Are cash and bonds really the safest investment options?

How safe are cash and bonds? Dominic McCormick discusses the state of these asset classes and whether the perception that they are investment safe havens is accurate.

Cash and government bonds have been seen as safe havens during the global financial crisis, having been the only two major asset classes to post positive returns in 2008.

But how safe are these asset classes really, especially looking forward?

Do large allocations to bond and diversified fixed interest funds and continued large inflows to, and weightings in, cash and term deposits make sense?

I suspect many financial advisers and investors are not fully appreciating the risks with such an approach in the current environment.

Investors who exited shares and property in the panic and de-leveraging of the last year may already be seeing some of these risks highlighted in the permanent losses that have been locked in and the dramatic underperformance of cash and bonds in the last three months or so.

Certainly, the strong rally in all risky assets since early March seems to be causing (and partly reflecting) some rethinking on these defensive strategies.

Take bonds. At the beginning of this year, US 10-year treasury bonds were yielding around 2 per cent per annum, while Australian 10-year government bonds were yielding 4 per cent per annum, both near record lows.

While such levels were based on deflation and depression fears, a valid question was whether those yields made sense in any scenario.

When it comes to future returns and risks for any asset, starting valuations are paramount. For a US investor buying a 10-year treasury bond in early 2009, around 2 per cent per annum was the best they could expect if held to maturity.

Expecting further capital gains in the interim from rates falling even more was arguably speculation rather than investment.

The risk of short-term capital losses if rates rose was clearly very high. If Armageddon was already priced in, anything less was always going to deliver a poor result to investors.

Warren Buffet described the situation in his letter to investors on March 6, 2009: “When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the US Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.”

US 10-year treasury yields have since risen to 3.5 per cent at the end of May. Australia never reached the same level of speculative excess, but local 10-year bonds have also risen sharply to 5.3 per cent.

Most conventional local and global bond funds are therefore down sharply this year to the end of May, and most diversified fixed interest funds are also negative despite the strong rally in credit related securities.

After such a big move, some retrace is likely, but it is worth noting that these higher current yields are only back to where they were in October 2008 and are still very low relative to history.

Unless we are definitely heading towards deflation, bonds hardly look to be attractive value here. Further capital losses are quite possible.

Meanwhile, the fundamentals to justify these low yields have been deteriorating. Sure, inflation does not look like this year’s problem but given enormous government and central bank stimulus, it is clearly a rising risk for the future.

Massive budget deficits will require enormous new issuance of bonds. The US budget deficit will be around 13 per cent of gross domestic product (GDP) in 2009, with the UK around the same level.

Australia is in a better situation at around 5 per cent of GDP for 2008-09, but this is a massive deterioration in a short period.

Indeed, Government deficits of some $6 trillion have to be financed globally this year. When the supply of something (government paper) increases dramatically, all other things being equal, the price should fall (and rates therefore rise).

As one commentator, Martin Hutchinson, said: “If governments were companies, you wouldn’t touch their stock with a 10-foot pole.”

Given this, who in their right mind was lending money to the US Government at 2 per cent per annum?

Passive fixed interest funds and those fixed interest funds heavily tied to their benchmark have little choice.

Then there were the many nervous investors blindly chasing a perceived safe haven at very low yields without understanding the rapidly deteriorating fundamentals.

Meanwhile, China and Japan, which own almost a quarter of US federal debt, are becoming increasingly nervous themselves.

Not only are they facing losses from rising rates but also from currency losses as the US dollar weakens. Across the Atlantic there is talk that the rating agencies may downgrade UK government debt.

Is the US next? What happens if investors sour on all government bonds as an asset class? Clearly their role as a safe haven would be under serious threat.

What about cash? In much of the developed world, cash rates are such that investors are receiving near zero on their ‘safe’ investment in cash. Australia is in a more fortunate position where investors can earn at least a couple of per cent and a little more on term deposits.

Depending on your risk profile, holding some cash makes sense and even aggressive investors should have access to some cash to pursue opportunities when they arise. Building up some cash by taking profits during strong market rallies can also be sensible from an asset allocation perspective.

The key risk to both cash and bonds is that inflation could be significantly higher at some point in the not too distant future.

The unprecedented actions of governments and central banks have created huge uncertainties for the inflation outlook.

The implications for bond markets of higher inflation are obviously negative.

But committing to a large strategic holding in cash for long-term clients given record low interest rates and significantly improved risk premiums on other asset classes seems like a flawed strategy.

Normally, cash rates would be expected to respond quickly to inflation, thereby giving investors some form of buffer (while being detrimental to long-term bond holders).

