Sponsored article: Each May, Berkshire Hathaway (the world’s eighth largest company) holds its annual meeting, where its businesses hawk their wares and chair Warren Buffett and vice chair Charlie Munger field questions from the more than 40,000 shareholders in attendance. Among them this year? The Payden & Rygel economics team. More than mere Berkshire fanatics, we sought out the Oracle of Omaha’s fixed income-related wisdom.
It’s 6:45 am in Omaha, Nebraska, on Saturday, May 5th, 2018. The air is freshly washed from rain earlier in the week. Beefy security guards with automatic rifles stand sentinel every few hundred yards. Thousands of hopeful Berkshire Hathaway shareholders linger in an interminable line winding around the CenturyLink Arena. Among the 42,000 strong assembled for the annual shareholder meeting, your authors wait, giddy for the day’s proceedings.
The event has been called the “Woodstock of Capitalism” and, to our eyes, was nothing short. The Friday before the shareholder meeting, Berkshire subsidiaries and investees set up small exhibitions in the CenturyLink Arena, hawking their wares at a discount to the visiting masses. This year, one could find everything from a 150-foot model train display offered up by BNSF railroad to a massive pickle hanging above the Kraft-Heinz outpost.
The event has been called the “Woodstock of capitalism” and to our eyes, was nothing short.
Saturday brings the shareholder meeting. After an hour of waiting to enter, a video featuring Warren Buffett versus Lebron James on the basketball court, and the morning session of questions, we returned to our seats for the afternoon question and answer session. Each year, the famed chair (Warren Buffett) and vice chair (Charlie Munger) of Berkshire play host to shareholder questions for six hours.
We sat contented, with boxed lunches supplied by Omaha’s favorite lunch spot, Jason’s Deli. Quite contented, that is, until the startling words emanated from the Oracle of Omaha’s mouth: “Long-term bonds are a terrible investment.”
Buffett’s aversion to bonds is well known. He talks about it all the time. However, as an employee of a fixed income manager, your author got to thinking: “What has the Oracle had to say over all these years about bonds?” He does manage, after all, one of the world’s largest insurance operations and has surely matched some liabilities with bonds despite his professed belief in the long-term returns of equities.
Luckily for us, adoring (obsessive?) fans have compiled Warren Edward Buffett (WEB) annual shareholder letters from 1957 to present. We combed the shareholder letter archives to ferret out any and all mentions of bonds. In what follows, we relay the three Bond Buffetts on display in the shareholder letters: Buffett as bond educator, Buffett as below investment grade buyer, and Buffett as bond bear.
Buffett as bond educator
Charlie Munger has described Berkshire as a “didactic enterprise.” It should be no surprise that Warren often assumes a teaching tone in his letters to shareholders when discussing bonds. Although WEB has taken up various fixed income lessons over the years, here we focus on the lessons dispensed as Buffett wound up his partnership (i.e., Berkshire pre-history).
The first WEB investor letter on record is his 1957 Buffett Partnership Ltd. (BPL) note. For the following dozen years, Buffett ran various limited investment partnerships and achieved an astounding 29.5% annual rate of return versus the Dow Jones which returned 9.1% over the same time.
Fearing the end of a bull market in 1968–1969, WEB decided to shut down his partnerships and return capital to his partners (while retaining a large stake in Berkshire Hathaway, the New England textile conglomerate which would later become his primary investment vehicle). As part of the wind-down, Buffett made himself available to his partners to guide their future asset allocation.
Buffett’s partnership letter of February 25th, 1970, undertakes “a very elementary education regarding tax-exempt bonds.” Like all good fixed-income instructors, Buffett acknowledged up front that the discussion was likely to “be a little weighty” and that he felt as if he was trying to “put all the meat of a 100 page book in 10 pages—and have it read like the funny papers.”
After a discussion of the mechanics of tax-free bonds and their expected marketability, Buffett expands on his preferred municipal bond areas. In descending order, we hear that the BPL partners are advised to focus first on “large revenue-producing public entities such as toll roads, electric power districts, water districts, etc.”
Warren favoured these bonds on account of their superior marketability and their relatively inefficient pricing due in part to “favorable sinking fund[s]”, insofar as these funds introduce prepayment risk into a given bond issue.
