Warren Buffett Called This Investment ‘Return Free Risk’

bonds

Should you cut back on your bond holdings? Consider the following comparison.

A 30-year Treasury bond purchased in January cost $100 and has a 2.34% coupon. Every year for 30 years the owner will receive $2.34.

At bond maturity in 30 years the bond will be redeemed for $100. The total annual return for that bond is thus 2.34%, the yield at purchase.

When the Federal Reserve cut short term rates and restarted its asset purchase plan, the yield on 30-year Treasurys dropped. A 30-year Treasury bond purchased in July, for instance, has a 1.33% coupon.

The lower current yield makes the bond purchased in January more valuable because the owner of that bond receives $2.34 each year rather than $1.33 for the bond issued in July.

The owner of the bond issued in January could sell that bond today for about $125, a 25% gain in six months. However, at maturity in 2050, the government will return the $100 it borrowed. So, the value of the bond will slowly decay to $100 over 30 years.

The total annual return is the $2.34 coupon payment minus the decay in the value of the bond divided by the $125 purchase price. That works out to 1.3%, the current yield.

Thus the average annual total return for a bond from purchase to maturity, absent default, is the current yield (not coupon) at purchase.

The average yield to maturity for the iShares U.S. Aggregate Bond ETF (AGG) is 1.10%. In 2008, Warren Buffett referred to this as “return free risk” and it is not an attractive portfolio return.

The risk of higher interest rates

What if the 30-year Treasury yield rose to just 3%? The market value of that bond issued in July would drop by more than 30%. It would slowly rise back to $100 in 2050 and the average annual total return would still be 1.3%, but the drop in current value for the bond would make an ugly contribution to overall portfolio return.

The diversification benefit of bonds was coupon payments and higher bond prices when interest rates fell during stock market slides. The iShares 20+ Year Treasury Bond ETF (TLT), for example, normally climbs during stock market corrections.

Today, the downside risk from higher rates is much greater than the potential diversification benefit with a 1.1% aggregate bond market yield.

The real, or inflation adjusted, yield for all Treasurys is negative. The 30-year bond’s 1.33% yield minus 2% inflation is a negative real return. The buying power of the bond and coupon payment after one year is less than the year before.

The SPDR T-Bill ETF (BIL) yield is even lower than the ETF expense ratio. A guaranteed real loss is not a productive investment.

Inflation may make matters worse. The Federal Reserve’s total assets increased by $3 trillion since the pandemic began. That is $3 trillion created by the Fed out of thin air. That should be inflationary.

Inflation is great for borrowers but horrible to lenders. Borrowers pay back inflated dollars and lenders (bond holders) get negative real returns.

By the way, if you wonder how the government will ever pay back the $23 trillion and rising national debt, the answer is inflation.

Watch bond yield spreads

The difference between the yields of Treasury bonds and corporate bonds is the yield spread. Treasurys are theoretically risk-free. Corporate bonds are not.

There is risk that the corporation will default on its debt. To compensate investors for this risk, corporate bonds pay a higher coupon — the risk premium. For low risk investment grade corporations, the risk premium is small.

For corporations with questionable prospects, the risk premium for high yield or “junk” bonds is several percentage points.

If default expectations rise because of the pandemic’s economic effects, spreads will widen. Wider spreads mean lower bond prices and negative returns for corporate bond investors.

Recommended Articles

See the World: How to Fund a Nomadic Retirement

According to the 18th Annual Transamerica Retirement Survey, 70% of American workers dream of a retirement spent travelling the world, visiting exotic locations and enjoying the diverse cultures of the

3 Tax-Friendly States for Retirement

When it is retirement planning time, there are many factors you will need to consider. In addition to weather, proximity to family, and health care access, the amount of income

9 Signs You’re In a Relationship With a Narcissist

Narcissism is a very widespread issue today in our society. Most of us have heard the term "narcissistic" thrown around in conversations from time to time. This term is often

Iaccino: Watch Biden Treasury Pick Yellen for Hints On Stock, Bond Markets

As the Biden administration gets to work, watch for a tussle over exactly how the new leadership in Washington will pay for the spending Democrats feel is necessary to save

As Clock Ticks in Congress, Union Retirees Face Pension Cuts of 90%

Unless Congress acts, some 10 million union retirees could see their pensions cut by 90%. Many private pensions ultimately are backed by the taxpayer, much like big government-backed home lenders

Are Your Yoga Pants Making You Sick? What You Need To Know

Many women nowadays are wearing yoga pants on a regular basis. Not only are they extremely comfy, but they compliment body shape as well. Multiple stores are well known for

4 Proven Ways to Build Passive Income

Digitization of the U.S. economy has accelerated beyond all estimates and the trend is only likely to intensify going forward. While traditional physical ways to build a passive income still

8 Unconventional and Fun Ways to Make Extra Money

The number one formula for making money is that there is no formula. In fact, if you are willing to move away from the traditional path to earn money you

Science Says the Perfect Female Body Should Look Like This

Everyone has their own opinion of what the female body should look like. Society and the media often exhibit women that are thin as the ideal womanly figure. This causes

Americans Are More Afraid of Doctor Bills Than They Are of Being Sick

The skyrocketing cost of healthcare has become prohibitive for many Americans. More people seem to be skipping physician visits, and U.S. healthcare costs rose to $10,000 a year per person in

Your Meat Is Treated with Carbon Monoxide to Make It Look Fresh

When you are looking for a nice steak, pork chops or chicken at your grocery store one of the main things you look for is the color of the meat.

Anxiety? 10 Foods You Should Be Eating (and What To Avoid!)

Occasional anxiety is a part of life. You may feel anxious when faced with a problem at work, before making a big change, or deciding on an important decision. But anxiety disorders