Cash is a low-yielding asset but has other virtues


EVER Had the feeling that there is a party somewhere that you are not invited to? It’s the same feeling investors have when they have capital in three-month notes or on deposit with a bank. Money is a safe asset, but a waste. The real returns on risky assets have been much higher. It is true that cash offers options: buy low when others sell. But the troubled selling episodes were fleeting, in large part thanks to central banks, which have been liberal in providing liquidity in times of emergency. Why then should investors bear the opportunity cost of owning them?

In its favor, cash at least now offers a small return, or the prospect of one. Overnight interest rates have increased, especially in Latin America and Eastern Europe. The Bank of England could raise its benchmark interest rate before the end of the year. The Federal Reserve could follow suit at some point next year. But the short-term money market rate of return is still below the rate of inflation and is expected to remain so. For those seeking returns, holding cash remains a deficit prospect in real terms.

The real appeal of cash as a portfolio asset lies elsewhere. More and more capital is tied up in investments, most of the benefits of which lie in the distant future. You see it in the huge market caps of a handful of tech companies in America and in the money pouring into private equity and venture capital funds. Investors have to wait longer and longer to get their money back. In the meantime, their portfolios are vulnerable to a sharp rise in interest rates. A simple way to mitigate this risk is to hold more cash.

The concept of “duration” is useful in this regard. Duration is a measure of the life of a bond. It is related to, but subtly different from, the maturity of a bond. Duration takes into account that part of what is owed to bondholders – the annual interest, or “coupon” – is paid earlier than the principal, which is returned when the bond matures. The longer you have to wait for coupon and principal payments, the longer the term. It is also a measure of how the price of a bond changes as interest rates move. The longer the duration of a bond, the more sensitive it is to a rise in interest rates.

You can also think of investing in stocks in terms of duration. Take the familiar price-earnings ratio, or PE, the price paid by investors for a given level of stock market profits. The idea is that if an action has a PE out of ten, based on recent earnings, it would take ten years to recoup the down payment from an investor buying the stock today, assuming earnings hold constant. If the PE at 20, it would take 20 years. The PE is therefore a crude measure of the duration of the action. On this basis, US stocks as a whole have rarely had a longer duration. The cyclically adjusted price-to-earnings ratio, a valuation measure popularized by Robert Shiller of Yale University, is now close to 40. It was only higher at the height of the dotcom boom in 1999- 2000.

The rationale for longer-lived assets is familiar. Long-term real interest rates are about as low as they have ever been. As a result, returns on investment, even in the distant future, when discounted, have a high value today. It’s not just actions. The property is valued at a high price relative to the flow of future rents. Investors are cramming into private equity and venture capital funds that won’t pay off for a decade or more. Everyone, it seems, is long-lived. But with a longer term comes a greater risk that unexpectedly aggressive interest rate hikes lead to a collapse in asset values.

A typical investment portfolio made up of stocks, bonds and real estate is vulnerable to this risk. There aren’t a lot of good ways to cover it up. Buying insurance in the options market against a stock market crash is expensive and time consuming.

This is where cash comes in. Cash is by definition a short-lived asset. If interest rates were to rise sharply, holders of cash would quickly benefit, even if other assets would suffer. So, as the duration of your portfolio increases, it makes sense to increase your cash flow as well. On how much precisely will depend, as always, your appetite for risk. Just as you are advised to sell your stocks at the level where a night’s rest is assured, you can also increase your liquidity to the point of sleep.

Of course, such a strategy has an opportunity cost. As long as asset markets continue to explode, liquidity will be a drag on your portfolio. So be it. Missing out on some returns is the price to pay for mitigating duration risk.

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This article appeared in the Finance & Economics section of the print edition under the title “For the duration”

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