PORTFOLIO POINT: Investors need to understand that the best hedge against inflation is often cash, in its many variants, but some are stronger than others.
What does the word 'cash’ mean to you? If you think about it, you will realise how slippery a concept 'cash’ is.
Is cash physical notes and coins? Is it an at-call savings account with a bank? Is it a term deposit? Could cash be a AAA-rated, floating-rate, major bank 'covered bond’ that you can trade in and out of every day (subject to a minimum $500k investment)?
What about the senior floating-rate bonds Australian banks issue, which can also be traded every day in $500k parcels, and are eligible for sale directly to the RBA?
Starting to sound a little confusing, isn’t it? And then how do these new 'hybrids’, which offer, say, 3-4% per annum over the 'cash rate’, and are being marketed as a cash-like investment, fit in?
Finally, are 'cash management trusts’ cash?
Very few Australians could answer all these questions accurately, including educated professionals who work in finance. Yet the secular increase in consumer risk-aversion triggered by the onset of the global financial crisis – which led to a 50% fall in Australian sharemarket values, and which has echoed through the European sovereign debt ructions that caused a 15% drop in local share prices last year – has made all investors acutely sensitive to 'risk’ and 'capital preservation’.
Separately, most Australians are overweight domestic and listed equities, and most people understand what losing money is about. Today, minds are turning to what returns they can realistically hope to achieve.
Over the long term, you should be targeting returns that get you a premium above the rise in the cost of goods and services (aka 'inflation’). In Australia, inflation has averaged about 3% per annum over the last 20 years. With the likes of the US Federal Reserve, Bank of England, Bank of Japan, and European Central Bank now all printing trillions of dollars, pounds, yen and euros to boost their ailing economies, the chances are that inflation will be higher, not lower, during our lifetimes. So if you can lock in a 'real’– or after inflation – return of 3% to 4% per annum, you are probably doing well.
One fact few financial advisors understand is that probably your best hedge against inflation is actually 'cash’. Here people get confused between fixed-rate bonds, or 'fixed-income’, and cash and floating-rate bonds. Australia’s central bank, the RBA, targets keeping inflation low as its main policy objective. This means that if we do get an outbreak of high inflation, interest rates will rise, just like they did in 2007-08 prior to the GFC, or during the late 1980s.
My first chart below shows the long-term relationship between the RBA’s official cash rate and Australian core inflation. People forget that banks were paying up to 15% on deposits in the early 1990s. The chart demonstrates that there has been a historically very close relationship, or correlation, between inflation and the RBA’s cash rate.
Almost all at-call bank accounts, short-dated term deposits, and floating-rate bonds 'price off’ the RBA’s official cash rate. So if you are worried about inflation or high interest rates, bank deposits and floating-rate bonds are the best place to be.
In contrast, a traditional fixed-rate bond has a price that moves in the opposite direction to interest rates. This is why people think that 'bonds’ are bad during high inflation periods. If you have a government bond paying you a fixed, say, 4% per annum, an increase in market interest rates above this level will generally reduce the value, and hence price, of your bond. The converse is also true. You can therefore make or lose a lot of money owning fixed-rate government bonds.
Last year, for example, long-term Australian government bonds gave a total return of around 30% because there was a huge decline in market interest rates (driving up their price).
On the other hand, at-call deposits and floating-rate bonds allow you to directly benefit from higher inflation and interest rates. As my second chart shows, if you could invest in a 'cash’ security that gave you about 1% above the RBA’s cash rate, you would have earned, on average, a 4% per annum after-inflation return.
So let’s turn to the tricky task of defining what 'cash’ really means. Physical notes and coins issued by the RBA are cash. But they offer you no return. In fact, thanks to inflation, their value falls by about 3% per annum, which is the rate at which all the goods and services you consume typically rises by.
An at-call bank account is a form of quasi-cash that pays you an interest rate. According to the RBA, the average annual interest rate on transaction accounts is 0%. Online savings accounts give you about 4.35% per annum, which is a little above the RBA’s 4.25% cash rate. The average 'bonus’ bank account does a bit better again, returning about 5.0% per annum.
On average, the banks earn about 2.4% per annum more than what they pay you in your bank deposit through their lending activities.
One bizarre feature of our financial system is that when you put money in the bank, and therefore lend to it, your deposit is not “valued” every day. This is odd. Whether you invest in bonds, shares, or managed funds, you receive regularly pricing on the value of your investment.
To cast this point into sharp relief, consider the AAA-rated 'covered bonds’ launched by CBA in January. These are senior-ranking and secured, and arguably safer than a bank deposit (above the $250,000 government-guaranteed threshold). You can also invest in 'floating-rate’ versions of these bonds that track changes in interest rates. Importantly, if you invest in a CBA covered bond, it will be revalued every single day reflecting the financial market’s best estimate of the credit risk associated with CBA.
Yet when you invest in a CBA bank deposit, you get no such benefit. You are led to believe, quite incorrectly, that you are taking no credit risk on the bank. If you are above the government guarantee, there is a remote possibility you could, in a crisis, lose money.
The banks’ covered bonds are rated AAA, which means they are actually safer than the banks themselves, which have a lower AA- rating. These covered bonds and the senior-ranking loans issued by Australian banks to institutional investors are also eligible for sale to the RBA under its so-called 'repurchase agreements’. That is, the RBA stands willing to buy these assets off a qualified counterparty at any time.
Since they can be traded every day, and are more secure than a bank deposit, I’d argue they are as good as 'cash’.
A long-dated term deposit is a little different, since it is the same as a fixed-rate bond. If you lock yourself into a term deposit for one to two years, you are taking a bet on the future direction of rates.
While the term deposit is not revalued every day (it should be, since if you break it you are hit with big penalties), it will offer you inferior/superior returns depending on whether interest rates rise/fall. And you are once again taking credit risk on the bank that offers you the TD.
A popular new investment product are so-called 'hybrid’ securities, which I previously warned readers about in these pages, only to have ASIC issue a similar caution a few days later.
There are many sneaky catches with hybrids that you have to look out for. They are marketed as offering a 'premium’ return to a bank deposit, and therefore seem like one. But they are not.
Under most hybrids, the company has the option to stop paying you interest for five years, which makes the investment effectively 'equity’ (i.e. you are losing out). If the hybrid has received a high 'equity credit’ from a rating agency, you know you are being stiffed: the rating agency basically thinks the company is asking you to take equity risk for debt returns.
Another catch with hybrids is their term. Most have terms ranging from 25 years to 60 years. They are like perpetual debt – i.e. the company has no obligation to repay your principal for an incredibly long time. They therefore look, smell, and feel like equity.
If the risk associated with the company issuing the hybrid increases, the value of it will fall and you will realise a loss on your investment. This happened recently with the banks’ listed hybrid securities, which were 'repriced’, which is a euphemism for saying investors started demanding higher returns from these investments given a reassessment of their risk.
Finally, one has 'cash management trusts’ or 'treasury’ funds. These are investments that are managed by professionals who typically put your money into institutional bank deposits, term deposits, and the floating-rate bonds issued by governments, banks, and high quality ('investment grade’) companies. If the strategy is conservative, and yields return above bank deposits – which they can – and the fund allows you to move your money in and out with ease, it can make sense to include such investments in a diversified portfolio.
In principle, a well-managed cash or treasury trust should be no riskier than a bank deposit without a government guarantee. The advantage is that cash funds can take out the middle-men’s (i.e. banks’) 'earn’ or 'spread’. That is, the 2.4% per annum banks, on average, keep above what they pay you.
Christopher Joye is a financial economist and a director of Yellow Brick Road Funds Management.