Although most people shun bonds, the investment masters have managed to hit the sweet spot on bond investing.
If we were asked to come up with 5 or 10 names of the world’s greatest stock market investors, most of us could do it easily and many of us would probably include one or more of the following – Buffett, Munger, Graham, Templeton, Lynch, Fisher, Steinhardt et, al.
But picking bond market gurus is a much more difficult task, however. Bill Gross and Jeff Gundlach are two names that come to mind for me, and to be honest, I can’t think of many others.
Gross and Gundlach’s ability to unravel the economic landscape has allowed their portfolios to beat their bond market benchmarks time and time again, and fund inflows have followed. But relative to the great stock market investors, their returns have been rather pedestrian. That’s in no way to say they’re inferior investors, they’re just fishing in a different pond.
Most of those people we consider the investment greats have made their money, not in bonds or 60:40 stock/bond allocations, but through owning stocks. If anything, they’ve shunned bonds.
“On the whole we are allergic to bonds.” Walter Schloss
“Gentlemen who prefer bonds don’t know what they’re missing.” Peter Lynch
In recent years, I can’t recall one Investment Master recommending government bonds as an investment. It’s fair to say that most have been outright dismissive….
“If I had a choice between holding a US Treasury bond or a hot burning coal in my hand, I would choose the coal. At least that way I would only lose my hand.” Paul Tudor Jones
“With interest rates being historically low right now I would not want to invest in bonds. Also a bond is a contract and you can’t do anything with that.” Ted Weschler
“I believe the risk lies in the risk-free rate.” Sir Michael Hintze
“It absolutely baffles me who buys a 30 year bond. I just don’t understand it. And, they sell a lot of them so clearly, there’s somebody out there buying them.” Warren Buffett
“It is very strange situation to have the Fed say our goal is 2% inflation and people buy Treasury bills at 1.5% and have to pay tax on it. The government has announced to you it doesn’t pay to save. You will have nothing in the way of purchasing power. To me it has just been absurd to see pension funds [in 2013 and future years]saying we ought to have 30% in bonds.” Charlie Munger
“Almost anybody who trades risk assets has felt the impact of low rate policies. If there is a bubble, it is probably in the price of sovereign debt globally.” Jon Pollock
“Long-term government bonds are ridiculous at current yields. They are not safe havens. Investors who have experienced the price run-up in the bond market but who have not marked down their forward expected portfolio rate of return are making, in our view, a possibly fatal mistake.” Paul Singer
There are a few good reasons that the Investment Masters haven’t been advocating bonds; they’re expensive, the return profile is asymmetric, there’s no upside participation, prices have been manipulated, and a bout of unexpected inflation would mean some seriously permanent capital losses. Furthermore, over the long term bond returns have significantly lagged equities, and that’s not likely to change in the future.
Let’s consider some of those..
Bonds are Expensive
Buffett advocates a common sense approach to buying bonds; that is, viewing bond investments with a businessman’s perspective. What does the return profile look like? What is an equivalent PE ratio? How long would it take to double your money? On this basis, and relative to equities, bonds have looked horribly expensive.
“The ten-year bond is selling at 40 times earnings. And it’s not going to grow. And if you can buy some business that earns high returns on equity and has even got mild growth prospects, you know, at much lower multiple earnings, you are going to do better than buying ten-year bonds at 2.30 or 30-year bonds at three, or something of the sort.” Warren Buffett
“A bond that pays you 2% is selling at 50X earnings and the earnings can’t go up. And the Government has told you we would like to take that 2% away from you by decreasing the value of money. That is to absurd to own something like that. To make that a voluntary choice in the last ten years against owning assets has struck me as absolutely foolish.” Warren Buffett
No Upside Participation
When you hold a bond you get paid a coupon and hopefully receive your face value at maturity. You don’t get more coupons if the government or the company issuing the bond does well. Unlike owning a stock, there is no upside optionality. That’s why it’s called ‘fixed’ income. The coupon, maturity date and repayment of par are all fixed.
“Bonds offer no growth in intrinsic-worth opportunities comparable to equity securities. A bond indenture makes two primary promises: to make generally fixed semi-annual interest payments and to redeem the bond at par value on maturity date. If there is no upside, it makes no sense to us whatsoever to expose our clients to risk on the downside.” Frank Martin
“Whereas companies routinely reward their shareholders with higher dividends, no company in the history of finance, going back as far as the Medicis, has rewarded its bondholders by raising the interest rate on a bond.” Peter Lynch
“In fixed income.. returns are limited and the manager’s greatest contribution comes through the avoidance of loss. Because the upside is truly “fixed,” the only variability is on the downside, and avoiding it holds the key. Thus, distinguishing yourself as a bond investor isn’t a matter of which paying bonds you hold, but largely of whether you’re able to exclude bonds that don’t pay. According to Graham and Dodd, this emphasis on exclusion makes fixed income investing a ‘negative art.'” Howard Marks
“In stocks you’ve got the company’s growth on your side. You’re a partner in a prosperous and expanding business. In bonds, your nothing more than the nearest source of spare change. When you lend money to someone, the best you can hope for is to get it back, plus interest.” Peter Lynch
Asymmetry of Bond Yields
When interest rates on bonds are plumbing record lows, close to zero or in some cases negative, it’s difficult to imagine them falling much further. However, should yields rise to a level more consistent with history and economic theory [eg Taylor rule], bond prices could fall a lot. The lower the coupon the more downside there is from interest rates rises. If you have to sell before maturity, you could be wearing a large loss. This is the exact opposite type of asymmetry the Investment Masters seek; limited upside, big downside.
