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Why Is Buffett Buying Bonds?

In his latest letter to shareholders, Warren Buffett made his views on cash and Treasuries very clear:

"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 U.S. 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. Holders of these instruments, of course, have felt increasingly comfortable -- in fact, almost smug -- in following this policy as financial turmoil has mounted. They regard their judgment as confirmed when they hear commentators proclaim "cash is king," even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.

It is true that government bond yields are higher since those words of Warren's were published in late February. The stock market is also up -- a lot -- having closed at its 2009 low on March 9. Even junk bonds have rallied. But the latest filings from Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) do not show Warren Buffett buying more stocks, they show him buying more bonds … non-dollar-denominated ones.

At the end of June, Berkshire held about $11.1 billion in foreign government bonds in its insurance units, quite a bit more than the $9.6 billion it held three months earlier. In total, Berkshire spent $2.6 billion on bonds in the quarter, compared with $350 million on stocks, the lowest equity purchase rate in more than five years.

Forced into bonds
In a way, Buffett is forced to buy bonds because dividends are becoming an endangered species in the current market environment. Core Berkshire holdings Wells Fargo (NYSE: WFC  ) , US Bancorp (NYSE: USB  ) , and General Electric (NYSE: GE  ) have cut dividends. Another core holding, American Express (NYSE: AXP  ) , surprised some folks by not cutting its dividend -- but then again, it wasn't a huge payer anyway.

Buffett managed to get equity upside by buying preferred shares in Goldman Sachs (NYSE: GS  ) and GE with very steep coupons that guarantee 10% annual interest, and to boot he got warrants that, if sold today, would bring him a hefty profit for the Goldman deal -- the strike price there was $115. The GE warrants so far are out of the money (the strike price is $22.50). Either way, he managed to get equity upside combined with a very hefty 10% preferred dividend.

Buffett is buying high-yield bonds. Berkshire increased holdings of such securities 13% in the second quarter. He is also buying foreign government bonds, which rose 16% above the previous quarter. Buffett did cut his stake in Treasuries and GSE bonds by 5.3%. The moves allowed investment income to rise by 9%, despite the dividend cuts, reflecting the shift into fixed-income.

Making sense of the moves
Buying high-yield bonds suggests that Buffett thinks the economy is improving, or is about to improve. High-yield bonds returned 23% in the second quarter, according to Merrill Lynch's High Yield Master II index, clearly showing that the market agrees.

Individual investors can capitalize on high-yield bonds via ETFs and mutual funds. One ETF worth considering is the iBoxx $High Yield Corporate Bond ETF (HYG). So I don't look completely foolish -- no pun intended -- I recommended this high-yield ETF in February, before the rally in the high-yield market. For foreign government bonds, look at the iShares S&P/Citigroup International Treasury Bond ETF (IGOV). Foreign investment-grade bonds have sold off since March, but the ETF has risen as the dollar has also declined. Since currency risk is not hedged, this is one way to conservatively bet on a lower dollar.

Keep in mind that if the stock market corrects in the coming months, high-yield bonds will tend to follow, while government bonds tend to rally. The dollar is the wild card. But those are short-term considerations.

I doubt Warren Buffett is making investment moves thinking three months out. His investment horizon is usually in years -- and so should yours be. Of course, if you are not comfortable making complicated asset-allocation moves between bonds and stocks, another option is buying some Berkshire shares and putting Buffett to work for you.

More on Buffett issues:

Fool contributor Ivan Martchev does not own shares in any of the companies in this story. The Motley Fool owns shares of Berkshire Hathaway. Berkshire is a Motley Fool Stock Advisor and Motley Fool Inside Value recommendation. American Express is also an Inside Value selection. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.

Read/Post Comments (7) | Recommend This Article (27)

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.

  • Report this Comment On August 20, 2009, at 4:06 PM, noblepaladin wrote:

    Buffett is very bearish on the dollar, so foreign bonds make sense. It is consistent with his belief that the economic recovery will be very slow (not much appreciation in stocks) and the stimulus side effects will cause large inflation (foreign currency or foreign fixed income will appreciate relative to the dollar).

  • Report this Comment On August 20, 2009, at 4:16 PM, ivanmartchev wrote:

    yes, there will be inflation, but as I opined earlier in the year, not in 2009, and it may not be in 2010...

  • Report this Comment On August 20, 2009, at 9:57 PM, PacificGatePost wrote:

    The Kings of Wall Street have long coveted the absolute supremacy they now enjoy over the largest economy in the world. The debt is a problem, but vast change is necessary throughout the banking system. A radical change is needed on Wall Street.

    It starts with the taxpayer's attitude adjustment.

  • Report this Comment On August 20, 2009, at 9:58 PM, PacificGatePost wrote:

    Remember that Buffett invested at least $5 billion in Goldman. He has something to "sell." ... not so clean.

  • Report this Comment On August 21, 2009, at 1:18 AM, AlexanderAkhavan wrote:

    That makes no sense whatsoever. Buffett invested 5 billion in Goldman Sacks and he made a profit on it. How does that make him "not so clean?"

  • Report this Comment On August 21, 2009, at 2:50 AM, cordwood wrote:

    Pacificgate-----What nefarious motive do you attribue to Buffets' investment in Goldman?

  • Report this Comment On September 11, 2009, at 12:54 AM, rmihai wrote:

    Warren invest in HY bonds for the same reason I do. To diversify and because their expected total return, over the next 2-3 years is around 11%. Well I like 11% p.a. a LOT when I am looking at 7.90%-9.40% expected range for equities for the same time horizon. Should I mention that bondholders are on the safer side of the balance sheet?

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