Warren Buffett is perhaps best known for his stock picking success. However, he also buys fixed-income securities. With fixed-income investments, Buffett selects between short term cash equivalents, medium-term fixed-income securities, long-term fixed-income securities and arbitrage plays. Buffett doesn’t have a strong preference for which of these categories to invest in, he simply considers which investment will return the highest after-tax return and invests accordingly.
In general, Buffett considers bonds to be mediocre investments. Buffett understands that in an inflationary scenario, the purchasing power of money declines. With confidence on the stability of a currency, Buffett would become more interested in bonds. Buffett also views bonds from a “business-persons perspective”. Most fixed-income returns are set below the returns that Buffett expects as a businessperson.
Buffett knows that the long-term average return on equity for American businesses is 12 percent. If an investment was made in a business that reliably earned 12 percent on equity and the company retained all of its earnings, an initial $10 million investment would be worth $300 million in 30 years. Therefore, in order to earn a businesslike return from a yield paying bond, the bond would have to pay a 12% yield and all coupons paid out would also need to be reinvested at 12%. Comparing the expected returns on investments between bonds and businesses is prudent in making a choice on where to invest.
Its noteworthy that Berkshire has historically held a much smaller percentage of fixed-income securities compared to other insurance companies. In 1993, Berkshire held only 17% of their investment portfolio in fixed-income securities compared to the 60%-80% that most of their insurance peers held in fixed-income securities.