By Harry Goodacre, Strategist, Strategic Research Unit, Schroders
Cash has become more appealing in the recent period of higher interest rates. But while it clearly has merits, there’s also drawbacks, and several other asset classes can complement cash holdings.
Many investors have been attracted by high rates available on cash in recent years. 5% rates in the US and UK and 4% in Europe have been a dramatic change from the near-zero on offer for most of the previous decade. Cash now not only provides investors with a store of nominal value and liquidity but has recently been providing a positive real return.
There’s no avoiding that current cash yields are attractive compared to some other assets. Cash (as proxied here by 3-month US Treasury Bills) is yielding higher than many government bonds and similar levels to many corporate bonds. However, while cash can play an important role in portfolios for many investors, it is not the ‘low-risk’ asset as first seems. For investors seeking income, other options can mitigate some of the downsides of cash, without as much of an increase in risk as may perhaps be thought. In this paper we look at popular assets that are often invested in for income, and assess the attributes and risks that each entails.
Interest rates on cash are currently above inflation – but there’s no certainty how long this will continue.
Locking in the current yields requires taking risk, but maybe less than initially thought…
With the recent declines in inflation, cash currently offers an inflation beating rate. This is not surprising but could be temporary. Central banks have been waiting for confirmation that inflation has been tamed before cutting rates, but once that confirmation is there, then cash rates could follow inflation lower.
For long term investors cash doesn’t provide a stable or even predictable income stream. Interest rates on cash are not constant over time. In contrast, bonds lock in yields for longer. For example, investment grade corporate bonds are currently yielding around 5-6% with an average maturity of 9 years. And given extremely low default losses, for long term investors that are less concerned about short term price movements, these may be an attractive option. Historically investment grade defaults have been very rare, with the average annual default rate being 0.1% of issuers. Even within high-yield where default rates can spike much higher, the long term average annual default rate has been around 4% in the last four decades (2.9% since 1920). And even if there is a default, everything is not lost as recovery rates on defaulted bonds have averaged around 40% over the long term.
When it comes to beating inflation in the long run, equities have outperformed both bonds and cash…
In the long run, equities have beaten bonds which have beaten cash. Over shorter horizons performance can vary, of course. And past performance is not a guide to the future and may not be repeated.
Equities have given a return above inflation for various look-back periods, whether that be in the last 5 years (c.12%) of 50 years (c.7%). Over longer look-back periods such as 20 or 50 years, bonds have also given a greater than inflation return. But it is less the case for shorter look back periods, as in recent years bonds have suffered from the rise in inflation and corresponding higher interest rates. Within bonds, corporate bonds have tended to beat inflation by more than government bonds.
Past analysis also shown that for every 20-year timeframe since 1926, equities have delivered inflation-beating returns. So while stock market investments may be risky in the short run, when viewed against inflation they have outperformed cash in long run. That’s not to say equities haven’t struggled at times during very high inflation periods and not all sectors will have fared equally against inflation.
But investors will need to accept that investing in equities can be a volatile ride…
Equities are more volatile than bonds which in turn are more volatile than cash. But long-term investors should beware of making knee-jerk reactions to increases in equity volatility. For investors that are taking a dividend income they may be less concerned with temporary falls in equity prices. Companies tend to be very reluctant to cut dividends, so income investors may not directly feel temporary weak corporate performance as long as they receive the dividends.
Conclusions
As with all investing there is a trade-off between risk and returns. Current high cash interest rates may appear attractive but over the long term too much invested in cash can have drawbacks. While cash can provide certainty of nominal value, it is exposed to more reinvestment risk than assets such as bonds which can lock in current elevated interest rates for longer. And while past performance isn’t a guide to future performance, over the longer-term equities have done better than cash at protecting against inflation risk. So for long term income investors that are willing to see some price volatility, a diversified mix of asset can be attractive.
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