May 10, 2013 5:56 pm

Alternatives to Buffett’s ‘terrible’ bonds

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Warren Buffett, chairman and chief executive officer of Berkshire Hathaway Inc., tours the exhibition floor prior to the start of the Berkshire shareholders meeting in Omaha, Nebraska, U.S., on Saturday, May 4, 2013. Buffett's Berkshire Hathaway said first-quarter profit rose 51 percent on gains from equity-linked derivatives and insurance operations.©Bloomberg

Warren Buffett, America’s best-known investor and the world’s fourth-richest person, has made his feelings about bonds clear, declaring them “terrible investments”.

Speaking on US television this week, the chief executive of Berkshire Hathaway said that many investors had been drawn to bonds because their prices tend to rise as interest rates fall. But, he warned, when the situation changes “people could lose a lot of money if they’re in long-term bonds”.

Talk of a “bond bubble” and a “great rotation” away from bonds and towards equities is not new. But bonds are still popular. The best selling sector for Individual Savings Accounts (Isa) money in the most recent tax year was the Sterling Strategic Bonds, according to the Investment Management Association. But in recent months investors have started to put more money in equities than bonds.

Daniel Godfrey, chief executive of the Investment Management Association (IMA), said that for the first time in years some months had seen net outflows of money from bond funds. “This is more than a blip,” he said. “The IMA is not a forecasting organisation but one can see that a long bull market cannot last forever.”

Advisers and analysts worry that the market might be heading for a repeat of 1994, when an unexpected rise in US interest rates slashed the value of bond holdings.

The catalyst for concern is linked to brighter hopes for the world’s financial prospects. If growth returns, inflation rises and interest rates start to head back to pre-crisis levels, then bond prices will fall. Investors who then all try to get out at the same time may find themselves crushed.

“People think of government bonds like gilts as non-risk,” says Alan Higgins, UK chief investment officer at Coutts. “But if the yield on a bond goes up then the prices go down and you can lose capital.”

 
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However, Higgins says that he only half agrees with Buffett’s analysis. “Equities are a better investment than bonds right now – just look at the yields,” he says. “The problem is that equity investment is not for everyone. For clients who want low risk we still believe bonds have a role to play.”

The private bank does not believe that rising interest rates are something investors in the UK will need to worry about in the near future. “We think that interest rates in the UK will stay low for four years and bonds will deliver reasonable returns for a few years yet,” added Higgins.

Iain Stealey, portfolio manager of JPMorgan Asset Management’s strategic bond fund, is also sceptical about the idea that rates will rise any time soon.

“But then bond yields are at record lows and people have concerns. Does it make sense to own 10-year gilts paying 1.75 per cent when inflation is above 2 per cent? Perhaps not. But there are still opportunities in fixed income.”

Stealey favours local currency debt such as Mexican bonds denominated in pesos as well as higher yield bonds, known as junk bonds in the US.

‘Don’t give up yet’

Equity funds may be outselling bond funds, but investment professionals are urging investors not to give up on the fixed-income sector.

Patrick Connolly of Chase de Vere favours strategic bond funds. He said: “These have the scope to invest in gilts, investment grade bonds and high yield and can be flexible in weighting. We like Fidelity Strategic Bond, which yields 3 per cent, Kames Strategic Bond fund (2.4 per cent) and Henderson Strategic Bond, yielding 5.5 per cent.”

Thomas Becket at Psigma has opted for the Axa Short Duration High Yield fund. He also thinks that the TwentyFour Income Fund, which invests in asset-backed bonds and targets a return between 7 per cent and 10 per cent, is interesting as a non-traditional income option.

“If you look around the world you have the UK flatlining, Europe in recession and the US growing – but slowly. So no, I don’t think this is an immediate concern,” he says.

A number of wealth managers are urging caution to investors tempted to sell out of bonds. The status quo of lower-for-longer rates, more quantitative easing and a hunt for yield is one that seems likely to continue, according to Adrian Grey, head of fixed income at Insight Investment. “This means anyone tempted to sell long-dated bonds in haste today to hedge against future duration risk, may well repent at leisure.”

Alternatives for investors who want income from their investment can also come at a price, warns Trevor Greetham, assistant allocation director at Fidelity.

Infrastructure funds offer solid sources of income. Investment trusts in the sector offer yields of 4 per cent or more but tend to trade at a premium to net asset value. Commodity investment – in precious metals, oil, gas and agriculture – offers diversification, but prices are volatile and there’s no income.

Instead, Greetham recommends strategic bond funds, which give managers more flexibility, and multi-asset income funds, which offer yields of about 4 per cent from a combination of bonds, income equities, commodities and high-yield securities.

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