Fixed Income Investors “Face a Bleak Future”
Warren Buffet’s Annual Shareholder Letter: Fifty-One Years of Wisdom
Since 1970, Warren Buffet’s annual letters have been a must read for almost any investor in any asset class. Buffet, widely regarded as the greatest investor of all time with returns that have consistently beaten the market for decades, oversees the powerhouse conglomerate Berkshire Hathaway that invests in a diversified portfolio of public and private companies in every industry from energy to finance, transportation, insurance, and even consumer goods. His insights are uniquely all encompassing, and his words are anything but hollow. Usually, his annual shareholder letter has a general sense of optimism, especially when it comes to betting on the U.S. economy. So when investors see words like bleak future, shaky borrowers, inadequate interest rates, and juice the pathetic returns in the 2021 shareholder letter, they tend to stand up and notice.
Fixed income investors rely on interest rates, which have been trending down for nearly 40 years. In his letter, Buffet writes:
“Can you believe that the income recently available from a 10-year U.S. Treasury bond – the yield was 0.93% at yearend – had fallen 94% from the 15.8% yield available in September 1981? In certain large and important countries, such as Germany and Japan, investors earn a negative return on trillions of dollars of sovereign debt. Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future."
It's no surprise that Buffet point blank summarizes the dire straits that fixed income investors face: “Bonds are not the place to be these days.”
Bonds Are Not the Place to Be These Days
Today, fixed income investors in the United States find themselves in a compromised position. The economy is in a protracted recession because of the COVID-19 health pandemic. The traditional playbook for the Federal Reserve would be to infuse cash into the economy in order to jumpstart the economy. This is usually done very carefully since too much cash can lead to uncontrolled inflation, which would then increase the yield seen on traditional fixed income investments. However, globalism has thrown a giant monkey wrench into the equation, as the fixed income securities in most developed countries (including Germany and Japan, which Buffet mentioned) are yielding negative interest rates. The result is that international fixed income investors are purchasing U.S. treasuries. Even though the rates are low in the United States, they are still positive, which looks a whole lot better than crossing over to the negative interest world. This unexpected series of events is keeping the yields in a tight low-yielding range with 10-year treasuries hovering around 1% for the majority of 2020 and 2021. The worst part of it all is that fixed income investors in the United States now have to compete with yield-starved investors all around the world that are salivating for 1%.
How Alternative Investments Can Help Fixed Income Investors
Alternative investments, especially real estate, have a built-in inflationary hedge. When wages rise, tenants can pay more rent, preserving the value of your investment capital. A typical apartment building that is purchased reasonably well can yield a middle to high single-digit annual return. The industry term for the annual return is your cash on cash (COC) return. This is without factoring in any gains an investor may see due to appreciation if the property is later sold. As an investor in apartments buildings, you don’t have to compete with foreign investors pushing down the yields. This allows you to focus on researching local markets instead of obsessing about what’s happening overseas.
With the average lifecycle of an apartment building investment being only 3–7 years, you can also access your money considerably earlier than when your 10-year bond comes due. I won’t even mention 30-year bonds! In most cases, you would have gone through two cycles with apartment buildings from start to finish before that bond fully matures.
Full Faith and Credit of the U.S Government
In 1971, the United States abandoned the gold standard for the U.S. dollar. This was a monumental shift in economic policy because the United States was no longer required to adhere to limiting the currency in supply to the amount of gold in supply. Overnight, the only backing the U.S. dollar had was the “full faith and credit of the U.S government,” which is derived from Article IV, Section 1 of the U.S. Constitution. The full faith and credit of the U.S. government pledges that the U.S. has the power to tax and raise revenue while having the ability to borrow. With the ability to borrow comes the obligation for the country to repay its obligations in a timely manner. It’s important to note that there has to be revenue coming in for the full faith and credit backing to mean anything. Without revenue, the U.S. wouldn’t be able to pay its obligations, and if that ever happens, there wouldn’t be much “faith” or “credit” left in the U.S. dollar.
When fixed income investors justify the returns they are receiving from U.S. treasuries, they cite the perceived safety of the investment. While there are merits to that perceived safety, full faith and credit is actually just another way of saying a preferred return.
A Preferred Return
In most commercial real estate investments, a preferred return is a return that’s earmarked to the investor before the operating partner sees any profit. Many deals are structured such that the investors put up the majority of the capital, while the operators use their expertise to source, operate, and sell a property. The preferred return aligns the interests of the investor and the operator. If the preferred returns aren’t distributed right away, the operator’s obligations to pay them remains intact. Usually, the decision to pay the distributions are a direct result of the revenue collected by the property, which the operator has the power to charge and collect on—very similar to the “full faith and credit” relationship with the U.S. government.
Maybe Not Such a Bleak Future?
Sometimes, it no longer makes sense to play the hand you’re dealt. My impressions from Buffet’s remarks are that it may be time to look at a different vehicle for yield because bonds the short- to medium-term outlook on bonds is bleak, quite frankly. The good news is that vehicle may not be as different as you think it is. Alternative investments—and commercial estate in particular—can offer many of the benefits seen with treasuries, but with a considerably more attractive yield.
Disclaimer: The information presented in this article is for informational purposes only and does not constitute professional financial or investment advice. The author does not make any guarantees or promises as to the results that may be obtained from it. You should never make any investment decision without first consulting with your own financial advisor and conducting your own research and due diligence. Even though, the author has made reasonable efforts to ensure that the contents of this article were correct at press time. The author disclaims all liability in the event that any information, commentary, analysis, opinions, advice and/or recommendations contained in this article results in any investment or other losses. Your use of the information in this article is at your own risk.
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