When Warren Buffett, the so-called “Oracle of Omaha,” makes a bold statement about investing, people’s ears perk up. While his May 6th declaration that fixed income is “a terrible investment right now” might have made more than a few headlines, his sentiment was hardly anything Earth-shattering, as some pundits have been claiming for years that investors should rethink their fixed income investments.
It’s an understandable position: interest rates are at extreme lows, and if they rise due to change in Fed policy or inflation expectations, bonds could lose a lot of value.
While we agree that on a relative basis, stocks look more attractive than bonds right now, and that bonds seem riskier than they used to be, we don’t think that you should get rid of your entire fixed income allocation. We believe that:
- A prudent investor should still hold some bonds, and
- Your bond portfolio should be diversified, just like your stock portfolio.
Why you should hang on to your bonds
While no one can predict the future with 100% accuracy, an effectively diversified portfolio can help minimize the shocks of a volatile economy. Consider this scenario: if the market suffers another downturn, you need something that can perform well in a recessionary environment – something like bonds. In such a situation, if interest rates fall even further, bond prices will rise, and this gain might help offset some of the losses that may occur in your equity portfolio. If you react to some of these headlines and sell out of all your bonds, your portfolio might suffer more dramatically in a recession.
Of course, we have to consider what may happen on the other end of the spectrum: if there’s a period of growth and inflation, interest rates will likely rise. In this scenario, you could potentially lose money in bonds, but if you’re effectively diversified, the strength of your equity portfolio may offset some of those losses. That being said, there’s no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Not all bonds are the same
Keep in mind that while some pundits are talking about Treasuries, those aren’t the only bonds out there. Just like there are many different kinds of stocks – growth, value, small cap, large cap, etc. – there are many different kinds of bonds.
For example, US government bonds look expensive at the moment, but emerging market local currency bonds still offer good returns with acceptable levels of risk when added to a well diversified portfolio.
The bottom line?
The Oracle of Omaha may have gotten everyone’s attention, but there’s more to the story than the headline. While there may be heightened risk in fixed income, we believe that careful exposure to fixed income is a key component of an effectively diversified portfolio that prepares your portfolio for a variety of economic environments.