Sun. Dec 4th, 2022

If you are fan of Warren Buffett, you may have seen his most recent opinion about investing in bonds. In his annual shareholder letter, he basically said if you own them, you face a bleak financial future. But bonds are a part of almost all prudent asset allocation strategies. I’m sure you’ve heard of the traditional 60% stock and 40% bond allocation for retirement plans. For over 100 years, this has served as a sound way of managing money. You take a reasonable amount of risk with stocks but balance it with a healthy dose of more stable bonds.

Photograph by Ellen Jaskol

Charlie Farrell

If bonds have been popular with investors, why is Buffett so down on bonds? Before recent history, bonds used to represent one of the best ways to modestly grow your wealth without taking much risk. With a bond, you receive a guaranteed interest rate for the term of the bond. And if the entity issuing the bond is financially healthy, you get your money back when the bond matures. For instance, you could invest $1,000 for 10 years at 6% in a government bond. That means you collect 6% a year and get your $1,000 back when it matures, very similar to how a CD works at a bank.

Sounds like a good deal, so what’s the problem? The problem is the interest rate. Currently, interest rates are below the rate of inflation and it’s likely they will stay there for a long time. If your interest rate is below the rate of inflation, then you are losing wealth (purchasing power) every year you hold money in bonds.

Let’s compare the “old” bonds to today’s “new” bonds. In the year 2000, if you invested in a 20-year U.S. Treasury bond, your interest rate would have been about 6.5% for the next 20 years. Even better, the inflation rate was only a little over 2% for that entire period. That means you were earning about 4% above inflation every year and increasing your wealth in terms of purchasing power.

But today, if you buy a new 20-year U.S. Treasury bond, your interest payment is about 2%. So unless inflation runs below 2% for the next 20 years, you will be losing purchasing power. That means whatever part of your portfolio you hold in bonds is likely “dead money” in terms of its ability to build wealth for retirement.

Even if inflation runs at 1%, your return above inflation would only be 1%. That’s a lot less than the 4% excess return investors received who bought bonds 20 years ago. That means you face two bad outcomes. Either you will lose purchasing power every year because inflation runs above 2% or you’ll barely be moving ahead if inflation runs below 2%.  And since the Federal Reserve is trying to create inflation, the first scenario is the more likely one.

That’s why Warren Buffet thinks the future is bleak for bond investors. Now you might be wondering if you should scrap all your bond holdings. The answer is a bit more nuanced.

By senior