All serious investors are familiar with stocks and bonds, but they may not recognize the value of cash and cash equivalents in their portfolio.
Cash is a portfolio diversification tool as well as a way businesses generate higher returns in the short-term.
Managing cash and cash equivalents was once considered a boring afterthought to investors and financial managers. It is now regarded as a distinct asset class, complete with its own benefits.
What Are Cash Equivalents?
Cash and cash equivalents are highly liquid, short-term instruments that can be used for emergencies, opportunistic purchases of stocks and bonds, or to pay for expenses. Since they don't fluctuate much in value, cash equivalents have a core role in any portfolio.
What Are Some Examples of Cash Equivalents?
The most common types include:
- Commercial paper
- Treasury bills
- Certificates of deposit
- Short-term government bonds that mature in three months or less
This category also includes marketable securities and money market holdings since they are liquid and don't suffer from price fluctuations, according to the Investopedia.
For individual investors, the most common cash equivalents are:
- Savings accounts
- Short-term bonds
- Money market funds
But this category also includes some less common instruments such as bank overdrafts. These are bank borrowings that must be repaid to the bank on demand. As such, they are a key element of a company's cash management operations.
Banker's acceptances are also in this category and are used in commercial transactions (often international trade) since the bank guarantees the payment as opposed to an individual account owner. These payments are often paid within 90 days of being issued, but the payment period can extend to 20 days.
Cash Equivalent Strategies for Individual Investors
The historic low returns in government bonds have pushed many investors into cash and money market funds. This happens in low-rate environments, but it can change quickly as rates rise and fall.
When the gap between long- and short-term rates closes, it makes cash and cash equivalents more appealing.
When long-term rates hover at low levels, they indicate low inflation. For investors that want income, they have to consider the trade-off between a low-yielding, volatile 30-year bond and the safety of a money market account.
Managing cash in low-interest-rate environments
Many investors overlook the role of cash management. This is because cash management is an essential part of financial planning and emphasizes the importance of liquidity management.
Individuals and businesses both need a predictable income stream for their daily living and operating expenses.
Since cash equivalents depend on short-term economic developments, all-cash strategies are very dependent on interest rates. In a falling-interest-rate environment, the return on these investments is shrinking. What should investors do?
As interest rates fall, bond values increase, with long-term bonds increasing in value compared to bonds with shorter-term maturities.
Individuals have many choices to manage their cash needs.
These include money market mutual funds, one-month U.S. Treasury bills, short-term municipal bonds, short-term government floating rate debt, and short-term corporate bonds.
Of these, money market funds are the most popular, according to the Investment Company Institute, since they invest in high-quality, short-term instruments such as corporate and Treasury debt. The interest payments of money market funds increase with rising interest rates. The drawback is that these funds are not FDIC-insured.
Cash Equivalent Tax Strategies for Individual Investors
Investors may also need to consider how to minimize the tax consequences of their cash equivalent investments. Here are a number of choices that can help in that regard:
One-month U.S. Treasury bills
U.S. Treasury bills are very safe investments that often deliver a higher rate than money market funds and are highly liquid. They can be purchased at TreasuryDirect.gov or through a broker.
Because Treasury bills deliver payments that are tax-free of state and local taxes, they are very appropriate for people who live in states and cities with high taxes, such as, Connecticut, New York City, or San Francisco. For these residents who are in high tax brackets, the T-bill equivalent yield gets a boost.
Short-term municipal bond funds
For investors in higher tax brackets, short term municipal bond funds may be attractive. These funds invest in high-quality muni-bonds, are liquid, and can boost the tax-equivalent yield, especially compared to corporate bond funds.
Short-term government floating rate notes (as an ETF)
A lesser-known cash equivalent is short-term government floating rate notes available as an ETF. These were issued by the U.S. government starting in 2014.
They pay a floating interest rate based on a 90-day Treasury bill's returns plus a spread.
As interest rates rise, floating note payments will increase. These also have a high degree of safety since they are issued by the U.S. government and carry no default risk.
Short-term corporate bond ETFs
Another cash equivalent accessible as an ETF is short-term corporate bond ETFs. These investments have durations ranging from one to 3.5 years.
