Warren Buffett (Trades, Portfolio) is regarded as one of the greatest investors in the world, and he has mostly achieved this level of success by buying up free cash flow-generative businesses, either by purchasing them whole or by buying minority shares via the public markets. In his time as the chairman of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), Buffett has, from time to time, dabbled in corporate bonds. In general, however, he believes that long-term bonds are not an optimum investment type. In his 1979 letter to Berkshire shareholders, Buffett explained why he thinks this is so.
Inflation erodes returns
Buffett's argument against bonds centers around inflation - the idea that the value of a dollar (or other fiat currency) denominated will erode faster than the bond will generate interest:
"Dollars, as well as paper creations of other governments, simply may have too many structural weaknesses to appropriately serve as a unit of long-term commercial reference. If so, really long bonds may turn out to be obsolete instruments and insurers who have bought those maturities of 2010 or 2020 could have major and continuing problems on their hands. We, likewise, will be unhappy with our 15-year bonds and will annually pay a price in terms of earning power that reflects that mistake."
This argument seems increasingly cogent in a world of historically low interest rates. As Buffett himself has pointed out previously, why would you want to own a government bond that pays 0.5% interest if the same government that issued that bond has it as its stated policy for inflation to run at 2% annually?
Of course, many investors still own long-duration, low interest government bonds that yield less than the rate of inflation. Why? One reason is that the rate of inflation in the developed world has rarely hit that 2% target over the last few decades. Another reason is that even though the interest rate on the bond may undershoot inflation, the price of the bond itself may rise. This is why investors still buy negative yielding bonds - the bet is that the bonds will become more valuable over time as other investors flock to them as a "safe haven."
It's easy to see why Buffett is skeptical of low-yielding bonds. As a value investor who looks for good cash flows, he doesn't like to buy assets in the hope that someone else might pay more for them in the future. He still has a sizable Treasury position, but that is only because Berkshire has huge cash reserves that it needs to park somewhere. There is no doubt that he would prefer to invest it in great companies at good prices.
Disclosure: The author owns no stocks mentioned.
Read more here:
- David Einhorn Issues a 3rd-Quarter Update
- Joel Greenblatt: Think About Buying a Business Like Buying a House
- The Value Investor's Handbook: The Broader Impact of Oil Prices​
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