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Coming Catastrophe in Bonds?

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February 01, 2013 – Comments (4)

Board: Berkshire Hathaway

Author: EliasFardo

I don’t know how we can avoid a catastrophe in bonds; it is just simple math. I believe that individual investors should not own any medium to long term bond maturities at all.

I agree that stocks make more sense now, especially the names you mentioned. But, Buffett’s admonition to not own anything that you are not willing to see fall 50% in price holds for stocks also. The difference between stocks and bonds now is that the losses in bonds will be permanent, where the losses in stocks should ( may, might, could ) prove to be temporary.

Since easy, cheap credit will disappear, you need to own only large companies that can self-finance their operations. You need to own companies that do not require large capital expenditures to maintain their operations. You need to own companies whose customers do not need to borrow money to buy your products. You need to own companies that sell the types of things that people buy every week. You need to own companies with little debt. You need to own companies with strong internal cash flow. You need to own companies whose products are close to being a necessity purchase which can not be postponed for years. You need to own companies with low fixed costs.

Here is a test. Ask yourself: if there is a serious financial crisis which severely disrupts the economy for years, will such disruption create a temporary or permanent impairment for the company. If a company is growing at 3% a year, will three years of negative growth result in a company that can rebound at the end of the crisis and have its volume output where it would have been if it had continued to grow at 3%, or will it be permanently impaired or even destroyed? OK, bad sentence. Say a company is operating at 500 and growing at 3% a year. In the recovery after three years of financial crisis, will it rebound to 546, or will it still be sub 500. That is the test. If you don’t believe that it has a significant chance of passing that test, you don’t want to own it now. The companies you mentioned do, but they are the exception.

People do not want to think about the disaster waiting in bonds; it is too painful. Since so many have been burned in equities, they don’t believe that they have any alternatives other than fixed income. Good to great stocks and cash are the alternatives. I hold a lot of cash and I am losing purchasing power in it every day. However, when bad times come I will have an opportunity to deploy that cash at very attractive returns. But, I must be willing to suffer while waiting. I am but most are not. My willingness is nothing special to me. It comes mostly from just living long enough to actually experience the economic cycles. I can’t even begin to imagine what a 30 year old money manager makes of all this.

So, why hold any stocks at all? I could be wrong. And, from experience, I know that it easier to buy cheap shares of a company when I already own some. I own stock in order to create the emotional environment to allow me to buy more stock when it is being given away. Simple as that. 

4 Comments – Post Your Own

#1) On February 01, 2013 at 3:20 PM, ibuildthings (< 20) wrote:

Stocks like Intel (INTC) and Verizon (VZ) pay fat dividends and are large enough to weather storms. Intel just drew down from an excited peak in low 30's, and is PE 9 right now.  Dividend is 4%.  Seems a better bet than a low interest bond or a rocket stock.

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#2) On February 01, 2013 at 5:25 PM, Mega (99.95) wrote:

Notice how this post doesn't actually attempt to quantify the bond catastrophe. Is the possibility of intermediate term bonds losing 3% in a year really that bad compared to the possibility of stocks losing 30%?

Yes, yields are very low but I don't think people should completely abandon their bond allocations. Maybe adjusting your bond mix to shorten duration and increase credit exposure is appropriate though.

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#3) On February 02, 2013 at 2:42 PM, somrh (88.61) wrote:

Like @Megashort, I'm curious about the bond catastrophe as well.

I'm especially curious about this statement:

The difference between stocks and bonds now is that the losses in bonds will be permanent, where the losses in stocks should ( may, might, could ) prove to be temporary.

In nominal terms, this is likely false. Unless the author is supposing a massive wave of defaults, there aren't going to be permanent losses. If interest rates go up, that will affect bond prices but that's just a temporary opportunity cost loss, not a real loss for a buy and hold bondholder.

If you buy a bond earning 3% yield and you hold until maturity (regarldess of what happens to interest rates) you'll earn your 3% (minus any default losses).

In real terms, he may have a point (with TIPS in negative territory at least) but that makes me wonder why he's choosing to hold cash which has an even greater real loss. 

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#4) On February 05, 2013 at 2:33 AM, outoffocus (22.75) wrote:

Well if the bond bubble pops as many are predicting it will, we are looking at losses to the tune of 30% and up.  Also interest rates will simultaneously skyrocket to levels unseen by many.  It will be the 2008 crisis 2.0 and it will be much harder to recover from.  If we were only looking at a loss of 3% a year then thats hardly a crisis at all.  But thats not what we're talking about here.  We are looking at bonds selling for practically pennies on the dollar. That in and of itself could destroy retiree income.  The implications are far reaching and dire.  So preparations need to be made to reduce exposure to bonds as much as possible.  As the author said, stick to short term bonds. There is just too much downside risk in long term.  Cash is king because there will be opportunties galore when the bond bubble pops.  Stocks are an ok alternative, but I have a feeling that in the event of a bond collapse, commodities will skyrocket.  So one should seek to increase exposure there, at least in the short term.

But thats just my two cents. 

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