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.