James Bond Isn't the Only Dangerous Bond

What are the three terrors of the Fire Swamp? 

One, the flame spurt - no problem. There's a popping sound preceding each; we can avoid that. 

Two, the lightning sand, which you were clever enough to discover what that looks like, so in the future we can avoid that too. 

Westley, what about the R.O.U.S.'s? 

Rodents Of Unusual Size? I don't think they exist. - Princess Bride

The best (though sometimes the worst) thing about having a blog is that you can quote whatever you like.  So why can it also be the worst thing?  Late at night when your brain shuts down, you struggle to find any quote close to resembling your article.

Tuning out the GIPSIs tonight (Greece, Ireland, Portugal, Italy, & Spain), I wanted to draw your attention to Oracle of Omaha's wisdom as reported by Bloomberg Buffett: Bonds Are Among Most Dangerous Assets

Warren Buffett, the billionaire chairman of Berkshire Hathaway Inc., said low interest rates and inflation should dissuade investors from buying bonds and other holdings tied to currencies.

“They are among the most dangerous of assets,” Buffett said in an adaptation of his annual letter to shareholders that appeared today on Fortune magazine’s website. “Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal.”

Buffett, 81, who built Omaha, Nebraska-based Berkshire from a failing textile maker into a firm selling insurance, energy and jewelry through acquisitions and stock picks, echoed Laurence D. Fink, chief executive officer of BlackRock Inc. Fink said this week that investors should be 100 percent in equities, because of depressed stock valuations and the Federal Reserve’s pledge to keep interest rates low.

“High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based investments -- and indeed, rates in the early 1980s did that job nicely,” Buffett wrote. “Current rates, however, do not come close to offsetting the purchasing-power risk that investors assume. Right now bonds should come with a warning label.”

The Fed has kept borrowing costs near zero, and said last month that economic conditions may warrant “exceptionally low levels” for rates through at least late 2014 to boost the economy and put more Americans back to work. Buffett said other currency-based investments that may pose a risk include money- market funds, mortgages and bank deposits.

Saying anything remotely opposite of Warren Buffett is like trying to cross a busy street during rush hour, you know you shouldn't do it because there's a good chance of getting hit. So let's talk about what I agree with in this quote - low interest rates and inflation should dissuade investors from buying bonds.

Looking at the following graph, we see the interest paid out by a 10 year treasury bond.  For a minute, let's ignore inflation and issuance of further government debt.  Let me ask you, what do you think the odds are that the rates get any lower versus the rates going higher?

It's fair to ask though why do higher rates matter to me?  If you own bonds or a bond mutual fund, they matter.  Let's walk through an extremely simple example where the numbers are for illustration purposes (e.g. I haven't calculated anything):

• A few years ago, I buy a 10 year bond that pays 5% interest for $100.  Two years later recession hits and interest rates go down.  Looking for a good rate, you offer me $110 for my 5% bond.  Realizing a 10% gain, I sell you the bond which pays you less than 5% because you paid $110 for it, not $100.  For simplicity sake, let's say it pays you 3%.
• 2 years later the economy recovers, but is now doing so well that new 10 year bonds pay 6% interest.  You have a choice, you can either hold the bond for 6 more years to get the $100 or you could sell it to someone else who may only pay you $90 for it. 

The lesson from this example is that investors that are buying newly issued debt, especially intermediate and long term debt, are like a moth near a bug light.  The moth thinks the light is safe, but it can easily get zapped.

So Where Might I Disagree with the Almighty Oracle

Rush hour must be ending because later in the article from Bloomberg:

Buffett said investors should avoid gold, because its uses are limited and it doesn’t have the potential of farmland or companies to produce new wealth. Achieving a long-term gain on the metal requires an “expanding pool of buyers” who believe the group will increase further, he said.

“What motivates most gold purchasers is their belief that the ranks of the fearful will grow,” he wrote. “During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As ‘bandwagon’ investors join any party, they create their own truth -- for a while.”

Gold prices have climbed to more than $1,700 an ounce from less than $300 in the last decade, as investors sought safety in bullion.

Hypothetical question: when is insurance cheap versus when is insurance expensive?  Insurance is cheap when there is little risk of collecting and expensive when there is a higher chance the insurer will have to pay a claim.  Gold is expensive, but there's a good reason - gold is an insurance policy.  Gold buyers are insuring that their wealth against low interest rates and the printing of money, these days known Quantitative Easing.

Interest Rates Pay Little for Much of This Period

Global Central Banks Expand Their Balance Sheets Double or More
From The Big Picture blog

Investors Seek Safety for Their Wealth

Note that the Federal Reserve has increased the its balance sheet from less than $1 Trillion to almost $3 Trillion.  The central banks in China and Europe had much larger increases.  Plus as we have already established, interest rates pay nothing.

So How Does this Affect Me

There are a variety of factors that affect bond rates.  Currently the slow economy plus the flight to safety out of Europe is keeping US bond rates low.  However, the day is coming when bond rates will turn.  While you may have seen previous posts where I state I own bond funds, those holdings are subject to change at any time and without prior warning.  I am looking to diversify out of intermediate and longer term bonds.

Regarding gold, I'm not sure when its price stops going up.  In fact, it may have already stopped.  However with the EU crisis still unresolved, talk of €1 Trillion more in ECB lending at the end of the month, increasing US debt levels, and talk of more quantitative easing from the Fed, I think the price can go higher.

There are many ways to "own" gold.  The reason I have quotation marks around own is that if you look around the Internet, you'll find quite a few differing opinions on what owning gold means.  Skipping that conversation, here are a few options that you can explore: buy physical gold (though let me warn you that might make you a terrorist), buy gold through an ETF fund, or buy gold mining equities, mutual funds, or ETFs.


Disclaimer: Please remember that I’m just a guy sharing information on a blog, and this is NOT official investment advice. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Please consult your investment adviser before making any investment decisions. During your conversation with said investment adviser, ask why they believe in their recommendation. If you are not convinced by their explanation, any action that you take or forego is also your responsibility. Just in case you missed that, you are responsible for your investments.