Cash is Trash: Financial Risks for Conservative Savers

Conservative savers covet cash and fixed income securities, for supposed safety of principal. On the surface, fixed income may appear safe, in comparison to the stock market. Beyond day-to-day volatility, all investors are very much familiar with the 2008 Great Recession, when the market took a nearly 40% beating.

Still, all financial products introduce distinct risks, and cash and fixed income securities are no different. Intelligent investors balance potential risks versus rewards through the economic cycle and transact business accordingly.

Fixed Income Securities 101

Fixed income, or credit securities, are loans made between investors, business interests, and government institutions. In exchange, investors collect interest at a fixed rate, until principal is repaid at maturity.

Lenders are granted senior asset claims above shareholders. Management declares and pays cash dividends on shares at its discretion, while remaining legally bound to pay interest on debt. Lenders are to be paid first, in the event of bankruptcy.

The fixed income space would include U.S. treasuries, corporate bonds, mortgages, and money market securities. Be further advised that money market securities are separate from money market deposit funds, which are FDIC insured.

Credit Risks

Credit risks apply to the chances for a particular borrower to default upon debt. Default is a prelude to bankruptcy, which means that loan principal might only be repaid for pennies on the dollar. Credit risks spike amid business recession when borrowers fail to generate sufficient cash flow for debt service.

Moody’s, Standard and Poor’s, and Fitch are the Big Three credit rating agencies that analyze issuer ability to pay. The U.S. Government is historically the gold standard, for its ability to tax and create money to honor debt. Now, Johnson & Johnson and Microsoft are the two remaining AAA rated corporations.

Investors demand higher rates as compensation for financing riskier projects for extended periods of time. 30-day treasuries, for example, pay out far less interest relative to junk bonds attached to businesses on the brink of bankruptcy.

Interest Rate and Reinvestment Risks

Higher rates undercut valuations for existing debt already in circulation. New credit securities would then pay out more interest, which means that old debt must sell for a discount to attract any investors.

Alternatively, falling interest rates support higher fixed income prices. Old bonds would then sell for top dollar when new credit securities are issued paying out meager investment income. Reinvestment risk immediately emerges as a concern, with fewer viable opportunities to park cash when older debt matures.

The Federal Reserve Board influences interest rates through monetary policy. The Fed has driven its federal funds rate from zero to 5.25% in two short years. Policymakers are attempting to contain the inflationary repercussions from massive COVID-19 government spending and cheap money.

Inflation Risks

Inflation destroys purchasing power over time. Alarmingly, the U.S. Dollar has lost 96% of its value since 1913, when an Act of Congress created the Federal Reserve.

The U.S. dollar is backed by full faith and credit. Hawks are quick to highlight $35 trillion in National Debt as the logical fallout from Washington being unshackled from any real gold reserves. In effect, Big Government may simply create money to buy votes. Money, like anything, is debased through increasing supply.

Real returns subtract out inflation away from nominal returns. By these calculations, fixed income might offer zero for long term investors. For several years running, European and Japanese savers were actually besieged by negative rates.

According to billionaire investor Ray Dalio:
Cash is Trash.

Financial Strategies

A diversified portfolio featuring credit securities, stocks, bonds, and real estate will mitigate downside risks, while also allowing for upside growth potential.

Onyx Investments will recommend a gradual shift towards higher fixed income allocations over time, for clients approaching retirement. In the interim, cash management and fixed income products are more so ideal savings vehicles for intermediate goals, like start-up business or first-time home purchase financing.

Lastly, opportunity cost is the silent, yet most dangerous risk for conservative savers. Ed from accounting would have already retired a multi-millionaire had he have bought shares of Apple stock, rather than maxing out his 401(k) at work, only to load up on index bond funds.