Deferred Cash?

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The Man with the Axe
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Deferred Cash?

Post by The Man with the Axe » Sat Jan 11, 2020 3:55 pm

Fixed income investors are living in interesting times.

Monetary policy adopted by various central banks has resulted in interest rates at or near zero in many non-US jurisdictions. As a result, fixed income investors are buying bonds that do not pay interest. In other words, they are buying Deferred Cash: a promise to return their principal at some future date, without interest.

Deferred Cash is at odds with the basic principles of Finance. The folks at the Motley Fool website summarize the Time Value of Money principle in these terms:

“Time value of money is one of the most basic fundamentals in all of finance. The underlying principle is that a dollar in your hand today is worth more than a dollar you will receive in the future because a dollar in hand today can be invested to turn into more money in the future. Additionally, there is always a risk that a dollar that you are supposed to receive in the future won't actually be paid to you.”

Why would anyone buy Deferred Cash?

Presumably some large financial institutions buy Deferred Cash because they must hold massive reserves in a particular currency and they have no other reasonable alternatives. They must buy their home country government debt, so they do so at whatever rate is available. Effectively, they have no choice.

In contrast, the individual investors reading this website – Bogleheads – have other reasonable alternatives. We do have a choice. So why would Bogleheads buy Deferred Cash?

The Boglehead investing philosophy might lead some Bogleheads to buy Deferred Cash without really thinking about it. Another Finance 101 concept sits at the core of the Boglehead investing philosophy: The Efficient Markets Hypothesis (EMH). Wikipedia describes the EMH as follows: “a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to 'beat the market' consistently on a risk-adjusted basis. . .” Sound familiar?

Some Bogleheads might unwittingly buy Deferred Cash because, whether they are conscious of it or not, they are unwavering disciples of the EMH and, accordingly, their investment decisions are on a form of “auto-pilot”. They are immediately suspicious of any effort to adjust their investing decisions in reaction to prevailing prices/rates, because that would mean they are engaged in “market-timing” (a mortal sin under Boglehead dogma).

Bogleheads who strictly observe the “Thou Shalt Not Market-Time” edict are similar to the protagonists in the old joke about disciples of the EMH in its strongest form: EMH true-believers would not stoop to pick up a $20 bill off the sidewalk, because the very fact that it is sitting on the sidewalk demonstrates that it must not be a real $20 bill. After all, in an efficient market, real $20 bills don’t just sit there on the sidewalk, right? If it were a real $20, someone would have picked it up already. You’re “market timing” if you pick up the $20, right?

Deferred Cash is the financial converse of the $20 bill on the sidewalk. Like the $20 bill, Deferred Cash illustrates the common-sense notion that uncritically following your investment hypothesis at all times as if it were gospel truth may result, at times, in irrational behavior.

If the good Boglehead IPS you adopted ten years ago tells you it is time to buy some foreign bonds and those foreign bonds yield zero, your IPS is telling you to buy Deferred Cash. Is that a reasonable thing to do? When it comes to interest rates, we are living in interesting times. In this interest rate environment, it is a reasonable time to re-evaluate the fixed income part of the portfolio allocations in your IPS if your allocations include foreign bonds.

Refusing to buy Deferred Cash is not “market-timing.” To illustrate: Every good Boglehead would refinance their mortgage if their financial calculations – based on the interest rate then available in the market – led to the common-sense conclusion that refinancing had a better expected value than keeping the existing mortgage. Refusing to buy Deferred Cash is like refinancing your mortgage when rates drop substantially. It is a common-sense response to a specific development in the prevailing interest rate environment. Are you “market timing” every time you refinance your mortgage? Of course not.

What should Bogleheads do if they don’t want to buy Deferred Cash? The easy answer would be to shift your fixed income portfolio allocation toward interest-bearing bonds and bond funds of comparable credit quality. For many of us, a diversified portfolio of USD bonds with a heavy dose of instruments backed by the full faith and credit of the United States (e.g., BND or AGG) accomplishes the basic requirements of our fixed income allocation. And (at least as of today) as a general matter bonds (and funds) from US issuers pay interest.

Investors who are intent on diversifying away from instruments denominated in USD from a credit risk perspective face a more challenging environment. There is Deferred Cash in a lot of foreign bond funds. Some of the funds themselves (for example, IGOV) have an SEC yield approaching zero.

With all of this in mind, allocating some part of the portfolio to gold seems like one reasonable response. One of the more common observations on this forum and elsewhere from gold critics holds that gold is a bad investment (or not an “investment” at all) because it doesn’t pay interest. But in today’s interest rate environment, the yield on gold is approximately the same as the yield on many foreign bonds. Is it so unreasonable to buy some gold instead of buying Deferred Cash?

Surely other Bogleheads have some ideas on the foregoing. Should Bogleheads buy Deferred Cash?

Ferdinand2014
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Re: Deferred Cash?

Post by Ferdinand2014 » Sat Jan 11, 2020 4:56 pm

I would buy neither gold nor foreign debt. There are many options that are better. For example FXAIX (Fidelity S&P 500 index). I would pick up the $20 U.S.D. bill as well and use it to buy more FXAIX. Like you, I do not understand why you would buy foreign debt. Ever.
“You only find out who is swimming naked when the tide goes out.“ — Warren Buffett

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RickBoglehead
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Re: Deferred Cash?

Post by RickBoglehead » Sat Jan 11, 2020 6:25 pm

Never. Nor gold.
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Stinky
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Re: Deferred Cash?

Post by Stinky » Sat Jan 11, 2020 6:29 pm

No gold for me. Ditto on foreign debt.
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The Man with the Axe
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Re: Deferred Cash?

Post by The Man with the Axe » Mon Jan 13, 2020 7:58 pm

Here is another perspective on why some financial institutions are willing to buy Deferred Cash:

"There is not enough collateral. So financial institutions will pay “anything” for it, including “guaranteed” losses on sovereign debt, assuming the government obligation is held to maturity, which it is not. These negative-yielding bonds are not investments but balance-sheet management tools."

https://blogs.cfainstitute.org/investor ... absurdity/

With so much Deferred Cash floating around, mostly in international bond markets, it is worth considering whether any of it is working its way into your portfolio -- and how you might prevent that from happening.

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