Warren Buffett commented this week that "long-term bonds are terrible investments right now." What was the newsflash across the bottom of the screen? "Buffett: Bonds are Terrible Investments."
The lack of a caveat there is nothing new. For years now the media has been obsessed with calling a top in the asset class. I agree with Buffett that there are far more attractive places in fixed income than the long end of the curve -- at least in high quality domestic paper. For many, bonds are a required allocation in achieving a diversified income-oriented portfolio. What then must mom and pop investors be thinking when such claims are blanketed on the entire asset class? Here's a few tips to help navigate investing in fixed income.
The reason investors stand to "lose" a lot of money on bonds with maturities far into the future is directly correlated with the design of bond pricing. All bonds are considered to have a "par" value of $1,000. As interest rates rise and fall, so does the price of the bond (albeit in an inverse fashion).
Evaluate Credit Quality
Pricing isn't the only factor affecting bond price; credit quality is a close second. As credit quality, rates, and a handful of other factors move around, bond prices move in inverse cadence. If a bond is priced below $1,000, it is said to be at a "discount" (to par) while a "premium" is observed when priced over $1,000. This is jargon for the most part. If you pay less than $1,000, you aren't necessarily purchasing a "discounted" bond and likewise are not necessarily paying a "premium" for another if over par. As value decreases below par, the "yield" (rate of return) increases for new purchasers. Bonds whose prices rise above par value have a decreasing yield to new purchasers. The yield dollar amount remains constant once purchased until it is redeemed at maturity, regardless of fluctuations in principle value. What one should concentrate on is credit quality and "duration."
Duration (time remaining until maturity or call) is a tool in reducing downside principle risk. For example, I'm comfortable owning US corporate paper and Treasuries that expire in three years or so. Paper with a short time until maturity has a much higher probability of being redeemed at par value than another with a maturity decades into the future. This isn't a certainty, however, so due diligence shouldn't take a backseat. The shorter time frame offers a "quantifiable" vision out into the future whereas guessing what could happen 20 years or further from today is arguably impossible. Further, in the advent of a corporate bankruptcy, bond obligations with near maturities are often required to be met as a condition while proceedings are underway.
Although yields are extremely low right now, a good bond manager can easily outperform the individual investor, both in principle appreciation and in obtaining a higher risk-adjusted yield. This is due to what fancy people call "economies of scale" or "purchasing power" to the layman. Fund managers often purchase large quantities of bonds, thereby affording a discount from the seller. One of my favorite's is the Virtus Multi-Sector Short Term Bond Fund
(MUTF:PIMSX). Here's a review of the fund
In short, despite the newsflash you saw this week, all bonds are not created equal, and everyone's risk tolerance and investment objectives are different. I recommend working with a financial advisor in designing a plan with what-if scenarios covering a variety of asset classes, including bonds.
Editor's note: If you're interested in deeper insight into the bond market, check out Minyanville's new subscription product by expert Peter Tchir ; sample a free webinar here.