I have recently been thinking about the role bonds play in asset allocation. Wealth managers will advise investors to devote a portion of their portfolios to bonds, something the father of value investing, Benjamin Graham, even advocated himself.
Warren Buffett (Trades, Portfolio), however, has said on multiple occasions that bonds are generally a poor investment for most people (although he still maintains a portfolio of bonds for Berkshire Hathaway's (BRK.A, Financial)(BRK.B, Financial) insurance business). With this in mind, I gathered together some of the advice Buffett has given in the past in an attempt to gain a better understanding of his view on the topic. I hope you find these insights valuable.
Buffett on bonds
First, a quote from the 1979 Berkshire Hathaway letter to investors:
"We have severe doubts as to whether a very long-term fixed-interest bond, denominated in dollars, remains an appropriate business contract in a world where the value of dollars seems almost certain to shrink by the day. Those 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 fifteen-year bonds and will annually pay a price in terms of earning power that reflects that mistake.
Furthermore, present interest rates incorporate much higher inflation projections than those of a year or two ago. Such rates may prove adequate or more than adequate to protect bond buyers. We even may miss large profits from a major rebound in bond prices. However, our unwillingness to fix a price now for a pound of See's candy or a yard of Berkshire cloth to be delivered in 2010 or 2020 makes us equally unwilling to buy bonds which set a price on money now for use in those years. Overall, we opt for Polonius (slightly restated): 'Neither a short-term borrower nor a long-term lender be.'"
This is a fascinating insight into not just Buffett's view on bonds, but also his long-term perspective. Here, he is considering the returns available on bonds maturing in 30 years, a time frame most other investors wouldn't even bother looking at (even if they are buying a 30-year bond). Many investors today would consider owning something until 2020 to be a long-term investment. A 40-year time horizon doesn't frustrate Buffett in the slightest.
The next quote is from Berkshire's 1992 letter to investors, which tackles the subject of evaluating bonds and stocks.
"In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows, but in the case of equities, the investment analyst must himself estimate the future 'coupons.'"
Combine this quote with the one from the 1979 letter, and you get an even better understanding of how the "Oracle of Omaha's"Ă‚ brain works. He is focused on what many would call the ultra-long term and is only willing to consider assets that provide attractive cash flows for many decades. Bond coupons are set, which makes them attractive from a predictability point of view, but unattractive after factoring in uncontrollable developments such as inflation. Stocks are much better placed to ride out inflationary trends, although the potential future returns do require a degree of estimation.
While some investors might consider the estimating element of equity analysis to be risky compared to a fixed return from bonds, it is not. Here's Buffett explanation from his 2017 letter:
"Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. 'Risk' is the possibility that this objective won’t be attained. By that standard, purportedly 'risk-free' long-term bonds in 2012 were a far riskier investment than a long-term investment in common stocks. At that time, even a 1% annual rate of inflation between 2012 and 2017 would have decreased the purchasing-power of the government bond that Protégé and I sold.
I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term U.S. bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.
It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment 'risk' by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk."
If there is any confusion as to why Buffett prefers stocks over bonds for the long term, he gave a succinct summary in an interview with CNBC earlier this year:
"If you had to choose between buying long-term bonds or equities, I would choose equities in a minute. If I were going to own a 30-year government bond or own equities for 30 years, I think equities will considerably outperform that 30-year bond."
Disclosure: The author owns shares of Berkshire Hathaway.
