Questions you can ask your UBS Financial Advisor
- What are the benefits of cash alternatives?
- What cash alternatives should I consider?
- How can CDs fulfill some of the benefits of cash while minimizing opportunity costs?
Investors may be considering holding more of their portfolio in cash, in light of increasing market volatility. However, cash comes with high opportunity costs. Cash alternatives such as CDs could fulfill some of the benefits of cash while minimizing the opportunity costs.
Cash and cash alternatives are appealing for a number or reasons, explains Leslie Falconio, Senior Fixed Income Strategist Americas, with the Chief Investment Office (CIO). For one, it’s impervious to volatility in stock and bond markets. This may hold a particular attraction for investors at the moment. Cash is also highly liquid, meaning the holder can access his or her money in an instant.
“Investors who require all of the benefits of cash – for instance those investors facing a significant short-term liability, such as the down payment for a house or a pending debt repayment – are unlikely to find an equivalent substitute that offers higher returns with the same total risk. Holding cash or a cash alternative on account is likely to be the best option,” says Falconio. “But those willing and able to sacrifice one or more of those benefits may be able to earn higher returns, while maintaining those features they value the most through cash alternatives.”
Certificates of Deposit (CDs) are fixed income investments that generally pay a set rate of interest over a fixed period of time. The interest rate is determined by money market conditions and the period of investment. A minimum amount required may also apply. There isn’t market risk for CDs in the sense that the promised interest rate is fixed and the principal is fully repaid in the case of a no credit/default event. There is a duration risk, however. For example, if interest rates increase, the deposit holder has an opportunity cost by foregoing higher prevailing market rates. There is also an element of liquidity risk. The classic certificate of deposit is a fixed term solution where the assets are locked according to the chosen tenor. Early withdrawals are sometimes possible, but not without penalty.
One way of mitigating short term market risk is to invest in a CD ladder, according to Falconio. “Laddering CDs to meet liquidity needs can mitigate short term risk from panic selling while earning a higher yield compared to cash,” she explains.
Depending on how frequently an investor may need access to capital, various maturity ladders may be created. “Creating CD ladders as a means of matching asset/liability cash flows can enhance overall yield with a minimal give-up in liquidity,” points out Falconio.