Warren Buffett is known for preferring stocks to bonds. But with yields on UK government bonds having increased by over 300% over the last three years, could bonds be worth a look?
Bonds
Buffett’s first reason for staying away from bonds is that the returns aren’t high enough. A 4% yield might seem good, but there’s more to it than meets the eye.
Inflation in the UK is currently running at around 10% per year. Getting 4% more cash when the value of that cash is depreciating at 10% means that bond returns are actually negative in real terms.
Rising interest rates are likely to bring inflation down. But the UK’s central bank is aiming for inflation at around 2%.
With 2% inflation, a bond with a 4% yield will return just 2% in real terms. Even over 30 years, it’s going to be difficult to make significant returns at that rate.
Stocks
Buffett also thinks that, over time, stocks generally outperform bonds. The reason is that bonds have fixed returns, whereas stock returns can grow.
A £1,000 investment would distribute £45 per year in annual payments. These could be reinvested to eventually distribute a total of £2,281.
I think that there are stock investments that I could make today that have a good chance of generating more than this over the next 30 years. One example is Diploma shares.
At today’s prices, Diploma shares offer a return of 3.58%. The stock has a market cap of £2.77bn and the underlying business has £254.5m in debt, £24.8m in cash, and generates £107.5m in free cash.
That’s lower than the 4% offered by the bond today. But I think that the stock can catch up and outperform the bond over 30 years.
Diploma has increased its free cash flow by an average of 12.5% each year. If this continues, then the company will provide a greater annual return than the bond within three years.
After that, if it continues to grow, it will leave the returns from the bond in the dust. If Diploma grows its free cash at 5% annually for the remaining 27 years, the total investment return will be £10,147.
That’s over four times the return from owning the 30 year bond for what I think is a realistic scenario for Diploma. As a result, I think Buffett is right that it’s better for me to own stocks than bonds.
Investing risks and rewards
Investing in stocks is riskier than investing in bonds. This is especially true with a stock like Diploma.
In order to outperform the 30-year bond, Diploma has to grow its free cash flow. If the business falters or doesn’t grow fast enough, the stock will underperform as an investment.
But it’s on track to achieve the required growth reasonably comfortably and I think that it will. So with the opportunity to buy shares in companies like Diploma on offer, I’m following Buffett’s advice and staying away from bonds.