- Cash provides high flexibility in terms of availability and purchase power.
- The costs of holding cash have meaningfully increased.
- Investors often overlook concentration risk and risk management in general for cash investments.
- There are ways to minimize the effect of negative interest rates, whereas a popular one is the “Liquidity Plus” concept, that targets to achieve a minimal positive yield, while accepting only very limited additional risk with daily liquidity.
When Liquidity is Essential
Owning Liquidity is not only essential when there is a crisis. Having a well balanced approach to a diversified asset allocation, liquidity plays an important role. The management of this asset class is essential because cash not only represents the safety aspects but also provides the highest flexibility when it comes to availability and purchase power. It is overall accepted that holding cash provides none or little compensation. It is therefore key to manage the risk where the liquidity is held and that holding liquidity is not penalized with sub-zero rates, something that got evident in Europe.
In order to stimulate the economic growth in the Eurozone, the European Central bank had introduced negative interest rates back in 2015. Since then, it has reiterated its goal to keep rates low for longer given the structural soft macroeconomic and inflation outlook the Eurozone is facing. Hence, the phenomenon of low interest rates will not change any time soon.
EURIBOR in % since 2014
The graph illustrates the historical development of the EURIBOR rate since 2014. After a period of stable (negative) yields, the downward pressure has re-emerged in Q2 2019.
Source: Bloomberg, Alpinum IM
Evidently, individuals are now paying banks to hold their CHF/EUR denominated money depending on the bank’s imposed threshold for sub-zero rates. To rephrase it, negative interest rates imposed by a central bank effectively mean commercial banks are required to pay for holding excess reserves with the central bank. This has direct implications on financial markets and the price level of every asset class. Ultimately, an investor needs to understand what this means for his welfare if interest rates remained at zero or sub-zero levels for a prolonged period of time.
The costs of holding cash has increased on three levels
- “Absolute” as the negative or 0% interest rate on the bank account leads to a loss of money on the account at latest after banking fees are charged,
- “Relative” as other [more risky] asset classes get more attractive on a relative basis vs. cash and
- “Real” as investors not only lose money on a nominal perspective, but even more so on an inflation adjusted basis.
Therefore, it is imperative to visualize the consequences on a medium term perspective, i.e. the expected “opportunity costs” of holding cash over a 3 or 5 years horizon. For example, on an inflation adjusted basis, an investment of EUR 100’000 would be worth only EUR 92’500 after 5 years if the inflation rate would on average be similar as in the last 10 years (~1.5%) and if the interest on the bank account was negative -0.5% p.a. on top of this, the amount would shrink to only EUR 90’000, what is equal to a loss of -10%.
There are multiple ways to address or minimize the effect of negative interest rates, whereas a popular one is to identify investment concepts to achieve a minimal positive yield, while accepting only very limited additional risk and holding liquidity constant. Therefore, three factors need to be harmonized and optimized among themselves: A) Return, B) Risk and C) Liquidity
- Return is defined by the annual target yield of the investment – i.e. 5% p.a.
- Liquidity is expressed in time units until the money is available and shall not be meaningfully sacrified.
- Risk is defined as the probability of permanent loss of capital (loss given default) and shall be held at a minimum.
Cash represents a variety of excellent attributes besides being a valuable asset class in a diversified asset allocation. Most importantly, it provides highest flexibility in terms of availability and purchase power. In this respect, it is accepted to earn a lower yield compared to other asset classes. Another essential characteristic of cash is the safety aspect, which has not changed despite the low or negative interest rate environment we are faced with. However, a variety of risk factors need to be considered, whereas the “default risk” (loss given default) is clearly the most prominent one. So, the ultimate avoidance of weak counterparties is a necessity. Other risk factors include: Liquidity, mark-to-market and concentration.
In practice, “concentration” risk is often underestimated as a risk factor and therefore, cash tends to be hoarded at one or very few counterparties only. However, concentrated cash positions can become a killing in case a counterparty faces a problem. Hence, it is advisable also to perform an active management for a cash position to avoid unwanted or unforeseeable risks.
An optimal cash portfolio is diversified across strong counterparties (avoiding concentration), offers daily liquidity and is overseen by an active risk management.