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Is Buffett Right to Be Bearish on Bonds?

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What You Need to Know

  • Riskier bonds offering higher yields are backed by increasingly “shaky borrowers.”
  • In many cases, the higher yields on debt from distressed firms has little bearing on actual returns.
  • The only way bond investors won’t be facing Buffett’s prediction of a bleak future is if interest rates continue their decades-long decline.

In his annual letter to shareholders last weekend, Warren Buffett warns that bond investors face a “bleak future.” 

Why does Buffet think that “bonds are not the place to be these days”?  Yields on Treasuries are near historical lows, and investors locking in these low returns by investing in long-term bonds face nearly zero upside with significant downside if rates rise. 

Riskier bonds offering higher yields are backed by increasingly “shaky borrowers.” In a low yield environment, it can be tempting to reach for higher yields by taking more risk. 

But Buffett notes that investors “may try to juice the pathetic returns now available by shifting their purchases to obligations backed by shaky borrowers,” but “risky loans are not the answer to inadequate interest rates.”

A new report by The American College of Financial Services confirms the headwinds that bond investors face today. 

Still, in the face of rising liquidity, investors are pouring record amounts of savings into bonds. In response, companies issued 65% more corporate debt in 2020 than in 2019 despite falling revenues in many industries damaged by the pandemic. 

Corporate debt has grown twice as quickly as U.S. GDP since 2000.  Clearly, low interest rates are not the result of a drop in bond supply.

Bond Market Dynamics

Does record issuance of debt at lower yields in the face of a global pandemic indicate irrational exuberance in the bond market? 

Even before the pandemic, lower credit quality Bbb-rated bonds had risen from 17% in 2001 to over 50% of the investment-grade debt market in mid-2019 according to a study by Blackrock. 

Risky bond prices dropped in the market uncertainty of March 2020 as Treasury/Baa corporate spreads jumped from 2% in January to 4.3%. Since then, spreads have fallen to just above 2%  back where they were for much of 2019 despite the far more unpredictable market environment.

Support by the Fed contributed to the drop in credit spreads. Nobody knows how long this support will continue, and whether the post-vaccine recovery will buoy distressed debt prices. 

While strong, well-capitalized firms may be well positioned to take advantage of a post-pandemic increase in consumer demand, many lower-quality firms are more highly leveraged than ever and many may not survive long enough to repay debt. 

Many industries such as retail become more concentrated during the pandemic, and there is no reason to believe that shoppers will return to their old ways in the near future.

Actual Returns

In many cases, the higher yields on debt from distressed firms has little bearing on actual returns. Historically, investor returns from 5-year B-rated corporate bonds are only 2% higher than 5-year Treasuries despite a 6% average yield spread. 

In other words, investors only capture one-third of the spread between high-yield bonds and Treasuries in actual returns. They also face far greater volatility and a much higher correlation with stocks, reducing their benefit in a portfolio. 

When stocks dropped in early March, intermediate-term corporate bonds fell by 20%.

What to Do About ‘Risky Bonds’

While investors did get some benefit from taking bond risk in the past, yield spreads on risky bonds are so low today that high-yield bond investors may not get any reward for taking credit risk today.

In a recent study, David Blanchett, head of retirement research at Morningstar and American College adjunct professor, and I estimate that investors can expect to receive a negative return relative to Treasuries from investing in B- or Caa-rated corporate bonds over the next 5 years. 

Why? Their yield isn’t much higher than Treasury bonds right now, and a predictable percentage will ultimately default on payments over a 5-year time horizon.

If investors can’t receive higher returns by investing in risky bonds, can’t they invest in longer-term bonds and receive a term premium? Anyone investing in long-term bonds today because they expect to earn a higher return than lower-yielding short term bonds may not realize the risk they face from a rise in interest rates.  

Nobody knows if inflation will head up after the pandemic, but if it does the Fed may be forced to raise interest rates. When interest rates are low and bond durations are high, prices can swing wildly with a modest increase in bond yields. 

The average duration on investment-grade corporate bonds has risen to 8.5 years according to Morningstar, which means that bond prices could fall by 8% for each 1% increase in interest rates.

The only way bond investors won’t be facing Buffett’s prediction of a bleak future is if interest rates continue their decades-long decline. This seems unlikely. 

Investors would do well to heed Buffett’s warnings about reaching for yield in a market that provides little expected reward for taking greater risk and many potential minefields.    

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Michael Finke is a professor and Frank M. Engle Chair of Economic Security at the American College of Financial Services and leads the Wealth Management Certified Professional designation program. He can be reached at [email protected]

(Photo: AP)