Following the muni project bonds, Buffett described his preference for industrial development authority bonds and suggests that the partnership’s “insurance company owns a majority of its bonds in this category.” He suggests that “prejudice” against these bonds caused by uncertainty around and changes made to their tax-exempt status made them a “most attractive field.” Beyond the private-activity type, WEB rounds out his muni preferences with AAA-rated public housing authority bonds and, last,“state obligations of a direct or indirect nature.”
My approach to bonds is pretty muck like my approach to stocks. If I can’t understand something, I tend to forget it.
Even in fixed income securities, though, Buffett stayed true to his “circle of competence.” He finishes his discussion of tax-free bonds by noting that he won’t purchase the debt issued by large cities such as New York or Chicago. He reports: “My approach to bonds is pretty much like my approach to stocks. If I can’t understand something, I tend to forget it.”
Buffett as distressed bond buyer
Warren Buffett’s letters not only show his understanding of the bond market, they also reveal many instances of his and Berkshire’s participation in more turbulent areas of fixed income: think of broad “junk bonds” and distressed or defaulted issues. As unusual as it sounds, the Buffett partnership letters report on various instances over the years where the Oracle of Omaha morphed into the Creditor near Creighton.
In the early days of the partnership, before Berkshire’s emergence, Buffett employed the principles of Benjamin Graham, finding proverbial cigar butt businesses and salvaging one last drag. Of special note in this category was the workout situation brought about by Texas National Petroleum’s sale to Union Oil in April 1962. In addition to purchasing common stock and warrants, BPL purchased 4.1% of the company’s 6 ½% debentures, callable at 104 ¼ at the time of the sale.
Union Oil faced little regulatory risk in acquiring Texas National Petroleum. There was, however, a fly in the ointment related to Union Oil receiving a “necessary tax ruling.” According to Buffett, “The University of Southern California was the production payment holder (a form of oil and gas financing) and there was some delay because of their eleemosynary status.” Thus Buffett entered into the trade, expecting the deal to close.
And indeed, come October 31, 1962, the sale closed. The results for the partnership were quite favorable, both on the debt and equity purchased. Buffett reported on the debt, “On the bonds we invested $260,773 and had an average holding period of slightly under five months. We received 6½% interest on our money and realized a capital gain of $14,446. This works out to an overall rate of return of approximately 20% per annum.” Not bad for a fellow known for his equity savvy!
A few other Berkshire bond purchases are worth mentioning. Following Texaco Inc.’s bankruptcy in 1987, Berkshire’s insurance portfolios invested in the short maturity, defaulted bonds. Buffett reasoned that “a worst-case” outcome with the Pennzoil litigation (Pennzoil sued Texaco in a messy merger contest for Getty Oil) the Texaco bonds would be “worth about what we paid for them.”
The worst-case scenario did not come to pass. In 1989, shareholders learned that Berkshire sold nearly all their Texaco bonds for a “pre-tax profit of about $22m.” Considering the reported amortized cost in 1987 of $104m, Berkshire achieved approximately 10% per annum on their bankruptcy bet.
Texaco’s defaulted bonds may be among the least predictable purchases in the annals of Berkshire bond buying, but not far behind are the conglomerate’s 2001 and 2002 purchases of euro-denominated retail-sector “junk bonds.” Which retailer you ask? And why euros? The answers to both questions tickle any conscious investor in 2018.
Throughout the mid-2000s, Buffett expressed his concern on the US dollar. The massive expansion of the US current account deficit motivated the famed investor to look far afield for non-dollar bets.
The 2007 shareholder letter describes an insight many Berkshire shareholders might have wished penetrated the equity investment framework of WEB: “in 2001 and 2002 we purchased €310m Amazon.com, Inc. 6 7/8 of 2010 at 57% of par (see Figure 2).
At the time, Amazon bonds were priced as “junk” credits, though they were anything but…in 2005 and 2006 some of our bonds were called and we received $253m for them. Our remaining bonds were valued at $162m at year end. Of our $246m of realised and unrealized gain, about $118m is attributable to the fall in the dollar. Currencies do matter.”
Last but not least is perhaps the biggest bond biff in the history of Berkshire. In 2007, Buffett directed Berkshire to purchase roughly $2bn worth of debt issued by Energy Future Holdings. If the issuer sounds familiar it is because it was a company “formed in 2007 to effect a giant leveraged buyout of electric utility assets in Texas.”