“When the [Treasury] yield is below 2.50%, it doesn’t take much of either an inflation scare or something else—but it would most likely be an inflation scare—to make rates rise. And as they rise from such low levels, the mathematics are just brutal, and you can get your clock cleaned by going long Treasuries or high-grade bonds.” Michael Lewitt
“How in the world could we be talking about rates never going up when in fact rates have bottomed?…In the investment world when you hear ‘never,’ as in rates are ‘never’ going up, it’s probably about to happen.” Jeff Gundlach
“It would only take a 100 basis point rise in Treasury bond yields to trigger the worst price decline in bonds since the 1981 bond market crash.” Ray Dalio
“An investor in fixed income today is beginning a compounding stream with the curve at the mid-1% level on cash to under 3% at 30 years. A rising interest environment will penalise the owner of long-dated debt with price declines, the longer the maturity the more severe the decline. A sustained increase in rates will help by allowing for re-investment at higher yields, but an expectation of returns much above initial yields would be asking for a lot.” Christopher Bloomstran
“The Federal Reserve was founded in 1913. This is the first time in 102 years that the central bank bought bonds, and that we’ve had zero interest rates, and we’ve had them for five or six years. So do you think this is the worst economic period looking at these numbers we’ve been in in the last 102 years? To me it’s incredible.” Stanley Druckenmiller
Permanent Capital Loss
Successful investing requires avoiding the permanent loss of capital. This means not only avoiding absolute capital losses but also the loss of purchasing power inflicted by inflation.
“I define risk as the chance of permanent capital loss adjusted for inflation.” Bruce Berkowitz
“What we care about is avoiding the permanent loss of capital and, increasingly relevant today, the permanent loss of purchasing power.” David Iben
“The goal of investing is to protect and increase your portfolio in inflation-adjusted dollars over time.” David Dreman
“There is no real safety without preserving purchasing power.” Sir John Templeton
“The riskiness of an investment is .. measured by the probability — the reasoned probability — of that investment causing its owner a loss of purchasing power over his contemplated holding period.” Warren Buffett
Ordinarily, one hundred dollars today will buy you more than $100 in ten years as inflation raises the cost of goods over time. Historically bonds have compensated investors for inflation, providing a real return of a few percent [see chart below]. In recent years, real returns have shrunk and in some instances turned negative.
“In our opinion, the only thing that is guaranteed with a bond that has a lower interest rate than the rate of inflation is impoverishment. Generating negative real returns goes against the very concept of investment. With each passing year, the holders of this asset class have their capital slowly crumble. From our perspective, the certainty of capital loss in purchasing power is the very definition of risk.” Francois Rochon
For the first time in history, some government and corporate bond yields have ventured below zero. Holding these bonds to maturity guarantees a permanent loss of capital even before inflation. Little wonder, the Investment Masters have steered well clear of buying bonds.
As we know, investors are prone to focus on the rear-view mirror. Prominent in most investor’s rear view mirror has been the financial crisis, where the collapse in aggregate demand raised the prospects of deflation. The subsequent recovery has been characterised by low inflation which has conditioned investors to expect more of the same; extrapolating the last 10 years. But the future could be very different.
In a post last year titled ‘The Buffett Series – Thinking About Bonds’ I recommended reading the chapter ‘The Last Hurrah for Bonds’ in the excellent book, ‘The Davis Dynasty’. Investment Master, Shelby Davis was an outspoken critic of bond investments in the 1940’s. Here’s an extract …
“[Shelby Davis] became an anti-bond maverick. The recent past had told people bonds were attractive and safe, but the present was telling Davis they were ugly and dangerous. Interest rates were fast approaching what economist John Maynard Keynes called the “balm and sweet simplicity of no percent.” Keynes was exaggerating, but not by much – the yield on long-term Treasuries hit bottom-2.03 percent in April 1946.
Buyers would have to wait 25 years to double their money, and, to Davis, this was pathetic compounding. He saw the threat in the “sea of money on which the U.S. Treasury has floated this costliest of wars.” With the government deep in hock and forced to borrow another $70 billion to cover its latest shortfall, he was certain lenders soon would demand higher rates, not lower. The most reliable inflation gauge, the consumer price index, rose sharply in 1946.”
What followed was a 34-year bear market in bonds that lasted from the Truman era to the Reagan years. The 2 to 3 percent bond yields in the late 1940’s expanded to 15 percent in the early 1980’s and, as yields rose, bond prices fell and bond investors lost money.
The same government bond that sold for $101 in 1946 was worth only $17 in 1981! After three decades, loyal bondholders who had held their bonds lost 83 cents on every dollar they’d invested. Ignoring the scene in the rear-view mirror, Davis focused his attention on navigating the future.
The biggest dupes in the triple swindle were fat cats and institutions (pension funds, insurance companies, and their ilk). These sophisticated types who could afford bonds might have seen the folly in owning government paper in the late 1940’s, but most didn’t.
Fanciful arguments tranquilized the bond bulls. They believed that because bonds were profitable in the past decade, they’d be profitable in the next. They convinced themselves that the Fed could keep interest rates from rising, indefinitely. A government that controlled the price of pork chops, it was widely assumed, could also control the price of money.”
And Davis was right …
“An individual in a 50% bracket who put money into T-bills or government bonds after World War 2 and kept re-investing in these instruments to 1996, lost the major part of his or her capital.” David Dreman