Buffett's Lesson on Inflation and Bonds

ByDon Dion

NEW YORK (TheStreet) -- Warren Buffet's Berkshire Hathaway has shifted its portfolio towards bonds with shorter maturities. The sage investor eschews gold as an asset, but is tightening up the Berkshire portfolio as inflation concerns weigh on his mind.

The representation of bonds in Berkshire's portfolio with a year or less until maturity has increased from 16% in early 2009, to 18% as of March 30 this year, and to 21% as of June 30. This shift means that the average maturity of the entire bond portfolio has been getting shorter.

A portfolio heavy in long-term bonds is locked into today's low interest rates. As interest rates increase, long-term bonds lose value because the market readjusts relevant securities to account for the new interest rate. If these rates increase enough, the price of the bonds may fall below par value. In contrast, short-term bonds reach maturity, at which point the investor can reinvest the principal at a higher interest rate.

Investors expecting a spike in interest rates can follow Berkshire's moves by overweighting their fixed income allocation in short-term bond ETFs such as iShares 1-3 Year Treasury. They can go even more short term with iShares Barclays Short Treasury Bond.

Aggressive investors who want to speculate on the same strategy can buy ProShares UltraShort 20+ Year Treasury, which delivers double the daily inverse of the index tracked by iShares Barclays 20+ Year Treasury.

If investors are wrong and interest rates fall, holding SHY means investors will forego higher interest rates and some capital appreciation in longer-dated bonds. If they're wrong and they hold TBT, they could suffer staggering losses. TBT is down about 30% in 2010 and nearly 20% in the past three months, which is why this fund is only for speculation and should not be confused with fixed income ETFs.

Another strategy for investors expecting inflation is inflation-protected securities: iShares Barclays TIPS is the ETF play here, although investors can also use mutual funds such as Fidelity Inflation Protected Bond.

The principal of a TIPS bond is adjusted based on the CPI. If interest rates move higher with the CPI, these bonds should do well, but if for some reason interest rates increase greater than inflation, TIPS will behave more like long-dated bonds that lack inflation protection.

The portfolio moves by Berkshire come as Buffett has repeated his forecast for higher inflation thanks to deficit spending by the U.S. government; if higher interest rates are in the cards, he's made the right play.

But Buffett has also said that all currencies could lose value. Back in May, while the world was anxiously watching Europe's response to the Greek crisis, he claimed that government responses to various debt crises around the world made him "more bearish on all currencies."

An asset that holds its value against widespread currency devaluation is gold, but Buffett sees no use for the metal, as I discussed in Professor Buffett's Anti-Gold Lesson .

On this score I disagree with the Oracle because adding gold to a bond portfolio offsets the risk that currencies will not hold their value. ETFs such as iShares Comex Gold offer investors easy access to the yellow metal.

The downside of gold investment is that it doesn't always protect against moderate inflation. If the inflation rate went back to 3% to 5% and the economy enjoyed stable growth, gold would probably decline in price as investors shed safe haven assets, as was the case during the 1980s and 1990s.

Buffett may also be wrong in his inflation expectations. Bond giant PIMCO would argue against his claims, instead stating that deflation may be the bigger threat, and that low rates will be with us for some time.

If this is indeed the case, shifting bond assets into shorter maturities will be costly to investors, as I outlined above. However, if deflation results in cheaper asset prices, investors may ultimately come out ahead as long as their principal is protected.

Therefore, in uncertain times, investors worried about deflation should gravitate towards the most secure debt, that of the U.S. government or blue chip corporations with manageable debt levels. ETFs such as TLT will tend to deliver some of the largest gains as long as rates are falling across the board.

At its heart, Berkshire's move is a conservative one. In all cases, shifting from long-term to short-term assets is a hedge against uncertainty, with cash as the ultimate example of the latter category. Whether Buffett is right or wrong on inflation, Berkshire's fixed income portfolio is better positioned for a change.

-- Written by Don Dion in Williamstown, Mass.