Thursday, December 23, 2010

Investing PART 4: Same genre, different tune

Beetles and Kingsmen aren’t your style? How about the Rolling Stones’ “Give Me Shelter?”

“Gimme, gimme shelter or I’m gonna fade away,” so say the Stones. Well, shelter is what cash is. By now you may have figured out that I don’t hide from risk. It really isn’t that hard to manage. Cash is a shelter that I seek to minimize. Cash isn’t the only shelter, but it does seem to be the one with the least potential.

Some investors try to “move to cash” as a market-timing effort. Others realize building up cash only makes sense if you can’t identify any better alternative. Cash is almost never the best shelter for any reasonable period of time, but not being the best is better than being the worst.

Even when cash does seem competitive, a portfolio will generate cash as assets reach sell points, come due or are called, or generate interest and dividends. In that sense, just not reinvesting the cash a portfolio will generate is fading away. Other than not investing until or unless you see an opportunity, building up cash beyond the level described in PART 3 doesn’t make sense. Keep in mind PART 3 can imply a cash position as large as a few years’ living expenses if you’re living off your investments.

Ultimately, what cash does is hedge the risk that other assets will become illiquid. For that purpose, it can’t be replaced. However, there are close substitutes. Since we could be talking about a few years’ cash needs, how it is held isn’t trivial for most people.

One close substitute to consider is a bond or bond-like instrument that you can call. Sound strange? They are offered from time to time. For example, no penalty CDs (i.e., CDs with no interest penalty if cashed in before maturity) were attractive at one point. FDIC insured no penalty CDs certainly meet the need for access to cash.

A ladder of appropriate maturity FDIC insured CDs or Treasury notes can meet the need. Remember we might be talking about covering a few years’ of cash needs. If you’re covering a few years, not all the cash needs to be available from day one. Keep in mind the yield curve generally is upward sloping so a two year note pays more interest than a 30 day note. Once constructed, that means you’re holding a ladder of maturity dates, but all CDs or notes have two year maturity. It’s the maturity dates, not the lengths of the bonds, that form the ladder.

Another option worth watching is Savings Bonds (I Bonds indexed for inflation or EE Bonds with a variable rate pegged to a percent of the 5 year Treasury). The Government periodically changes the terms of I Bonds and EE Bonds. Right now the Government seems to be bent upon making Savings Bonds unattractive, but there still are advantages. They can meet immediate cash needs until after they have been held for a year (with an interest penalty) and after 5 years the interest penalty is dropped. So, after 5 years they are totally liquid. (Interest is federal tax deferred and state and local tax free).

It is possible to reduce the pain associated with the lack of return on cash, but it is important to remember that the purpose is to have cash available when needed. Any instrument has counterparty risk. The options discussed above place that risk with the government. Governments issue cash; so, the counterparty risk doesn’t really change.

Similarly, once FDIC insurance was extended to money markets, counterparty risk was shifted to the government for money market funds too. However, money markets funds hold short-term assets. They don’t take advantage of the common theme of the alternatives discussed. Assets with maturities further into the future generally pay higher interest. No penalty CDs, ladders, and Savings Bonds take advantage of the higher yield characteristic of longer maturity assets without sacrificing liquidity.

Recent events like the freezing of the auction rate market for munis and the impact of the liquidity squeeze on the ability of some money market funds to redeem at a dollar per share illustrate another potential risk. Any cash instrument that provides liquidity based on the ability to sell the underlying asset introduces market risk. Thus, other near cash instruments will be discussed along with other investments in subsequent postings.

1 comment:

  1. I got a request for clarification on Saving Bonds. Right now, don't touch them. I Bond have virtually no real return and EE Bond have a fixed, laughingly low rate until maturity. Put bluntly, the Governmennt isn't paying you for the risk associated with lending them the money. But, as stated, the Treasury changes the structure of Savings Bonds from time to time. So, watch of opportunities perhaps with a new administration.