The long and gruesome story made short: Energy Future Holdings has since gone down in history as one of the largest utility bankruptcies
By 2013, Buffett reported to shareholders that the $2bn investment had brought about a pre-tax loss of $873m. Buffett stressed that he had made the purchase decision without calling his esteemed vice chair Charlie Munger and reflected in the wake of the loss: “Next time I’ll call Charlie.”
Buffett the bond bear
As fun as the tour through Berkshire’s bond history has been, no discussion of such a matter would be complete without mentions of Buffett’s general dislike of, and periodic bearishness on, fixed income securities.
The bond-bashing begins as early as 1961, a mere four years after the Buffett partnership formed. In a discussion of the partnership’s investment style, Buffett chastised those who mindlessly sought safe harbor in bonds: “Many people some years back thought they were behaving in the most conservative manner by purchasing medium or long-term municipal or government bonds.
“This policy has produced substantial market depreciation in many cases, and most certainly has failed to maintain or increase real buying power.”
And, although he didn’t return to this point specifically in the following years, Buffett’s disdain proved more prudent. US Treasury yields rose steadily throughout most of the 1960s.
Another “low-light” of the Berkshire attitude towards long-term bond investing sprung up in 1987 and 1988. At that point in time, after a decline in yields since the highs of the early 80s (the 10-year US Treasury reached 15.8% in September 1981), Buffett reminded shareholders “we continue to have an aversion to long-term bonds. We will become enthused about such securities only when we have become enthused about prospects for long-term stability in the purchasing power of money. And that kind of stability isn’t in the cards.” (He would later provide shareholders a revisionist history of 1980s bonds…stay tuned.)
But Warren reserved his sourest scorn for government debt until 2008 in the aftermath of the Global Financial Crisis. Whether motivated by patriotism or superior returns, Buffett opined on his vision of financial history, relating the US Treasury bond market to Internet stocks in the late 1990s and the housing bubble of the mid-2000s: “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 US Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary. Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long.”
Since the collapse of Lehman Brothers in September 2008, Buffett’s ominous bubble prediction has itself burst. Indeed, an index of US Treasury securities purchased at the depth of the crisis has produced about a 28% total return, as long-term interest rates have not returned to their pre-crisis levels. We cannot pronounce Buffett’s preference for equities at the depth of the crisis wrong, though. Over the same time period, the S&P 500 returned 175%.
We cannot pronouce Buffett’s preference for equities at the depth of the crisis wrong, though. Over the same time period, the S&P 500 returned 175%.
Berkshire’s bid for bonds to be determined
Whether functioning as a lecturer, as an opportunistic buyer of distressed debt, or as a perennial bond bear, Buffett emerges from the pages of his 61 shareholder letters as a capable bond investor. And, as one often in control of large insurance float portfolios, Buffett would be hard pressed never to dabble in debt, despite an expressed preference for equities. Much of this has to do with his extreme bullishness on the US economy. At one point during this year’s meeting, Buffett proclaimed: “I would love to be a baby….born in the United States today.”
To be utterly certain, though, we send our readers off with a final thought Buffett imparted to shareholders at the 2018 meeting regarding the merits of US Treasuries. Responding to a question about the future of interest rates, the chair mused: “I don’t know and no one else knows.”
But, he continued:“In light of the Fed’s 2% inflation target and 30-year US Treasury yields just above 3%, the average investor’s after-tax real return per annum sums to only 0.5%. That math does not work well for those requiring 7-8% per year.”
Buffett’s reasoning was not dogmatic. He closed his answer to the shareholder’s question by reflecting on the history of US Treasuries. With the benefit of hindsight, the Oracle of Omaha carefully revised his earlier dislike for government bonds in the 1980s: “I think Treasury bonds have been unattractive since the 2.9% war bonds of 1942. In the early 1980s, though, one could have purchased a 14% 30-year zero-coupon U.S. Treasury to guarantee an appropriate return.” Even in Buffett’s mind, there are times when bonds make sense.
SOURCE
1 Niveshak, Safal (2013). “Warren Buffett Berkshire Letters 1957 to 2012.” Accessed May 7, 2018.
This article was first published in the latest edition of Payden&Rygel’s Point of View: Our Perspective on Issues Affecting Global Financial Markets.
