When Warren Buffett speaks, people listen. And his most anticipated pronouncements come in the Chairman's Letter portion of Berkshire Hathaway's annual report, which was released yesterday. There are already lots of comments in print and on the web from various experts offering interpretations of the letter. In the true spirit of Yet Another Investment Opinion, I decided to (briefly) share mine.
"When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary".
This comment by Buffett will produce some interesting macroeconomic research reports tomorrow morning from the brokers and research shops. Many of the most ardent bears on the economy have insisted that treasury bond levels are not due to a bubble, but rather to the high demand for secure income in a risky and deflationary environment. It will be interesting to see if anyone has the guts to say that Warren is wrong (perhaps he is, but will anyone challenge him?).
Here's why you should care: First, many other bonds are priced relative to treasuries. Most municipals and good quality corporates are priced by observing the rate for a U.S. Treasury of similar maturity and then adding a spread. For example, you could buy a treasury note with a five year maturity and a yield of about 2.00%. A similar maturity corporate bond like the newly issued Chevron 3.95% offers a yield of about 4%, for a spread of 2% (200 basis points) A good quality tax-exempt municipal bond might yield 2.25%, or a spread of 25 basis points. While both of those spreads are extremely high relative to their historical levels, the yields themselves (4% and 2.25%) aren't particularly unusual.
Bond bulls will tell you that you should buy bonds mostly because they're very cheap. But they're only cheap because of the wide spreads. Since 1980, that five-year treasury yield has ranged from 16% to just over 1% with an average of around 7%. Now I'll quickly admit that today's economic situation is very different from that of the early 1980s. And good quality bonds in short maturities are very suitable investments for risk-adverse portfolios. However, if Buffett is right about the treasury bubble, when the bubble pops those corporates and munis aren't going to look nearly as cheap.
Buffett notes that, while historical default rates for munis have been very low, it's likely that they'll get much worse. His point is primarily about the influence of insurance on default rates, and I'll leave it to you to read if you're interested. However, he comments on pressures facing municipalities:
"Local governments are going to face far tougher fiscal problems in the future than they have to date.The pension liabilities I talked about in last year’s report will be a huge contributor to these woes. Many cities and states were surely horrified when they inspected the status of their funding at yearend 2008. The gap between assets and a realistic actuarial valuation of present liabilities is simply staggering."
Finally on munis, although it's not a Buffet point: Munis are bought by rich people. They help rich people avoid taxes. Take a look at the Obama budget plan and think about how tax-avoidance plans for rich people will be treated in coming years.
Interest rate risk, credit risk, and political risk.
I don't want to seem to be overly bearish on bonds. But with the stock market down 50%, I see lots more opportunity in equities. Sure, you can lock in low single digit yields in bonds. But I'm betting that over the next 5 years, stocks will do substantially better.
I added to my DuPont position on Friday. Current holdings: ABB Limited, Boeing, Caterpillar, Cisco, DuPont, General Electric, Google, Goldman Sachs, Intel, New York Times, Procter&Gamble, Slumberger, Sysco, and Walgreen.