Investors in bonds face a bleak outlook from Warren Buffett in Berkshire Hathaway’s most recent annual shareholder letter.
The first-quarter yield on 10-year US Treasury bonds rose to 1.74 percent, leaving bond investors with a negative (3.4 percent) return on their investments.
- With inflation expectations rising, it’s hard to make a case for bonds as a long-term investment. Many investors do not, however, invest all of their available assets in bonds. Buffett simply looks at a company’s individual investing qualities. This is a good opportunity to reassess the function of bonds in a portfolio, given that most of our customers possess bonds in a diverse mix of stocks, real estate, and other asset classes.
A bond is a kind of loan that may be issued by a government agency, a firm, or an individual. With bonds, the investor is lending money and expects to get it all back, plus interest, at some point in time. Quality and maturity are the two most important aspects of bonds.
Credit risk is a measure of how likely an organisation is to repay a debt. The lower interest rates on high-quality bonds are a reflection of their reduced risk of default. In the preceding example, Buffett explains the highest-quality U.S. Treasury bond, which has a lower interest rate. If a company has a “junk” credit rating, the interest rate will be substantially higher in order to compensate investors for the greater risk of default that comes with that grade.
Interest rate risk is quantified in terms of maturity. It is possible to measure a bond portfolio’s sensitivity to changes in interest rates by using the word “duration.” For example, if interest rates increase by 1% across all maturities, a 10-year bond portfolio’s value would drop by 10% if interest payments are excluded. The duration-interest-rate risk relationship is inversely correlated.
The essentials are in place, so let’s get into the specifics of how bonds fit into a well-diversified portfolio. According to markets, the best long-term returns, volatility, and correlations will be achieved by investing in a variety of different asset classes. Investing in bonds is an essential part of that strategy. We only invest in short-to-intermediate (two to five year) maturities of high-quality U.S. government bonds with the objective of reducing risk and providing stability. When it comes to taxable accounts, we prefer to invest in municipal bonds, which are tax-free and provide the same function. Taxpayers are also protected against inflation via the purchase of Treasury Inflation-Protected Securities (TIPS).
With bonds, you’re providing downside protection to your portfolio. Without bonds, there would be no need for any other kind of asset class. We were reminded of this fact in March when the stock market fell sharply. During these times, bonds often gain in value, providing a safety net in the event of a stock market downturn or recession. In reality, eight years have passed since 1976, when stock prices fell. A rise in bond prices in each of those years helped to alleviate the pain. That way, we may take advantage of rising bond prices and a fall in stock prices to rebalance our portfolios.
In general, the relationship between bonds and stocks is quite weak. That link decreases much more when the stock market is in decline. However, this does not imply that bonds always have negative returns while equities are rising. During bull markets, bonds actually have a tiny positive correlation with equities. This was recently seen in 2020 when both equities and bonds had positive year-end total returns.
So, despite the reduced predicted returns for bonds in the future, it is crucial to understand the features of bonds and why we should invest in them. However, our team is still looking for methods to strengthen the portfolio’s fixed-income portion. Two new asset classes have been developed during the last several years to boost returns that are uncorrelated to both equity and bond markets, such as Alternative Lending and Reinsurance. We’ll keep looking for new methods to make bonds a more important part of the portfolio in the future.