Bond Risk
Markets had another volatile week, with an especially volatile Friday that saw significant initial losses turn into significant gains by the end of the day. When all was said and done, the S&P 500 ended the week up 0.48%, and the Nasdaq rose 1.6%.
But bonds were probably the bigger story, as longer-term yields continued their climb and the interest rate curve continued to flatten. The 10-year Treasury rose north of 4.8% before ending the week just below that mark.
Bond investors have also continued to be reminded that bonds aren’t always safe and that they can lose money, too:
As the 1960s were coming to a close, Warren Buffett’s investment partnership had compiled one of the all-time great records. But the market was becoming something different—with higher valuations and more speculation—than the environment in which he built that record. So he decided to close up shop and return money to shareholders.
For those partners in Buffett Partnership, Ltd. that chose not to roll their money into Berkshire Hathaway or send it to one of the investment managers he was willing to introduce them to, Buffett offered to help them buy tax-free bonds, as he thought they were likely safer than the stock market and provided good absolute value at the time. In a letter outlining some of the details in February of 1970, he also wrote about the things to consider when buying bonds of any kind in a section titled “Maturity and the Mathematics of Bonds”:
Many people, in buying bonds, select maturities based on how long they think they are going to want to hold bonds, how long they are going to live, etc. While this is not a silly approach, it is not necessarily the most logical. The primary determinants in selection of maturity should probably be (1) the shape of the yield curve; (2) your expectations regarding future levels of interest rates and (3) the degree of quotational fluctuation you are willing to endure or hope to possibly profit from. Of course, (2) is the most important but by far the most difficult upon which to comment intelligently.
…Anyone who has done much predicting in this field has tended to look very foolish very fast. I did not regard rates as unattractive one year ago, and I was proved very wrong almost immediately. I believe present rates are not unattractive and I may look foolish again. Nevertheless, a decision has to be made and you can make just as great a mistake if you buy short term securities now and rates available on reinvestment in a few years are much lower.
Much of the investment industry bought bonds during the last several years without considering any of the above, including the starting rate of interest, even when that rate was near zero in 2020-2021 (and earlier). The popularity of 60/40 portfolios, Target Date Funds in 401(k) Plans, and intervention by the Fed—which all had rules to buy bonds without thinking about expected return—were significant contributors to the constant bid for bonds even at lower and lower interest rates.
But a few people have started to pay attention now that losses have materialized, even if much of the passive side of the investing industry continues on with business as usual.
We don’t know what bond maturity might be a good deal today. Short-term Treasury Bills seem like a decent place for excess cash, and many have argued that the real yield one can get in TIPS today is attractive compared to most other places.
But we think investors are paying more attention to the fact that bonds can also be risky. And when you are considering your bond allocation, reading the words of 39-year-old Warren Buffett to help you think through the process isn’t such a bad idea.
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