Short-term thinking is gold
Cash in the form of coins is acknowledged to have first been invented around the 6th or 5th century BC by the Lydians in what is now modern-day Turkey.
The first Lydian “Lion” coins were made of an alloy of gold and silver called electrum, which forms the basis of the now established visage of the gold coin.
Fast forward many centuries, and the most common form of money sits in abstract electronic form in the ledgers of commercial banks as deposits all around the world. The core business of banking is taking the risk of translating these short-term deposits – ‘TDs’ – into longer-term loans to other activities in the economy, such as mortgage or business lending, for a profit margin.
With overnight cash rates at 0.75 per cent and the potential to drop further, advertised 1-year TD rates from the big four banks are now around 1.20 per cent to 1.45 per cent, causing investors to seek out alternative investments to replace the low risk income they used to receive from such deposits. Cash is the second-largest asset allocation within SMSFs, which collectively hold around 21 per cent of their total assets, or $157 billion dollars (30 July 2019, ATO) in cash and TDs at banks.
Product providers have risen to the occasion with high-yielding investment products and structures that generally have a few common factors. They either promote high-dividend yield equities (which have no maturity date and rank last when it comes to security of capital), hybrid securities from banks (which have an uncertain maturity date and rank just above equities in terms of capital security), or they invest substantial amounts in lower credit quality bonds and/or less liquid private loans to corporates.
Thus, what links a lot of these income replacement products together is locking up money in securities with long-term or uncertain “return of capital” maturity dates, and/or lending to less credit-worthy counterparties. It is a substantial step-up in risk from term deposits.
Despite central banks’ trying to push investors into riskier assets by lowering interest rates, the case for holding a cash allocation during uncertain and volatile markets is increasing. We think what investors prize most about cash and TDs is that they are short-term investments – you can get your capital back with its principal value intact quickly when you need it, in exchange for a modest return.
And in offering an investment strategy that aims to outperform cash and TDs without taking too much additional risk, this type of thinking should be paramount.
An investment team with this strategy prioritises low expected volatility (being the average daily variation of prices), seeks securities that are highly liquid (meaning the securities can be bought and sold quickly without moving the price much), pays a regular income and importantly, seeks to lend to only the better, more resilient, borrowers in the world.
Borrowers like the big four Australian banks and systemically important global banks like Citigroup and Bank of America, monopoly infrastructure providers like Sydney Airport, EastLink toll road in Melbourne, Transurban, and Australian mortgage-backed bonds, benefit from the world-class credit quality of Australian home owners.
Rather than accepting low returns from traditional cash investments, by expanding their universe to global fixed income markets investors can uncover many “gold-plated” lending opportunities that while they are not guaranteed, seek to mimic the risk and performance characteristics one would historically expect from shorter term, cash-like instruments but with regular income and higher expected returns of about 2 percent to 3 percent above cash rates over the medium term.
The oft-used cliché in investing is to invest for the long term, and that certainly is the mindset you need when investing in riskier and/or less liquid income-seeking asset classes. But in building portfolios suitable for investors who want to recover some of the lost yield from cash and term deposits, it can pay to think short term – shorter term maturity portfolios comprising bonds issued by stable and reliable borrowers, typically referred to as “investment grade”, meaning they have a strong capacity to pay you back.