Sitting on cash? Avoiding the mistakes of Tolkien’s antagonist

In JRR Tolkien’s The Hobbit, Smaug the Dragon lies for over a century atop a vast pile of treasure, guarding a hoarded wealth in the Lonely Mountain. His wariness is absolute, his paralysis embodies risk avoidance. However, his strategy ultimately fails, as even the most defensive of approaches cannot fully protect reserves not put to work.

Although one of literature’s most fearsome antagonists, Smaug’s is a cautionary tale of how hiding away presents its own risks. While he sleeps, the outside world conspires, ultimately leading to his downfall. The dragon pays a high price for sleeping on his fortune.

"After more than a decade of ultra-low interest rates and dragon-sized central bank asset purchases, a reversal of these policies presents widespread risks."

Excessive cash risk

Today’s investors can perhaps identify with Smaug’s insecurities, if not his character or motives. After more than a decade of ultra-low interest rates and dragon-sized central bank asset purchases, a reversal of these policies presents widespread risks. In these circumstances, it can be tempting to hoard the safest of assets: cash.

But the outside world may have other ideas. Inflation continues to rise, reaching its highest levels in decades, increasingly eroding the real value of investors’ ‘treasure’. This is particularly evident in the European insurance sector, where hundreds of billions of euros in cash are thought to sit uninvested on insurers’ balance sheets.

Insurers have good reasons to stay cash rich. Liquidity is essential for meeting liabilities and, against an uncertain financial, macroeconomic and geopolitical backdrop, adding risk goes against many instincts. But rising inflation suggests that hoarding excessive cash is a likely way to lose serious amounts of money in real terms over the long term.

Cash alternatives

Fortunately, there are degrees of risk one can take. Cash may be the safest asset class, but there are others that can potentially offer a modest, but still significant, premium while keeping expected default and credit risks low.

The first step out of cash for many investors is usually government debt. Short-dated yields are already pricing in anticipated central bank rate rises. However, these securities present material duration risks, which means investors should be prepared to hold them until maturity.

Short-dated corporate bonds may offer some potential additional opportunities to earn a yield premium, although arguably not at an aggregate level, given the outsized weighting of lower-rated issuers in many investment grade indices. A notable feature of corporate bond markets is spread dispersion – that is, a relatively wide range of spreads available on bonds with identical credit ratings – which can help investors to manage relative risks and rewards.

High-grade asset-backed securities (ABS) are often overlooked, given their association with high capital charges under the Solvency II framework. However, the asset class offers floating rate coupons alongside a potentially compelling level of income compared to equivalently rated corporate bonds.

It is worth noting that European ABS do not share the historical default experience of their US counterparts. European residential mortgage-backed securities (RMBS), for instance, have averaged defaults of 0.3% p.a. across all credit ratings (including high yield) since inception  – a period that includes double-digit interest rates in the 1990s and the 2008 global financial crisis – compared to 4.9% in the US¹.

Heading off inflation

That is not to say that an entire cash balance can be replaced by higher-yielding alternatives. However, thinking more strategically about cash allocations that are unlikely to be committed over the next 6-12 months could be a helpful strategy to help protect capital. Financial markets are unpredictable, and the catalysts for change unknowable, but insurers may still wish to venture down from the Lonely Mountain to head off the inflation stealing their treasure.

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¹S&P Global, Annual Global Structured Finance Default And Rating Transition Study, May 2021

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.