When Does Buying Bonds Make Sense?

I mentioned in an earlier post that when buying index funds, it makes sense to value it based on earnings yield of AAA grade bonds.

But when does it make sense to buy bonds when all index funds are indeed overvalued versus the earnings yield of AAA grade bonds? I used to think it was whenever the overvaluation occurred until I stumbled upon this quote from Warren Buffett:

“We could take the $16 billion we have in cash earning 1.5% and invest it in 20-year bonds earning 5% and increase our current earnings a lot, but we’re betting that we can find a good place to invest this cash and don’t want to take the risk of principal loss of long-term bonds [if interest rates rise, the value of 20-year bonds will decline].”

The point of parking money into bonds is to have a safe haven where permanent loss of capital is minimized while still being able to generate a return on it, which means that two criteria must be fulfilled before parking cash into bonds when index funds are overvalued, which is:

  • The P/E & P/B multiple of index funds are above earnings yield of AAA grade bonds
  • Interest rates of short term, mid term and long term US treasury bonds are flat

As explained by Preston Pysch, Every time the US Department of The Treasury thinks the economy needs more inflation for economic growth, the yield curve of short term, mid term and long term US treasury bonds is a S curve trending upwards from low short term interest rates. When the US Department of The Treasury thinks the economy needs to cool down, the yield curve of short term, mid term and long term US treasury bonds will trend a flat line to discourage borrowing by making it expensive.

What this implies is, if the US treasury bonds resemble a S curve, even if I can’t predict when interest rates are going to hike, the fact is that it is going to hike some day, which present a risk of permanent loss of capital since bond values decrease when interest rates increase. The opposite is also true.

This checklist thus helps me better make the decision of going all cash or all bonds when index funds are overvalued.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

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