Alternatives in a low-interest-rate environment
There is a saying that ‘cash is king’ which reflects the belief that holding cash is more valuable than any other form of asset. Certainly, keeping a certain amount of cash on the side for rainy days can be a reasonable strategy. However, over time, it can come at a rather large cost, especially when the cash component becomes a significant portion of the portfolio.
Albert Einstein is said to have stated that “compound interest is the eighth wonder of the world. He who understands it, earns it...he who doesn’t, pays it.” Thus, investors with a large cash position pay a high price in terms of lost performance, as the money just sits around. In this context, cash is like any asset: if you put it to work, it works for you.
The price of holding cash
Today, the price of holding cash in major European currencies is even greater as major central banks have kept deposit rates to historically low levels. The European Central Bank (ECB) was the first to move its deposit rate into negative territory, closely followed by its peers. Hence, investors holding EUR, CHF, SEK and DKK cash are being penalised as local central banks continue to pursue negative interest rate policies. Our analysts do not believe that the situation will improve any time soon. Quite to the contrary, the ECB who sets the tone in Continental Europe, is likely to loosen liquidity conditions to address slower growth and tighter lending standards.
Negative central bank rates across Europe
EUR: -0.40% (ECB deposit rate), CHF: -0.75% (SNC 3-month libor target rate), SEK: -0.25% (Riksbank reference rate), DKK: -0.65% (Denmark’s National Bank deposit rate). Data as of 12 March 2019. Source: Respective central bank websites.
Unpleasant effects on pensions
The challenge of low to even negative interest rates is magnified by the fact that life expectancy is on an upward trajectory. Hence, the risk that people’s accumulated savings are inadequate to sustain a desired living standard as they grow older is increasing. For example, according to the World Bank, the life expectancy at birth in the European Union has risen from 75 years in 1990 to over 80 years in 2016. Thus, it is even more essential than ever that investors plan ahead when it comes to their savings. In our view, this means that unneeded cash in a portfolio should be put to work to generate more interest or a greater rate of return over time.
In this context, we think it is the right time for investors to consider a reallocation of their portfolios and to make a portion of their cash work for them, while taking into account their personal situation. Specifically, they may
- Stay with quality
Investors could consider gaining exposure to bonds issued by highly rated sovereign or corporate issuers in order to preserve capital. By actively managing a fixed income portfolio, an additional yield pickup can be generated. Risk can be actively managed – not only by being diversified, but also by focusing on bonds with a short duration.
- Invest with the reassurance of capital protection
Investors could consider structured products that offer the reassurance of capital protection at maturity and allow them to gain exposure to the performance of a financial asset like a stock, fund or interest rate product. Depending on the product, they may participate in the underlying asset’s upside to varying degrees and protect the capital either entirely or partially.
- Enhance the portfolio’s yield
A yield enhancement product may provide a yield pickup in return for the willingness to take on downside risk in a financial asset, such as a stock or a currency pair. This type of product can be used as a building block to complement portfolios. Yield enhancement products can be tailored to strike the right balance in terms of return and risk, while taking into account the investor’s overall portfolio exposure.
In keeping with Albert Einstein’s famous observation: Understand it, earn it.