By Master Class Invest
The bond market has witnessed a truly spectacular rally over the last thirty five odd years. In recent times there have been trillions of dollars of bonds trading at negative yields – something that has never happened before. Over the years Mr Buffett has written about investing in bonds. Revisiting his 1984 letter, it’s no wonder he wouldn’t think of investing in bonds at current prices.
“Our approach to bond investment – treating it as an unusual sort of “business” with special advantages and disadvantages – may strike you as a bit quirky. However, we believe that many staggering errors by investors could have been avoided if they had viewed bond investment with a businessman’s perspective. For example, in 1946, 20-year AAA tax-exempt bonds traded at slightly below a 1% yield. In effect, the buyer of those bonds at that time bought a “business” that earned about 1% on “book value” (and that, moreover, could never earn a dime more than 1% on book), and paid 100 cents on the dollar for that abominable business.
If an investor had been business-minded enough to think in those terms - and that was the precise reality of the bargain struck - he would have laughed at the proposition and walked away. For, at the same time, businesses with excellent future prospects could have been bought at, or close to, book value while earning 10%, 12%, or 15% after tax on book. Probably no business in America changed hands in 1946 at book value that the buyer believed lacked the ability to earn more than 1% on book. But investors with bond-buying habits eagerly made economic commitments throughout the year on just that basis. Similar, although less extreme, conditions prevailed for the next two decades as bond investors happily signed up for twenty or thirty years on terms outrageously inadequate by business standards. (In what I think is by far the best book on investing ever written - “The Intelligent Investor”, by Ben Graham - the last section of the last chapter begins with, “Investment is most intelligent when it is most businesslike.” This section is called “A Final Word”, and it is appropriately titled.)"
In a recent CNBC interview Mr Buffett once again re-iterated the attractiveness of American companies return on tangible capital which allows many companies to reinvest capital in their businesses well above current interest rates. With regards to bonds he made the following remarks ...
“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. But that's been true for quite a while. And I've been talking about it the whole time. I said people were idiots in 2008 to put their money in cash. I mean, it was the one thing that wasn't going to go anyplace. And interest rates are enormously important over time. And that's – if bonds yield a whole lot more a year from now than they do now, stocks may well be lower.”
“I think that when rates have been where they've been the last five or six years, or even a little longer, selling very long bonds makes sense for the same reason I think it's dumb to buy them. I wouldn't buy a 50-year bond, you know, in a million years at these rates. So if it's that dumb for me to buy it, it's probably pretty smart for the entity to sell them if I'm right. So I would say that the Treasury – I would've been – there's a lot of considerations they have. But I would be shoving out long bonds. And of course at Berkshire, you mentioned we had $80-some billion in very short stuff. I mean, everything we buy in the way of bonds is short.”
“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. But the idea of committing your money, you know, at roughly 3 percent for 30 years-- now-- I think Austria sold some 50 year bond here, you know, at-- below 2 percent. I just don't understand the-- in Europe, there are certain inducements actually for the banks in terms of capital requirements to load up on governments. But it doesn't make any sense to me”.
Those investors buying bonds at the negative or very low yields now on offer are likely doing so because a) they're scared, b) their mandate makes them or c) they're speculating rates will go even lower. It's unlikely they're buying them because d) they think they're good value.
Understanding history can provide an edge in investing and Buffett brings up the 1946 bond market as an example in his 1984 letter above [I recommend reading the David Dynasty chapter 4 on the 1940's bond market titled "The Last Hurrah for Bonds"]. It's important to remember that the recent past is not necessarily a good guide to the future, that the unexpected can happen and the crowd is usually wrong.
The bond market looks very much like a bubble. Howard Marks makes an insightful observation regarding bubbles … "The belief that some fundamental limiter is no longer valid - and thus historic notions of fair value no longer matter - is invariably at the core of every bubble and consequent crash"
The first breach of a fundamental limiter was real bond returns had to be positive. The final limiter breached was bond investors accepting negative rates. It's likely investors of the future will look back on this era and ask … "What were they thinking?".