However, there is a risk that central banks will be slower to react in raising rates in this cycle given the ongoing financial and economic impacts of the current crisis, even once a recovery develops.

Further, there is a risk that higher inflation may actually be sparked by currency dislocation and fading confidence in the economic policies being applied, which may cause inflation to rise even while economies remain mired in recession.

I am not suggesting that investors should not hold some bonds in defensive portfolios. After all, diversification makes sense and the deflation scenario, while looking less likely, is still a possibility.

Meanwhile, the rise in bond rates in recent months has improved valuations marginally.

Further, holding some cash is always useful as a source for opportunities no matter how low the cash rate.

But having cash and bonds make up the bulk of a long-term portfolio in the current environment is, in my view, quite dangerous.

The idea that a conventional capital stable type portfolio that is made up of 70 per cent to 80 per cent cash/fixed interest (dominated by government bonds) and 20 per cent to 30 per cent shares and property is defensive may well be tested again in much the same way that it was tested in 1994.

Then, bond rates rose sharply, causing large losses to capital stable funds, much to the surprise and eventual anger of both advisers and investors, who incorrectly assumed that capital stable was akin to capital guaranteed.

However, it could be worse this time around because bond yield starting levels are almost half the level they were back then and the pressures on government finances are greater, in addition to the possibility that many retired investors may have switched to these defensive funds/portfolios given the recent volatility in share and property markets.

Investors therefore need to get smarter about building the defensive component of their portfolios.

Credit securities, despite the pain in the last year, should be part of a well diversified fixed interest portfolio.

A core holding in inflation-linked bonds can also make sense.

Even well-selected mortgages (in the right structure) can add to diversification.

Some diversified fixed interest funds with truly flexible mandates are well placed to exploit these various opportunities, but I would be wary about some more restricted funds that tend always to have a large benchmark holding in governments bonds.

Outside the fixed interest area, other inflation hedges like gold and commodities also make sense. Fund of hedge funds failed as defensive vehicles in 2008, but the case for some exposure to well-selected hedge funds remains strong.

The jury is still out on whether the rally in risk assets from early March is a bear market rally or a new bull market. A strong rally was inevitable given the excessive pessimism that developed and even bear market rallies can go much further than many expect.

On the other hand, the speed with which many investors have moved from extreme pessimism to optimism and begun deploying cash is actually not supportive of the new bull market case.

Normally, such optimism only comes slowly when a genuine major bear market bottom has been reached.

Valuations for risky assets have also quickly lost some of their ‘cheapness’ from earlier in the year.

Still, key issues for those investors who have chased the safe havens of cash and bonds is not that they have too much in equities, nor a failure to appreciate the risks that come with equities (that’s probably why they moved to cash/bonds in the first place).

Rather, it is holding far too much of a long-term portfolio in cash, term deposits and bonds thinking they are safe, and not appreciating the particular risks of holding large weightings in them.

Again, Warren Buffet’s March 6 letter said it as well as anybody: “Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long.

"Holders of these instruments, of course, have felt increasingly comfortable — in fact, almost smug — in following this policy as financial turmoil has mounted. 

"They regard their judgement confirmed when they hear commentators proclaim ‘cash is king’, even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.”

Ultimately, there are no asset classes that are ‘safe’ in the sense that they can be relied upon to always preserve and enhance value for a long-term investor.

It is crucial to recognise that starting valuations are a key variable to future returns, the approach to asset allocation should be flexible enough to deal with a range of investment scenarios and that sensible diversification is crucial.

If investors take this perspective, they will be in a much stronger position to be proactive rather than reactive when difficult times arrive.

In my view, it is this ability to remain proactive in tough times that will separate those who come through the financial crisis with robust portfolios and as committed ongoing investors.

On the other hand, those who have become reactive, impatiently dumping badly performing assets and chasing the latest ‘safe havens’ irrespective of price (including many structured guaranteed products) have simply set themselves (or their clients) up for a continuous cycle of disappointment. Indeed, many such investors have or will ultimately lose all faith in the investment industry to the detriment of their own long-term wealth (and that of the industry).

On a practical and emotional level such behaviour is understandable, especially when you consider that many investors had very poorly structured portfolios in the first place, notwithstanding the worst financial crisis in decades.

Many were too geared, had too many poorly structured or flawed investments or simply were not adequately diversified.

In any case, the financial planning industry faces enormous challenges to regain the confidence of these investors.

Sensible and open communication and decisions on asset allocation issues such as those raised above is an important step in what is going to be a long road back to building investor confidence.