Investing in Fixed-Income Securities 151Nowadays, however, he does not engage in arbitrage on a large
scale but rather keeps his excess cash in Treasuries and other short-term
liquid investments. Sometimes Buffett holds medium-term, tax-exempt
bonds as cash alternatives. He realizes that by substituting medium-
term bonds for short-term Treasury bills, he runs the risk of principal
loss if he is forced to sell at disadvantageous time. But because these tax-
free bonds offer higher aftertax returns than Treasury bills, Buffett f ig-
ures that the potential loss is offset by the gain in income.
With Berkshire’s historical success in arbitrage, shareholders might
wonder why Buffett strayed from this strategy. Admittedly, Buffett’s in-
vestment returns were better than he imagined, but by 1989 the arbi-
trage landscape started changing. The f inancial excesses brought about by
the leveraged buyout market were creating an environment of unbridled
enthusiasm. Buffett was not sure when lenders and buyers would come to
their senses, but he has always acted cautiously when others are giddy.
Even before the collapse of the UAL buyout in October 1989, Buffett
was pulling back from arbitrage transactions. Another reason may be that
deals of a size that would really make a difference to Buffett’s very large
portfolio simply do not exist.
In any case, Berkshire’s withdrawal from arbitrage was made easier
with the advent of convertible preferred stocks.
CONVERTIBLE PREFERRED STOCKS
A convertible preferred stock is a hybrid security that possesses charac-
teristics of both stocks and bonds. Generally, these stocks provide in-
vestors with higher current income than common stocks. This higher
yield offers protection from downside price risk. If the common stock
declines, the higher yield of the convertible preferred stock prevents it
from falling as low as the common shares. In theory, the convertible
stock will fall in price until its current yield approximates the value of a
nonconvertible bond with a similar yield, credit, and maturity.
A convertible preferred stock also provides the investor with the op-
portunity to participate in the upside potential of the common shares.
Since it is convertible into common shares, when the common rises, the
convertible stock will rise as well. However, because the convertible
stock provides high income and has the potential for capital gains, it is