Track the companies that matter to you. It's FREE! Click one of these fan favorites to get started: Apple; Google; Ford.



Buffett on Bonds

"Investment is most intelligent when it is most businesslike," says Ben Graham in The Intelligent Investor.

He doesn't specify what type of investment is most intelligent; he's saying all investment considerations should be approached with a businesslike mentality. The same goes for investing in bonds.

Only investments that offer the most compelling opportunities -- given all other available options -- should be considered worthy of your money. For example, even with their seemingly unstoppable price appreciation and my love for their products, I cannot invest in Google (Nasdaq: GOOG  ) or Chipotle (NYSE: CMG  ) at their current valuations of 51 and 73 times earnings, respectively. Better capital allocation alternatives worth looking into are, for example, Berkshire Hathaway (NYSE: BRK-A  ) , or Home Depot (NYSE: HD  ) .

When evaluating a stock, using a businesslike approach means that you will invest at a fair price with a comfortable margin of safety. The same characteristics should apply when investing in bonds.

Buffett invested big in bonds at various points in his career. In 1969 after folding his partnerships, Buffett told his investors that he would put his money into bonds and offered to do the same for any of the limited partners. Several years ago, during the ultra-low interest rate period, Buffett bet big on junk bonds. In both instances, buying bonds offered a better alternative than the general stock market and the degree of margin of safety was sufficient.

Bonds as business
In his 1984 annual report, Buffett explained the businesslike approach to bond investing. Like purchasing marketable stocks based on quality of the business, soundness of management, and attractive valuation, he said, "We extend this business-valuation approach even to bond purchases."

In 1983 and 1984 Buffett and Munger acquired bonds in the Washington Public Power Supply System (WPPSS). Berkshire's price tag came to $139 million. This WPPSS stake earned $22.7 in annual interest payments that Berkshire received each year as cash. According to Buffett:

We compare the $139 million cost of our year-end investment in WPPSS to a similar $139 investment in an operating business. In the case of WPPSS ... [it] earns $22.7 million after tax. ... We are unable to buy operating businesses with economics close to these. Only a relatively few businesses earn the 16.3% after tax on unleveraged capital that our WPPSS investment does, and those businesses, when available purchase, sell at large premiums to that capital.

To be sure, the attractive return on WPPSS was because this same entity defaulted on $2.2 billion in bonds in 1983, which subsequently led to the abandonment of those underlying projects. WPPSS followed its default with bond offerings on completely different projects that were materially different in terms of promises and properties. While there still existed a possibility that a default could occur (what investment exists without any risk?), Buffett believed he'd be compensated adequately for that risk:

Charlie and I judged the risks at the time we purchased the bonds and at the prices Berkshire paid to be considerably more than compensated for by prospects of profit.

Like stocks, investing in bonds must be done after careful examination of:

  • The underlying entity
  • Its rate of return
  • Probability of default or suspension of earnings
  • Its soundness compared to other stock and bond investments.

"Investing is simple, but not easy," as Buffett once said. You only need to understand the three or four major variables of a stock or bond to determine whether or not you have an attractive investment. Just make sure you know those variables cold.

For related Foolishness:

Read/Post Comments (0) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 538507, ~/Articles/ArticleHandler.aspx, 10/26/2016 5:43:24 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated 8 hours ago Sponsored by:
DOW 18,169.27 -53.76 -0.30%
S&P 500 2,143.16 -8.17 -0.38%
NASD 5,283.40 -26.43 -0.50%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

10/25/2016 4:00 PM
BRK-A $215249.96 Down -250.04 -0.12%
Berkshire Hathaway… CAPS Rating: *****
CMG $405.67 Down -7.68 -1.86%
Chipotle Mexican G… CAPS Rating: ****
GOOGL $828.55 Down -7.19 -0.86%
Alphabet (A shares… CAPS Rating: *****
HD $123.34 Down -4.44 -3.47%
Home Depot CAPS Rating: ****