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In rare twist, cash may prove better portfolio protector than bonds

If government bonds don’t yield much, move around a lot in value and won’t pay off when your other assets are going down, then their value to investors is far less.

With bond yields at historic lows, cash may now be in a rare period when it offers better portfolio protection and diversification than bonds.

Yields on benchmark 10-year U.S. Treasury notes are just 2.2 per cent, driven nearly 40 basis points lower since March by a rally in bond prices on moderate growth and sluggish inflation.

The yield on cash, of course, is even lower, with three-month Treasury bills yielding just 0.98 per cent, but cash’s usually discreet attractions may now, unusually, mean that its low volatility and more symmetrical risks give it the upper hand over bonds in portfolio construction.

“In a low-return world, the drawdowns from government bonds have been significant,” Alain Bokobza and the asset allocation team at Societe Generale write in a note to clients.

“We find the excess return offered by government bonds over cash is now in negative territory. Due to lower volatility, lower correlation and a similar expected return as for bonds, our (methodology) finds cash a more effective instrument for portfolio protection in the current market environment.”

In dollar terms, the rolling 12-month returns from Treasuries have turned negative and the maximum drawdown – the biggest loss – has increased this year. Clearly, too, with government bonds at such low yields, an investor realistically faces more risk from rising rates, which hit capital values, than potential returns from falling rates.

Perhaps even more importantly, Societe Generale calculates that government bonds are now more highly correlated to a basket of other assets including equities than cash. An uncorrelated asset, one which tends to move less in the same direction, is useful as a diversifier.

Investors diversify, usually primarily into government bonds, not because they expect to make more money in them but because they serve as ballast, keeping a portfolio stable and allowing the owner to take on more risk via high-returning assets like equities than they otherwise would.

Over the very long term, since 1871, the equity-bond correlation has been close to zero, meaning bonds are extremely useful as portfolio insurance, generally moving in the opposite direction to stocks.

That’s changed, perhaps as markets have become more tightly integrated, and Socgen now sees a correlation of about 30 per cent between stocks and the rest of the financial universe outside cash.

If government bonds don’t yield much, move around a lot in value and won’t pay off when your other assets are going down, then their value to investors is far less.

History not kind to cash

To be sure, history has not been kind to cash. In the U.S., cash has averaged an annualized real return of just 0.8 per cent since 1900, compared to 2 per cent for bonds, according to Credit Suisse data. Since 2000, the comparison is even less flattering: cash has lost 0.5 per cent of its value annually in real terms, compared to a 5.1 per cent return from bonds.

Cash has usually had a place in investment portfolios, but its attractions and payoffs are only loosely related to the small yield it generates. Cash is valued by investors for its optionality, meaning cash’s value isn’t in its returns, which are small other than in the rare periods when short-term rates are much above inflation, but in the way in which it can be deployed.

But cash also holds its value better than stocks and bonds during periods of volatility.

A concern now is the not far-fetched scenario in which bonds and stocks both lose value at the same time and at close to the same rate, a contrast to their usual lower level of co-movement.

Investor and historian Peter Bernstein made the case in the 1980s for a portfolio split 75/25 between equities and cash, over the typical 60 per cent equities/40 per cent bonds. Bernstein observed that though cash tends to return less than bonds, it always outperforms when bonds lose money and, he held, would keep pace with bonds about a third of the rest of the time.

Add in lower volatility and you can create a portfolio which takes on more risk in higher-returning assets, be they equities, real estate or whatever you prefer.

The truth is that investors have never faced a period analogous to today – with interest rates this low and asset markets supported so much by monetary policy.

Cash looks better than it usually does, but when in uncharted waters it is usually best to proceed slowly.