Tuesday, May 7, 2013

More Thoughts on Bonds in a Balanced Portfolio

Warren Buffett was interviewed yesterday by Betsy Quick of CNBC.  As usual, he was asked about his views on stocks:

Acknowledging that milestones like Dow 15,000 can draw Main Street's attention to stocks, Buffett said people should pay more attention when indexes cross those milestones on the way down because that's when stocks are "cheaper" and more attractive to buy. 

While not as "cheap" as they were a few years ago, Buffett thinks stocks are now "reasonably priced" and not "ridiculously" high.


However, when asked about bonds, the Oracle was direct and to the point:

Buffett said that bonds are a "terrible" investment right now because they are "priced artificially" high due to the Federal Reserve's massive asset buying program and could lose people a lot of money when inevitably interest rates start to rise. He doesn't know when that will happen and he doesn't know how much rates will rise, but he's certain they will be going up eventually. 

As I wrote yesterday, there have been generally three approaches that institutional investors with balanced portfolios have been taking with respect to bonds.

The first is to stay the course.  Managers are directed to try to outperform a benchmark such as the Barclays Government/Credit index even though there is a significant possibility of negative returns when interest rates rise.

The second approach is less conventional - invest bond holdings in short maturity, high quality issues, even though the yields are modestly lower than the alternatives.  The drawback here is mostly psychological: holding near-cash fixed income means that there is a risk of underperforming the usual benchmarks in the short term, particularly if interest rates move lower over the coming months.

The final idea is one that in my opinion makes little sense:  try to increase the yield on your bond holdings by ignoring credit risk and buying the highest yield bonds available.

However, I appear to be in a minority:  high yield debt is being gobbled up by the market, pushing yields to levels that once were considered only possible for investment grade issuers.

Ned Davis Research this morning wrote the following:

With yields on high yield debt falling to a record low of nearly 5.00% on Friday, pushing the average price above 107 for the first time, the term "high yield" has become somewhat of a misnomer.  In absolute space, 5.00% no longer qualifies as "high yield".  Not long ago, a 5.00% yield was the domain of investment grade debt.

Meanwhile, over in Europe, Portugal has issued its first bonds since it was bailed out two years. 

No one thinks that Portugal has suddenly solved all of its problems.  According to the Financial Times, the country's financing needs are covered only through the end of this year.  What will be the course of future policy in Portugal remains uncertain.

So why were investors lining up to buy Portuguese debt?

Here's what the FT wrote:

Portugal has issued its first new government bonds since requesting an international bailout two years ago, in an offer of 10-year debt that raised 3bn euro...

Investor demand was broadly spread across Europe and the U.S., according to bankers.  The yield was fixed at the midswaps market plus 400 basis points, offering a return of 5.6 percent.


In some ways, the current rush for yield is reminiscent of the insatiable demand for technology stocks in the late 1990's.

Then, as now, there is a sense that somehow this will all end badly at some point.  However, with high yield bonds producing the best total returns in the fixed income world over the past couple of years, and the European Central Bank determined to do "whatever it takes" to keep the euro intact, advice of caution and restraint is being widely ignored.