Learning from Warren Buffett Shareholders Letters – Year 1979 – Part 2 Bonds.

31st August 2024.

Learning from Warren Buffett Shareholders Letters – Year 1979 – Part 2 Bonds.

Dear Investors,

Namaste! This post is relevant in today’s scenario as we have the same situations today – which was in 1980. (1979 letter was sent in 1980). The USA had inflation at 14%. Bond interest rates at 9.5%-10%. Gold prices had moved from USD 450 in 1979 to USD 850 in 1980. Today also the USA has the same situations of higher inflation / higher bond rates and higher gold rates. It’s 40 years but the problem is the same. It makes sense to understand today’s post for your wealth creation.

Insurance Industry Lost Money in Bond Market: -

An extraordinary amount of money has been lost by the insurance industry
in the bond area - notwithstanding the accounting convention that
allows insurance companies to carry their bond investments at amortized
cost, regardless of impaired market value. Actually, that very accounting
convention may have contributed in a major way to the losses; had management
been forced to recognize market values, its attention might have been focused
much earlier on the dangers of a very long-term bond contract.

Our explanation: -

Today also the same situation is going on thanks to accounting standards. Say
you bought a bond of Rs.1 lakh in 2023. Interest rate is 10% and you have
bought it for 30 years. It means you have locked your money for 30 years at
10% p.a. interest.

Now, the current rate of interest has increased to 12%. It means you are losing
2% in interest rates. So, the market will price your bond prices to Rs.98000/-
( your purchase price was Rs.1 lakh) to adjust for the current bond interest rates.
So, when you sell your bond – you will get Rs.98000 plus 10% interest on the
same. It means your bond is in loss!!

Ideally, insurance companies should show the same as loss. But accounting
principles says your bond value is Rs.1.10 lakhs ( Rs.1 lakh principle +
Rs.10000 interest). This means your balance-sheet looks healthy, while it is not
as per the market value of your bonds.

What happens due to this accounting practices?

Say you have to make an emergency payment due to sudden big insurance
claims – akin to 9/11 in the USA. Insurance companies will go and sell bonds to
generate the cash. Since the market price is much lower than their book values –
they will have less cash to pay and due to that they will incur the losses.

Master says: - ( how inflation affected Policy prices and Tenure?).

Ironically, many insurance companies have decided that a one-year auto policy
is inappropriate during a time of inflation, and six-month policies have been
brought in as replacements. “How,” say many of the insurance managers, “can
we be expected to look forward twelve months and estimate such imponderables
as hospital costs, auto parts prices, etc.?” But, having decided that one year is
too long a period for which to set a fixed price for insurance in an inflationary world, 

they then have turned around, taken the proceeds from the sale of that six-month policy, 

and sold the money at a fixed price for thirty or forty years. ( It means they invested
money for 30-40 years while they were not ready to see the prices beyond
the 6 months!!).

Master Says – How does the bond market work?

A cultural lag has prevailed in the bond area. The buyers
(borrowers) and middlemen (underwriters) of money hardly could be expected
to raise the question of whether it all made sense, and the sellers (lenders) slept
through an economic and contractual revolution.

( This is how the typical employee managed companies work. They follow the
rules blindly. If you look at the working of KOTAK BANK while UDAY
KOTAK was at the top and other private banks during that times – you will
understand where the banks focused?).

How Buffett insurance companies invested in bonds?

For the last few years our insurance companies have not been a net purchaser of
any straight long-term bonds (those without conversion rights or other attributes
offering profit possibilities). There have been some purchases in the straight
bond area, of course, but they have been offset by sales or maturities. Even
prior to this period, we never would buy thirty or forty-year bonds; instead we
tried to concentrate in the straight bond area on shorter issues with sinking funds
and on issues that seemed relatively undervalued because of bond market
inefficiencies.

However, the mild degree of caution that we exercised was an improper
response to the world unfolding about us. You do not adequately protect
yourself by being half awake while others are sleeping. It was a mistake to
buy fifteen-year bonds, and yet we did; we made an even more serious
mistake in not selling them (at losses, if necessary) when our present views
began to crystallize.

Harking back to our textile experience, we should have realized the futility of
trying to be very clever (via sinking funds and other special type issues) in an
area where the tide was running heavily against us.

Our explanation: -

Instead of 30-40 years bonds – Buffett bought 15 years bonds with the selling
options. It means he can sell when he wants. But when the prices went down –
he didn’t follow the STOP LOSS and suffered the losses. So, his strategy to buy
flexible bonds and with lower maturity did not help him!!

Master’s final call: -

Overall, we opt for Polonius (slightly restated): “Neither a short-term borrower
nor a long-term lender be.”


Our explanation: -


If you reverse the word LOAN – it becomes NA LO.


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Hitesh Parikh.