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Fixed Income

While our approach to equity investing has changed very little in the last 20 years, one aspect of how we invest in fixed income has changed beginning about five or six years ago. From the early 1980s until fairly recently, the dominant characteristic of the credit markets was a gradual squeezing out of the inflation that had built up during the late 1960s and 1970s. This process resulted in a pronounced decline in zigzag fashion of long-term interest rates, accompanied by periodic financial disasters. Holders of the highest-quality long-term bonds were handsomely rewarded.

But interest rates are not likely to go to zero; it seems more likely that long Treasury rates will fluctuate in a fairly narrow range depending on financial conditions, for the foreseeable future. The opportunity for big profits on long-term bonds is much diminished so we have tended to keep durations short.

What has not changed in our approach to fixed-income investing is our aversion to credit risk. (Owning a defaulted bond is truly a miserable experience.) Probably the biggest mistakes I have seen in my investing career involved not investors who lost taking a flier on some speculative stock—they knew in advance that it was a flier and allocated resources appropriately, i.e., sparingly—but investors who unwittingly took inordinate credit risk in order to earn a few extra percentage points over the going risk-free rate. If I am going to risk all my capital on an investment, I want the prospective reward to be more than a few additional percentage points; I want the prospect of hundreds of extra percentage points. For that kind of return I look to the stock market.

Thus our bond accounts hold only top-quality government, government agency, mortgage-backed, corporate, and municipal securities, depending on the client’s circumstances. Junk bonds are generally excluded, as they too often live up to their name.

Nevertheless, opportunities do present themselves in the bond market and we are always interested in taking advantage of them. These opportunities tend to arise when credit spreads, that is, the difference between what the most credit-worthy borrower, the U.S. Government, and what the rest of us have to pay for money, blow out to unreasonable and probably unsustainable levels. When this happens, we have the chance to buy heavily discounted non-Treasury debt at prices that provide us with highly satisfactory current, cash-on-cash returns, and capital gains when spreads return to more normal levels which in turn are reflected in higher prices for our bonds. The most obvious example occurred during the financial meltdown in late 2008 and early 2009 when credit spreads blew out to levels not seen since the depths of the Great Depression in 1932. In this case, perfectly good government agency, municipal, and corporate bonds were available at prices that offered returns commensurate with returns normally only associated with the best common stocks, but at considerably less risk. We were happy to make substantial allocations to the fixed income market in 2008, 2009, and 2010, and were well rewarded for our trouble. Similar chances for gain arose in the early 2000s as concerns over corporate debt became exaggerated in the wake of the Enron and Worldcom bankruptcies, and in the late 1990s after Russia’s default significantly depressed the debt of nearly all developing nation debt.

We are cautious but opportunistic participants in the fixed income markets.

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