Since they may include a wide variety of bonds with different ratings, the price of this ETF fluctuates more than the money market and short-term bond fund ETFs.
There are over 25 of these ETFs available today. One popular ETF tracks U.S. investment-grade corporate bonds, listed in U.S. dollars, with maturities less than five years.
Cash Equivalent Strategies for Businesses
Businesses need cash to survive. In business, cash flows depend on sales.
These flows fund acquisitions and the payment of business obligations. These flows also provide important information about the business's overall health, including its working capital.
Since "cash is king" among individual investors and corporations, cash equivalents have an important role in financial management and corporate accounting practices. This is evident in determining the working capital of any business. Working capital is available cash used to fund inventory purchases and operating expenses. An important barometer of any business's financial health is its net working capital. This is defined as current assets minus current liabilities.
How liquid assets are reported on the balance sheet
Bankers love cash and cash equivalents since they serve as a ready form of collateral for loans and other capital purchases. The reason: cash and cash equivalents can be converted into cash within days or hours.
This also explains the difference between cash equivalents and short-term assets.
On a balance sheet, short-term assets are those that can be converted into cash in less than one year. From this definition, "quick assets" can be converted to cash within 90 days while "current assets" can be converted to cash within one year. Similarly, accounts receivable are not cash equivalents since they carry a conversion time over 15 days.
Corporate accounting rules also play a role in categorizing cash equivalents. This is because cash equivalents are part of the calculation to determine liquidity ratios.
This ratio helps determine how fast a company can pay its short-term debt. Since liquidity ratios depend on interest rates, they may even be used as a factor that determines whether loan covenants, or provisions to perform certain acts or meet certain standards, will trigger the repayment of a loan before it is due. This can cause a financial hardship on any business, so it is important to know what assets are being used to calculate cash equivalents.
Balance sheet strategies
On a business balance sheet, cash is listed as an asset along with account receivables, inventory, and property and equipment. In financial modeling, cash is often the last asset class that is counted since it indicates whether the accounts balance and how the company is operating.
Many corporate and pension fund cash managers rely on treasury bills, prime commercial paper, repurchase agreements, and certificates of deposits for their cash-management needs.
Some managers are investing in ultra-short liquidity strategies such as credit cards and auto loans. Other large institutions are using the repo and reverse repo markets. This involves loaning securities, such as U.S. Treasuries or other government bonds for a fee and collateral that could include high-quality securities. This is because these instruments offer security, ease of purchase and liquidity (including maturity), and enhanced yield.
Corporate cash managers can take a passive or active approach in how they deploy available cash. The passive approach invests in liquid and secure instruments such as T-bills and prime commercial paper. However, some managers have used more active strategies to deploy idle cash such as investing in hedged dividend re-capture strategies that became popular in the mid-1980s. This strategy involved writing a covered call prior to the first ex-dividend date and unwinding the entire holding immediately after the next. However, due to changes in the tax code, this strategy became less popular. *
More commonly, companies with excess cash have used it to issue dividends, raise salaries, start a stock buy-back program, improve pension, 401(k) and medical employee benefit programs, buying new equipment, or expanding the business through acquisitions.
If a company wants to reduce its cash outflow, and it has publicly-traded stock or stock that will soon be publicly available, it can offer employees stock options on the company stock. This offers a few benefits: the company does not have to write a check for the option sales; it generates goodwill with employees, and it generates cash inflows when the employees exercise the options, even though that may be years in the future. **
Cash Remains King
Cash is a portfolio diversification tool for individuals and businesses alike. And it's a way businesses generate higher returns in the short-term. Businesses realize that cash management can contribute to a company's overall financial health and make it the engine for future expansion. In short, cash remains king in the investment world.
*A Multi-Objective Approach to the Cash Management Problem.
Authors: Salas-Molina, Francisco1, Pla-Santamaria, Rodriguez-Aguilar, Juan A.
Source: Annals of Operations Research; Aug2018, Vol. 267 Issue 1/2, p515-529, 15p
**Cooke, Robert A., and Clayton W. Leadbetter. Positive Cash Flow: Powerful Tools and Techniques to Collect Your Receivables, Manage Your Payables, and Fuel Your Growth. Career Press, 2003.