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Chicago Bridge & Iron Company N.V. (CBI), Wells Fargo & Co (WFC): Three Reasons Why Warren Buffett Hates Bonds

“We’re not buying corporate bonds of any kind. Not at these yields.” Warren Buffett

“Bonds are terrible investments now.” Warren Buffett

“Bonds really should come with a warning label.” Warren Buffett

Berkshire Hathaway Inc.It’s no secret that Berkshire Hathaway Inc. (NYSE:BRK.B) CEO Warren Buffett doesn’t like bonds. The herald Oracle of Omaha has been warning investors to avoid the entire asset class in favor of better alternatives. So why does Buffett dislike bonds so much?

Picking up nickles in front of a steamroller

Today, the nominal yield on the iShares Barclays 7-10 Year Treasury Bond Fund (NYSEMKT:IEF) is about 1.7%.

The key word is nominal. Because the 1.7% yield doesn’t reflect the real change in investor wealth. After factoring in taxes and inflation, investors’ real returns are negative.

Another problem when interest rates are this low is that a small change in yield can have a massive impact on the price of a bond. If yields increase by 1%, the value of the fund will decline almost 10%. If interest rates rise 2%, which would still put yields well below historical norms, this fund would lose nearly 20% of its value.

Several catalysts could send rates higher. A slight uptick in inflation or improvement in the overall economy would encourage investors to rotate out of bonds and into alternatives.

In exchange for this risk: a measly 1.7% yield.

Corporate credit even riskier

The crowding out effect of central bank purchases of government securities is forcing investors to chase yield in increasingly risky securities. Given that these bonds are being priced against artificially priced treasuries, this has to end badly.

Consider Apple Inc. (NASDAQ:AAPL)‘s recent 30 year debt issue. What will the next three decades bring? Higher inflation? New technology? Who’s to say Apple will be relevant five years from now. There’s no reason anyone should reach for a 30-year bond from a good yet risky company.

The hunt for yield is causing a stampede into junk bonds. Global high yield bond issuance reached a record $148.6 billion during the first quarter, up 25% from the same period last year.

Of course, credit risk is nothing new. What’s different today is how little investors are being compensated to take on that risk. Junk bonds and 30-year Apple debt yield only 100 basis points over U.S. Treasuries.

We’re witnessing a “dash for trash,” in which investors are willing to buy any bond that pays a premium rate no matter how risky.

Better alternatives

So where is Buffett investing Berkshire Hathaway Inc. (NYSE:BRK.B)’s $85 billion portfolio? Equities.

Productive assets like stocks are, in Buffett’s own admission, reasonably priced. But in addition to higher potential returns, equities will better retain their real value if inflation makes an unwelcome return.

We can find specific examples in the company’s latest SEC 13-F filing earlier this month.

In of its biggest transactions this quarter, Berkshire disclosed a $376 million stake in Chicago Bridge & Iron Company N.V. (NYSE:CBI). Chicago Bridge & Iron Company N.V. (NYSE:CBI) is an energy infrastructure company that provides engineering, construction, and maintenance services. Boasting some of the world’s largest energy companies as clients, the company is positioned to benefit from the development of America’s shale oil and gas reserves.

Chicago Bridge & Iron Company N.V. (NYSE:CBI) also has a visible growth trajectory with a $25.5 billion project backlog. The company’s purchase of Shaw Group last year for $3.3 billion has also allowed Chicago Bridge & Iron Company N.V. (NYSE:CBI) to expand into nuclear infrastructure construction.

In other notable transactions, Berkshire also added to its positions in American business icons such as Wells Fargo & Co (NYSE:WFC), International Business Machines Corp. (NYSE:IBM), and Wal-Mart Stores, Inc. (NYSE:WMT).

These are businesses with competitive advantages. Defensive moats that will will allow these companies to crank out profits for shareholders for the next five, 10, or 50 years.

Foolish bottom line

Buffett has admitted that he would consider buying bonds under the right circumstances. There are conditions when bonds offer potential for great returns such as if a particular corporate credit issue has been mispriced or there’s room for substantial appreciation if interest rates fall. But that is definitely not the case today.

The article 3 Reasons Why Warren Buffett Hates Bonds originally appeared on Fool.com and is written by Robert Baillieul.

Robert is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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