Warren Buffett's Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B) has a record amount of cash on hand, and it's not just because of the conglomerate's retained earnings. Buffett has pulled back on Berkshire's vast bond portfolio, passing up on billions of dollars in interest income by keeping its money in super-safe U.S. Treasuries.
His commentary and recent behavior suggests to me that Buffett is no bull when it comes to the bond market. Here are three reasons I think Buffett views bonds as a bad bet.
1. Buffett's comments on interest rates
In January, CNBC anchor Becky Quick asked Buffett about stock market valuations, to which the Oracle of Omaha replied that stocks are "not richly valued relative to interest rates." That's been Buffett's go-to market comment in recent years -- supposing that interest rates stay where they are, stocks appear to be reasonably priced. In a low-interest-rate world, stock prices should be high, as businesses are simply worth more when alternatives (like bonds) offer low yields.
Image source: The Motley Fool.
But even as Buffett says that stock prices are reasonable based on the current level of interest rates, his actions suggest he doesn't think interest rates will stay where they are. Berkshire hasn't been a substantial investor in stocks, and it has reduced its bond exposure in recent years, things you'd do if you expected rates to rise relatively quickly.
2. Berkshire is letting its bond holdings dwindle
I consider Berkshire's moves in the "insurance and other" segment as offering the best view of how Buffett is thinking about markets. Berkshire breaks out its assets in the insurance and other segment in four broad categories: Cash and cash equivalents, fixed maturity securities (longer-term bonds), equity (stocks) and other (preferred stock or warrants, among other types).
When you look at this part of Berkshire's balance sheet over the last decade, you'll quickly notice that bond investments have been reduced substantially. From a peak of roughly 23% of the insurance and other segment's cash and investments in 2010, bonds now stand at about 7% of the portfolio. Berkshire's bond portfolio is essentially in run-off, as when its principal is returned, Buffett simply keeps the money in cash and cash-like instruments rather than buy new bonds.
Data source: Berkshire Hathaway's annual reports. Author calculations.
Berkshire is winding down its bond portfolio even as its subsidiaries access the bond market to borrow more money, locking in their borrowing costs for years into the future. The capital-intensive railroad and utilities businesses had $62.2 billion of debt outstanding at the end of 2017. In 2012, these subsidiaries had only $36.2 billion of debt outstanding.
So while Buffett isn't buying corporate bonds, he's been very happy to issue them to lock in low yields, suggesting that now is a better time to be a borrower than a lender.
3. Holding cash is a costly choice
Make no mistake: Avoiding bonds is not just an accident. Buffett knows better than anyone that holding cash instead of higher-yielding securities costs Berkshire billions of dollars in income on an annualized basis.
The following table shows the difference in yields between T-bills, five-year Treasury notes, and five-year corporate bonds.
6 month T-bill
5-year U.S. Treasury note
5-year corporate bond
Data sources: U.S. Treasury, Guggenheim Investments.
The differences in yields may seem small, but when you're talking about more than $116 billion of cash at Berkshire, there's no such thing as a rounding error. A percentage point is a billion-dollar difference to Berkshire's pre-tax earnings year after year.
Insurance companies like Berkshire's rarely keep so much of their balance sheets in cash, preferring to keep fully invested in a mix of stocks and bonds to earn the highest return on their float. In this respect, Berkshire's preference for cash is really extraordinary, the kind of thing that would draw a lot of pressure if Berkshire were managed by anyone other than Warren Buffett.
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