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Warren Buffett on Junk Bonds, Part 1

Warren Buffett (Trades, Portfolio)'s extremely enviable record is undoubtedly a product of his investing acumen. But it is also a product of his ability of soberly assess the risk profile of a given investment. Over the last seven decades, he has lived through many bubbles and periods of folly, and has lived to tell the tale (unlike many others). In the early 1990s, he correctly diagnosed the damage that junk bonds had done to investors' returns - an issue he explored in his 1990 letter to shareholders of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B).

Not your classic fallen angel

In 1990, Buffett made the decision to enter the market for below-investment-grade bonds by adding to his holding of RJR Nabisco bonds. This, as he acknowledged, was a little out of character for Berkshire. However, he was willing to do this because he understood the underlying business, and thought the opportunity was too good to pass up:

"We will look at any category of investment, so long as we understand the business we're buying into and believe that price and value may differ significantly. (Woody Allen, in another context, pointed out the advantage of open-mindedness: 'I can't understand why more people aren't bi-sexual because it doubles your chances for a date on Saturday night.')"

Buffett had purchased similar bonds before, though they were, in his own words, "old-fashioned fallen angels" - that is, bonds that used to be investment grade, but fell out of favor when the companies issuing them fell on hard times. Crucially, he made a distinction between such investments and "junk bonds" - bonds that were significantly below investment grade even when they were first issued. These became popular during the excesses in the 1980s, which saw credit standards deteriorate over the course of the decade. This, predictably, led to a problem:

"The disciples of debt assured us that this collapse wouldn't happen: Huge debt, we were told, would cause operating managers to focus their efforts as never before, much as a dagger mounted on the steering wheel of a car could be expected to make its driver proceed with intensified care. We'll acknowledge that such an attention-getter would produce a very alert driver. But another certain consequence would be a deadly - and unnecessary - accident if the car hit even the tiniest pothole or sliver of ice. The roads of business are riddled with potholes; a plan that requires dodging them all is a plan for disaster."

While this "dagger thesis" does hold some water - it definitely leads to more aware drivers - it also reduces the margin of safety considerably. Everything has to be absolutely perfect to avoid catastrophe. And, as we know, real life is rarely perfect. Junk bonds delivered good yields for investors right up until they no longer did. And when they didn't, the fallout was painful.

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.