In the current market environment, there may be good reasons for investors to consider increasing their portfolio’s allocations to cash, according to a new report by Mercer.
At the end of August 2019, cash yielded more than long bonds, says Dave Makarchuk, partner and Western Canada wealth business leader at Mercer, noting Canadian 91-day treasury bills yielded 1.62 per cent and Canadian long-term federal bonds, with the same credit risk, yielded 1.46 per cent.
Cash is a good liquidity tool and may have other benefits, he adds. “In the short term, the yields are materially the same as inflation. And for some investors that’s not so bad.”
It also has the potential to provide some dry powder in case the market corrects and then investors are in a better position to move into something else.
Of course, long-term investors aren’t typically holding a lot of cash because it has limited return potential. “The downside of holding cash is that it’s still only 1.6 per cent; it’s not a positive real return,” says Makarchuk. “For longer-term investors, we’d still recommend a diversified portfolio of pretty much anything else other than long bonds. Whether it’s equities, whether it’s private markets, whether its private debt, private equity, infrastructure, real estate — we expect all of those to have a higher return over a [10-year] period with conviction.”
While the Mercer report doesn’t advocate holding more cash for its return potential, it does make the case for holding more cash to help with risk management.
“From a pure return perspective, it’s potentially less risky than long bonds,” says Makarchuk. “If the yield curve moves up at all, long bonds could get hammered and hammered hard. They’ve done amazing this year, but we’re in a situation where it’s quite easy to see long bonds lose 10 per cent.”
Through mid-August, long-bond investors posted a return of about 16 per cent. As such, if the yield curve returns to where it was, investors could lose that percentage, says Makarchuk. “There’s not a lot I’ll promise people, but you’re not going to lose 16 per cent in cash. But can I promise a bond investor that you won’t lose 16 per cent in a long-bond portfolio in a short period of time? Absolutely not.
“All that has to happen is we have to go back to where we were at the beginning of the year, which was not an unusual place to be. Today is the unusual place to be.”
For defined benefit pension plans, it’s important to remember that, while cash is a low volatility asset, it’s still not a good match for pension liabilities, he says. “Sponsors should be rethinking whether they should be hedging long pension liabilities in September 2019 the same way that they did one, two, three, five [or] 10 years ago, whenever they decided whatever their prior duration was.
“But be cognizant of the fact that our expectations for return for longer fixed income are a whole lot lower than they used to be and that cash could provide a better return, with a lot less risk over the short term.”