‘Bonds are not the place to be’

On February 27, Berkshire Hathaway Inc, the investment conglomerate run by legendary investor Warren Buffett, published its annual letter to shareholders in conjunction with the publication of its 2020 financial statements.

The annual letter is widely followed by many investors around the world and also by the international financial media since it is considered as one of the best reviews on the US stock market and the wider economy. Many financial commentators generally publish articles detailing a number of the key findings from the lengthy publication to highlight the most important lessons for investors.

One of the main highlights in the recent letter was a very pessimistic comment about bonds. Buffett stated:

“Bonds are not the place to be these days. Can you believe that the income recently available from a 10-year US Treasury bond – the yield was 0.93 per cent at year end – had fallen 94 per cent from the 15.8 per cent yield available in September 1981? In certain large and important countries, such as Germany and Japan, investors earn a negative return on trillions of dollars of sovereign debt. Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future.”

Buffett was mainly referring to the sovereign debt market where 10-year yields on US Treasuries dropped from around 1.80 per cent prior to COVID-19 in early 2020 to a historic low of 0.30 per cent on March 9, 2020, before rising steadily in recent months to above 1.60 per cent. Likewise, the benchmark eurozone 10-year German Bund yield slid from -0.20 per cent in early 2020 to -0.90 per cent also on March 9, 2020, before recovering back to -0.20 per cent in recent weeks.

Buffett was warning about the low yields being generated by these sovereign bonds and the ensuing price risk. Since prices move inversely to yields, there is significant price risk if yields recover towards more normalised levels. In fact, as the 10-year US Treasury yield rallied to a high of 1.61 per cent during the month of February, bond prices tumbled. Treasury yields rallied in recent months as investors are anticipating faster economic growth once restrictions are lifted as the vaccine rollout accelerates and also following the significant fiscal stimulus by the US government, including the latest USD1.9 trillion package approved last weekend.

The chairman of Berkshire Hathaway has had a bearish outlook for bonds for several years and, in 2018, he had also stated that: “The longer you hold stocks (equities), the less risky they become, whereas the longer the maturity of a bond, the more risky it becomes”.

The warning about the outlook for bonds by one of the most successful value investors may come as a shock to many Maltese investors who have generally favoured a large exposure to fixed income instruments within their portfolios.

However, it is important to note that bonds play an important role in investors’ portfolios, especially those investors who are generally risk-averse and normally dependent on a sustainable generation of income on a regular basis.

An important element of the bond component within a portfolio for an investor is capital preservation, especially at times of severe market dislocations such as that experienced exactly one year ago, when international equity markets suffered their quickest sell-off into bear market territory.

Yields on bonds shrunk to very low levels in recent years

Some international investors describe bonds as securities providing “insurance against a bad outcome”. Investors who may not be able to hold investments for a long period of time and are dependent on either the income stream or may need to liquidate a portion of their portfolio to finance an alternative investment, do require an exposure to bonds as part of a portfolio.

Several years ago, I had written an article about the importance of periodic rebalancing over time to a portfolio of a retail investor due to changing circumstances. The lifestyling of a portfolio generally dictates that the bond exposure should increase as an investor ages since capital preservation becomes fundamental, together with the generation of a regular and known income stream.

However, in view of the historically low interest rate environment, yields on bonds shrunk to very low levels in recent years, posing significant challenges to retail investors to generate sufficient income from bonds to maintain their standard of living.

The statement by Buffett highlights the price risk inherent in bonds as bond prices fall when yields recover to more normalised levels in anticipation of higher rates of inflation and the possibility that central banks may have to adjust their highly accommodative monetary stimulus measures.

Retail investors who have a large exposure to bonds are, therefore, bound to see a reduction in the value of their portfolio as yields on sovereign bonds are expected to increase from the very low levels experienced in recent months.

Maltese investors, who over the years accumulated sizeable holdings of Malta Government Stocks, should by now appreciate the intense volatility in bond prices and the decline in prices as yields rise. Those bonds with longer-term maturities experience larger price movements than those bonds with shorter periods until maturity. The volatility in MGS prices in recent years has been extraordinary and possibly came as an initial surprise to many retail investors.

In view of the consensus that yields are bound to continue to recover, especially in the US, some financial commentators are arguing that investors should be underweight bonds compared to their traditional allocation to fixed-income securities.

Despite the significant upturn in international equity markets from the lows registered on March 23, 2020, many financial analysts continue to claim that, in many ways, shares are cheap relative to bonds. This is mainly due to the fact that bonds have become very expensive and therefore on course to experience another sharp sell-off in the future as that witnessed in the first two months of 2021.

While many investors may argue against higher exposures to shares due to the unpredictability of dividends which was very evident during COVID-19, a well-diversified portfolio of shares should continue to form an important part of an investment portfolio since over extended periods of time, shares outperform bonds. This was also the case in Malta over the years as highlighted in a recent article with the MSE Equity Total Return Index producing a compound annual growth rate (CAGR) of 8.7 per cent since 1996.

Meanwhile, the increase in US Treasury yields is also resulting in a major shift across US equities with shares of technology companies plummeting following an extraordinary rally from the lows reached on March 23, 2020, while shares of ‘value’ companies (which are deemed to be cheap on the basis of valuation metrics), rising steadily.

A recent commentator noted that shares of US banks outperformed those of technology companies by a wide margin over recent months, which may be surprising to many stock market followers. This clearly shows the importance for investors to maintain a long-term and disciplined approach to investing while continuously rebalancing exposures in line with evolving market dynamics.

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