With front-end US interest rates flirting with the zero mark recently, the question of how to manage cash investments in a world of ultralow or even negative yields has been top of mind these days. So I’d like to share my latest thoughts, from an investment treasurer’s standpoint, on how investors with cash positions might navigate this challenging landscape.
Nothing special about ultralow or negative rates
The decline in yields over the past year or so has had a meaningful impact on the search for incremental alpha, particularly in the cash and short-duration space. Many institutional clients need or want to put languishing cash balances to work in an effort to earn additional return. Unfortunately, very liquid, high-quality investment alternatives are unlikely to offer significantly higher yields in today’s environment — so what’s a yield-strapped cash allocator to do?
First, in one sense, it’s important to remember that there’s nothing that “special” about ultralow or even negative rates. What matters most for investors (and for the performance of their portfolios) is the change in the level of yields. For example, going from earning 1 basis point (bp) on cash to -1 bp is really no different than going from 3 bps to 1 bp. The decision of how to invest one’s cash continues to be about choosing the best available investment option, based not only on its yield, but also on its risk and operational ease. That’s always the case, regardless of the prevailing rate backdrop.
What if rates do go to zero or below?
Even if market rates were to go negative, financial custodian rates would likely remain floored at 0%, at least for a while. That was what happened in Europe (although, eventually, many European custodians did introduce negative rates).
Beyond that, it comes down to a simple equation: Incremental alpha is essentially the cash balance multiplied by the rate differential between your various investment options. For example, if the best option earns 5 bps more than the worst, and if cash is 2% of the portfolio, then moving from the worst to the best option only yields 0.1 bp of annualized incremental return. If that best option is not operationally onerous and doesn’t constrain the portfolio, you might as well take it; but otherwise, if cash balances are fairly small and you don’t want to overcomplicate your cash allocation, it may not pay to go for the slight bump in yield.
There are, of course, cash investment options that offer more substantial yield pick-ups, but not without increased risk or decreased liquidity.
So all else being equal, we think that if market rates dip to zero or below, it may make sense to leave cash to go on deposit or into the short-term investment fund (STIF) vehicle the client has set up. There will be exceptions and nuances to consider in certain instances, but broadly speaking, that is the playbook we’re following should yields fall further.
More to come
We believe it is prudent for clients to “tier” their cash allocations. This blog post is specific to the highly liquid “tier 1” cash balances most investors should seek to maintain. In future blog posts, my Wellington colleagues will help investors think through excess cash balances in “tier 2,” which may warrant a higher risk tolerance.