes to the bond portfolio. The deflationary threat is more imminent at the moment, but far too often we forget who is manning the Federal Reserve. Ben Bernanke has shown as deep a concern about deflation as any economist. He earned the nickname "helicopter Ben" because of his reasoning (borrowed from Milton Friedman) that deflation could be fought by dropping money from helicopters. Though I wouldn't speculate and short bonds, I think the case for a stagnant, 0% inflation Japan-type economy is overdone. In the 1980's the Volcker Fed successfully squashed inflation. If the economy were to dip into a steady deflationary rate, I can't imagine the Bernanke Fed sitting on their hands.

*Explanation of duration:

A zero-coupon bond (pays no coupon payments) would have both the same maturity and duration because the cash flow (repayment of principal) would come at expiration. For a bond that pays normal coupon payments, the higher the rate, the lower the duration will be. The reason why it would be lower is because you are receiving the cash flows sooner and the duration measures how soon the asset is repaid. Hence the duration will always be equal to or lower than the maturity. A mathematical approximation can be found at wikipedia


Disclosure: Holding share of Berkshire Hathaway

Josh Zachariah

About the author:

Josh Zachariah
I credit my father and Warren Buffett for molding me into the investor I am today.

Rating: 2.9/5 (23 votes)

Comments

Josh Zachariah
Josh Zachariah premium member - 3 years ago
For anyone disliking the article can they shoot me some feedback/criticism? Is it too dated? Too opinionated?

Josh Zachariah
DeepValue
DeepValue - 3 years ago


I would like to see Mr. Buffett update his great piece from '99 in Fortune. He talked about interest rates in that article. The question is, did anyone make a bundle in bond options?

http://money.cnn.com/magazines/fortune/fortune_archive/1999/11/22/269071/index.htm

"Today, if an investor is to achieve juicy profits in the market over ten years or 17 or 20, one or more of three things must happen. I'll delay talking about the last of them for a bit, but here are the first two:

(1) Interest rates must fall further. If government interest rates, now at a level of about 6%, were to fall to 3%, that factor alone would come close to doubling the value of common stocks. Incidentally, if you think interest rates are going to do that--or fall to the 1% that Japan has experienced--you should head for where you can really make a bundle: bond options. " - Warren Buffett

batbeer2
Batbeer2 premium member - 3 years ago
For anyone disliking the article can they shoot me some feedback/criticism? Is it too dated? Too opinionated?

FWIW, I think it is an article worth reading (and writing). It would be better, as far as I'm concerned, if there were a more obvious, actionable, idea in there somewhere.

Having said that, don't go taking advice from me. Many of my articles score much worse.
jim.falbe
Jim.falbe - 3 years ago
Josh,

Your article would be better if gave either: 1. a mathematical workout of a bond's duration being altered. or 2. A word picture/analogy that would explain this feature. The definition of duration as it stands isn't sufficient for full-understanding.

Otherwise, great article.

Please leave your comment:


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