You Know You Shouldn't Own Bonds at These Rates Right?

Yesterday the always thoughtful Jim Grant appeared on CNBC and once again expressed his thoughts on the fact every Central Banker of consequence is employing unprecedented levels of easy money policy.



Grant knows how this is going to end; he just doesn’t know when. The end that he knows is eventually coming is going to be immense inflation (his words).

Now, Grant has been talking about this for a couple of years now. And when the action doesn’t immediately follow the warning people tend to stop listening.

I think that is a mistake.

This reminds me of something. It reminds me of the recurring warnings we heard in the late '90s about a massive bubble in growth stocks. And it reminds me of the repeated warnings we heard (from fewer voices) about the housing bubble in the years leading up to the financial crisis.

The voices warning us about inflation today, or if not inflation specifically, the dangers of owning bonds in a zero interest-rate environment, are strangely similar to the voices that were warning us about the stock market bubble in the late '90s, and the housing bubble after that.

Given that these smart folks (Grant, Grantham, etc.) have a track record of getting these things right, I think we should all be paying attention.

I’d like to share some thoughts from Warren Buffett on the risks to investors today posed by currency-based investments (from the 2011 Berkshire shareholder letter).

Although Buffett didn't correctly foresee the housing bubble, he certainly did see the growth stock bubble of the late '90s. Here is Buffett's warning about bonds and currency-based investments:

Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. 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 tax-paying 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.

It’s noteworthy that the implicit inflation “tax” was more than triple the explicit income tax that our investor probably thought of as his main burden. “In God We Trust” may be imprinted on our currency, but the hand that activates our government’s printing press has been all too human.

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. 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.

Under today’s conditions, therefore, I do not like currency-based investments. Even so, Berkshire holds significant amounts of them, primarily of the short-term variety. At Berkshire the need for ample liquidity occupies center stage and will never be slighted, however inadequate rates may be.

Accommodating this need, we primarily hold U.S. Treasury bills, the only investment that can be counted on for liquidity under the most chaotic of economic conditions. Our working level for liquidity is $20 billion; $10 billion is our absolute minimum.

Beyond the requirements that liquidity and regulators impose on us, we will purchase currency-related securities only if they offer the possibility of unusual gain – either because a particular credit is mispriced, as can occur in periodic junk-bond debacles, or because rates rise to a level that offers the possibility of realizing substantial capital gains on high-grade bonds when rates fall. Though we’ve exploited both opportunities in the past – and may do so again – we are now 180 degrees removed from such prospects.

Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”

I’m not the sharpest knife in the drawer, but I’m smart enough to know who to listen to. And Buffett and Grant are those people.

These are the people I trust for guidance.

The people I don’t trust for guidance are the central bankers who built a housing bubble with their low interest-rate policies and had absolutely no idea that they had done so.

These are the same people who today keep priming the pump again with easy money policies and are telling us that they can reverse those actions with no inflationary consequences.

I’m not sure that I know immense inflation is coming as Grant does, but I do feel quite certain that it is a major risk. I’m positioning my portfolio and personal finances with that risk in mind.