E.VER HAD the feeling that there is a party going on somewhere that you are not invited to? It’s the same feeling investors get when they have the capital on a three-month bill or on a bank deposit. Cash is a safe asset, but it is wasteful. The real returns on risky assets were much higher. True, cash offers options – buying cheap when others are selling. But episodes of emergency sales were fleeting, largely thanks to the central banks, who have been generous in providing cash in emergencies. Then why should investors bear the opportunity cost to hold them?
In its favor, at least now, cash offers a small return or the prospect of one. Call rates have risen, especially in Latin America and Eastern Europe. The Bank of England can raise its key rate before the end of the year. The Federal Reserve could follow suit sometime next year. But the return in the short-term money markets is still and is likely to remain below the rate of inflation. For those looking for returns, holding cash in real numbers remains a losing prospect.
The real appeal of cash as an asset lies elsewhere. More and more capital is being tied up in investments with a large part of the payout in the distant future. You can see this in the huge market caps of a handful of tech companies in America and the flood of cash in 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. An easy 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 the maturity of a bond, but is subtly different from it. Duration takes into account that part of what the bondholders are entitled to – the annual interest rate or “coupon” – will be paid out earlier than the principal that will be delivered when the bond matures. The longer you have to wait for coupon and redemption payments, the longer the duration. It’s also a measure of how much the price of a bond changes when interest rates change. The longer the duration of a bond, the more sensitive it is to rising interest rates.
You can also think of capital investment in terms of duration. Take the well-known price / earnings ratio, or SPORTS, the price that investors pay for a certain amount of stock market profits. The idea is that when a stock is a SPORTS out of ten, based on recent earnings, it would take ten years to regain the spend of an investor buying the stock today, provided earnings are constant. If the SPORTS 20, it would take 20 years. the SPORTS is therefore a rough measure of the duration of the share. On this basis, American stocks seldom had a longer duration overall. The cyclically adjusted price / earnings ratio, a valuation measure popularized by Robert Shiller of Yale University, is now close to 40. It was only higher at the dizzying height of the dot-com boom in 1999-2000.
The rationale for assets with longer maturities is known. Long-term real interest rates are lower than ever before. As a result, investment returns, once discounted, have a high value today even in the distant future. It’s not just stocks. Real estate is valued at a high price in relation to the flow of future rents. Investors are piling up in private equity and venture capital funds that won’t pay off for a decade or more. Each, it seems, is long-lasting. However, the longer duration increases, the greater the risk that unexpectedly aggressive rate hikes will lead to a collapse in assets.
A typical investment portfolio of stocks, bonds, and real estate is exposed to this risk. There aren’t many good ways to hedge it. Buying insurance in the options market against a stock market crash is expensive and tedious.
This is where cash comes in. By definition, cash is a short-term asset. If interest rates were to rise sharply, cash holders would quickly benefit, even if other assets suffer. So if the duration of your portfolio increases, it makes sense to increase your cash holdings as well. How much exactly depends, as always, on your willingness to take risks. Just as you are advised to sell your stocks to levels that will ensure a good night’s sleep, you can also build your cash holdings to sleep.
Of course, such a strategy comes with opportunity costs. As long as the asset markets continue to boom, cash will weigh on your portfolio. So be it. Missing out on some returns is the price you pay to mitigate duration risk.
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This article appeared in the Finance & Economics section of the print edition under the heading “For the duration”