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Buffett's word on bonds

As Warren Buffett points out in his annual letter, faced with low returns, fixed-income investors are making some bad choices

Buffett's word on bonds

Every year, in one short stretch of prose, generally 10-12 pages long, the legendary investor Warren Buffett lays down some simple principles - often illustrated by some anecdotes - that all investors should keep in mind while investing. This is the annual Warren Buffett letter that all his fans look forward to at this time of the year. This year's annual letter to the shareholders of Berkshire Hathaway was released last week. Of course, all company CEOs write to shareholders with their annual reports. Almost without exception, they contain dull public-relations type material that no one reads. Buffett has long been an exception, and now Jeff Bezos is too.

Buffett's letters are as interesting as the 90-year-old himself and his investing career has been. Obviously, the letters contain routine stuff about business performance and outlook that have to be there in such a letter. However, all this is written in a genuinely interesting and human way, meant to be actually read and conveying the warmth and wisdom of Buffett's personality.

However, what makes these letters more interesting than details of Buffett's corporate investing is that they are always woven with some examples and advice about money, business, savings and even life in general.

This year's letter is no exception. Here's a part that struck me as being of great relevance to Indian savers, who suffer from being a 'fixed-income country'.

...And bonds are not the place to be these days. Can you believe that the income recently available from a 10-year U.S. Treasury bond - the yield was 0.93% at year end - had fallen 94% from the 15.8% yield available in September 1981? In certain large and important countries, such as Germany and Japan, investors earn a negative return on trillions of dollars of sovereign debt. Fixed-income investors worldwide - whether pension funds, insurance companies or retirees - face a bleak future.

Some insurers, as well as other bond investors, may try to juice the pathetic returns now available by shifting their purchases to obligations backed by shaky borrowers. Risky loans, however, are not the answer to inadequate interest rates. Three decades ago, the once-mighty savings and loan industry destroyed itself, partly by ignoring that maxim.

Of course, the rates available on US treasury paper, as well as those in Germany and Japan, are of little direct concern to savers in India, but the decline in fixed-income rates and the devastating impact on those who rely on fixed income is very real and has been ongoing for a few years. In India, fixed income has three main uses. One, as a place to park money that will be needed soon, as in up to two-three years or so. This is done mostly by corporates or other organisations but by individuals too. Two, as an investment by those who are saving for the longer term, and three, by retirees who need to generate a regular income.

Out of these, item one is the only one for which exclusive reliance on fixed income is justifiable. It's harmful for the second category and in the long term, absolutely lethal for the third.

In no country of the world are the earnings from fixed income now capable of protecting the saver adequately from inflation, let alone earning a decent return on top of the inflation rate. The latter is what is needed for the retiree's income. Some amount of equity exposure is necessary. That brings volatility but, if managed correctly, can generate enough extra returns for savers' ultimate financial goal to be met.

Unfortunately, as Buffett points out, the low returns from fixed-income sources often leads to the worst-possible choice - investing in low quality fixed-income assets. This is something that Indian investors have long done, usually to their detriment. In the old days, this would happen when the worst companies would offer high interest rates on their fixed deposits and in recent times when investors got surprised in mutual funds which had a different risk profile than they had expected.

To go into fixed income because it is low-risk and then choose riskier fixed-income options because they promise higher returns leaves savers with the worst of both worlds.