Tuesday, August 24, 2010

What Buffett Thinks About Interest Rates

In a news article a couple weeks ago Bloomberg reported that Berkshire Hathaway had been shortening the duration of their bond portfolio. Unlike maturity, duration considers the sensitivity of interest rates and expresses the effective time the bond will be paid back, inclusive of coupon payments .

Bloomberg wrote that the holdings due to mature in less than a year were increased from 16% in 2009 to 21% this past quarter. Though not a significant increase, it was consistent in his Buffett's comments from late last year; "the United States is spewing a potentially damaging substance into our economy - greenback emissions, unchecked greenback emissions will certainly cause the purchasing power of currency to melt.”

Bonds have a precise inverse relationship with interest rates. An increase in interest rates will lead to a decrease in bond prices and vice versa. The logic is simple. If the Treasury was issuing 3% 30 year T-bonds this year and interest rates shoot up to 6% next year, those holding the bonds paying 3% will be stuck with that coupon payment for the next 29 years. The new batch of T-bonds will be offered at the going rate; 6% and demand for 3% bonds will naturally decrease. So in Berkshire reducing the the duration of their bond portfolio, they reduce the risk that interest rates increase and they're left with holding longer dated bonds that would have diminished in value.

Buffett has regularly mentioned the difficulty in predicting where interest rates will go. He mentioned much about this in the early 1980's annual reports. That may explain the relatively minor changes to the bond portfolio. The deflationary threat is more imminent at the moment, but far too often we forget who is manning the Federal Reserve. Ben Bernanke has shown as deep a concern about deflation as any economist. He earned the nickname "helicopter Ben" because of his reasoning (borrowed from Milton Friedman) that deflation could be fought by dropping money from helicopters. Though I wouldn't speculate and short bonds, I think the case for a stagnant Japan-type economy is overdone. In the 1980's the Volcker Fed successfully squashed inflation. If the economy were to dip into a steady deflationary rate, I can't imagine the Bernanke Fed sitting on their hands.

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