Despite Risks, Bonds Still a Have Role

By Charles Rotblut

Had this piece gone out earlier, it would have opened with a summary of a conversation I recently had with an AAII member about bonds and interest rates. This morning, after reading Warren Buffett’s arguments against bonds on Fortune’s website, I felt the need to revise the first few paragraphs to incorporate the Berkshire Hathaway’s (BRK.A) CEO’s opinions.

Buffett argued that bonds fail to protect investors’ purchasing power. He calculates that when taxes and inflation are subtracted from bond returns, investors fail to gain wealth. Given declines in the value of the U.S. dollar, bonds have ultimately hurt investors’ purchasing power. (Purchasing power is a measure of how much goods an amount of currency buys. As the cost of goods and services rises, purchasing power is diminished if wealth is not increased at an even faster pace. In non-economic terms, a dollar ain’t what it used to be.)

Buffett is right. If you hold your entire portfolio in cash or bonds, you run the risk of losing out to inflation. This is particularly a threat in today’s low-interest-rate environment. Worse yet, as I explained to the AAII member who recently called, there aren’t any fixed-income investments that don’t expose you to low yields, potentially falling bond prices in the future, credit risk or currency risk. Any option in the bond market right now has identifiable faults.

Still, I explained to the AAII member that I don’t think bonds should be eschewed. When held to maturity, bonds provide return of capital. Bonds also have low long-term correlations with stocks, making them a good diversifier. Plus, to the extent that the Federal Reserve’s economic forecast is correct, interest rates should not move much over the next few years.

The obvious downside is that interest rates could move higher sooner rather than later, hurting bond prices. Even a reversion to the historical average rates would adversely impact bond prices. This is not a problem if you hold a bond to maturity (unless you recently bought a newly issued long-term bond), but it will adversely impact bond fund prices.

Another downside, of course, is the low yields. We remain in a lousy environment for savers, with yields on the benchmark 10-year Treasury hovering just above 2%. Higher yields are attainable by investing in lower-credit-quality bonds and foreign bonds, but as yields rise, so do the risks.

The way around the current problems is to diversify your fixed-income holdings. Treasury, corporate, municipal, high-yield and foreign bonds (and bond funds) can all play a role in your portfolio. If you are willing to buy individual bonds, you can also build a ladder with bonds of differing maturities to offset future interest rate risk. Granted, this is far from a perfect solution, but given the prevailing interest rate environment, it is less risky than trying to predict unknown outcomes.

Keep in mind that bonds should only comprise one part of your portfolio. You still need to invest with a focus on price appreciation if you want returns high enough to preserve your purchasing power. Dividend-paying stocks, preferred stocks, real estate investment trusts and master limited partnerships can all give you capital gains and enhance your portfolio’s income. Just make sure you understand the characteristics and risk of any investment before you add it to your portfolio.

Buffett on Gold

Buffett also criticized gold as an investment, saying that it has “two significant shortcomings, being neither of much use nor procreative.”

I’ve personally never bought gold as an investment because I cannot value it. Gold has no cash flows; it is only worth the value that people are assigning to it at a point in time. Like other commodities, it does provide diversification to a portfolio, but beyond that, an investment in gold assumes that someone will think the precious metal is more valuable in the future than what you paid for it

The Week Ahead

Approximately 50 members of the S&P 500 will report earnings, including MetLife (MET) on Tuesday, Comcast (CMCSA) on Wednesday and Apache (APA) on Thursday. No Dow components will report next week.

The week’s first economic reports will be January retail sales and December business inventories on Tuesday. Wednesday will feature January industrial production and capacity utilization, the minutes from the January Federal Open Market Committee meeting, the February Empire State index and the National Association of Home Builders’ February housing market index. January housing starts and building permits, the January Producer Price Index (PPI) and the February Philadelphia Fed Survey will be published on Thursday. Friday will feature the January Consumer Price Index and the January Leading Indicators Index.

Three Federal Reserve officials will speak publicly: Philadelphia President Charles Plosser on Tuesday, Dallas President Richard Fisher on Wednesday and Chairman Ben Bernanke on Thursday.

The Treasury Department will auction $9 billion of 30-year inflation-protected securities (TIPS) on Thursday.

February stock options will expire on Friday.

About The Author - Charles Rotblut, CFA is  the VP for American Association of Individual Investors Editor.  Charles is also the author of Better Good than Lucky.  EconMatters author archive here

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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