Financial Times - Bond proxies: Can you afford not to own them?

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” Warren Buffett once said.

 

I agree with Mr Buffett’s description of a good company. To quote from his 1979 annual chairman’s letter: “The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry etc) and not the achievement of consistent gains in earnings per share.”

 

What Mr Buffett is describing is return on equity capital and despite this guidance more than 35 years ago from one of the world’s most successful investors, his advice continues to be ignored by most.

 

One of the objections levelled at investors who attempt to invest along the lines which Mr Buffett suggested — and I would count myself as one of them — is that the sort of companies with these characteristics may be too expensive. This concern has reached fever pitch recently, with myriad warnings about what will happen to so-called “bond proxies” when US interest rates rise.

 

A “bond proxy” is shorthand to describe equities such as consumer staples and utilities with safe, predictable returns, but have higher yields than much of the bond market (and, crucially, yields which can grow over time).

 

Bond markets have experienced a bull run since the financial crisis and the onset of quantitative easing, which has seen central banks pump billions into buying their own governments bonds, and a disinflationary environment which has led to the sister policy of zero interest rates. Faced with seemingly ever-lower yields, investors have crowded into equities in general and especially those which are considered “bond proxies”.

 

The obvious problem is what happens if — or when — interest rates rise. Bond yields then rise and those equities which have been used as bond proxies will surely fare badly.

 

I would suggest a slightly less simplistic approach.

 

Let’s start with the assumption that interest rates will rise. Eventually that must be true, but when and by how much is less easy to predict. The “when” has some bearing on the matter. There are a number of fine fund managers who have had their performance shredded by attempting to time this and other events.

 

The “how much” also matters. In my view we remain in a disinflationary environment with a mostly weak economic recovery, so the rise when it comes may not be anything like the gradient which we have come to expect from previous recoveries. Short-term interest rates may be at or close to zero and may rise, but they are of less significance in valuing bonds and equities than long-term rates, and US 30-year Treasuries already yield over 3 per cent. This yield may not budge much.

 

If you are worrying about bond proxy equities in this scenario, you might also like to ask yourself where you will put the money that you realise from selling them. Into cash? Good luck with your timing. Into bonds? I think not. Into other equities? Maybe, but the S&P 500 Index’s price/earnings ratio is 19x, so it’s not that they are obviously cheap, and most of the Index is much more heavily cyclical than the bond proxies, making it an interesting choice if you are seeking safety in a rising rate environment. One thing we can be sure of is that the stocks in the index are not of the same quality as the so-called bond proxies.

 

If you are a long-term investor you should own the high-quality bond proxies and close your ears to the siren song of those who say a rate rise will cause you problems

There is another quote from Mr Buffett’s business partner, Charlie Munger, on this subject: “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6 per cent on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6 per cent return — even if you originally buy it at a huge discount. Conversely, if a

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