The Economist November 13th 2021 Finance & economics 77ligible in size”. In total, the value of debt
forclimate and natureswap agreements
between 1985 and 2015 came to just $2.6bn,
according to the United Nations Develop
ment Programme. Of the 39 debtor nations
that benefited from the swaps, only 12 ne
gotiated debts of over $30m. “It was really
an exercise in public relations,” Mr Buch
heit says.
A lot has changed since then. Govern
ments are now under immense pressure to
make ambitious commitments on climate
change and biodiversity. And investors are
eager to show they can make money as well
as being committed to environmental, so
cial and governance goals.
Other poor countries are trying to move
in the same direction. At the cop26 climate
summit in Glasgow Ecuador’s president
Guillermo Lasso proposed enlarging the
country’s Galapagos nature reserve
through a debtfornature swap. And tnc
is in talks with other poor countries inter
ested in doing something similar. Once a
blueprint is in place, agreement gets sim
pler. The last restructuring of the same sort
that it took part in, which involved $21.6m
of debt owed by the Seychelles to the ParisClub of creditors, took four years to thrash
out. Negotiations in Belize lasted a year
and a half.
Yet no amount of creative dealmaking
can distract from the grim truth: many
emerging marketsstill suffer from crush
ing debts. The pandemic has pushed half
of the world’s poorest countries into debt
distress or heightened the vulnerability to
it. And debtfornature swaps only help at
the margin. Last week’s restructuring re
duced Belize’s externaldebt by $250m, or
12% of gdp. The successis for coral reefs
more than debt relief.nE
verhadthefeelingthatthereisa
party somewhere that you’re not
invited to? It is the same feeling investors
have when they have capital sitting in
threemonth bills or on deposit at a
bank. Cash is a safe asset, but a wasting
one. The real returns on risky assets have
been much greater. True, cash affords
options—to buy cheaply when others are
selling. But episodes of distressed selling
have been fleeting, largely thanks to
central banks, which have been liberal in
supplying cash in emergencies. Why
then should investors incur the opportu
nity cost of holding it?
In its favour, cash is at least now
offering a small return, or the prospect of
one. Overnight interest rates have risen,
notably in Latin America and Eastern
Europe. The Bank of England may raise
its benchmark interest rate before the
year is out. The Federal Reserve may
follow at some time next year. But the
rate of return in shortterm money mar
kets is still below the rate of inflation and
is forecast to stay that way. For those
seeking returns, holding cash remains a
lossmaking prospect in real terms.
The true appeal of cash as a portfolio
asset lies somewhere else. More and
more capital is tied up in investments
where much of the payoff lies in the
distant future. You see this in the huge
market capitalisations of a handful of
tech companies in America and in the
money flooding into privateequity and
venturecapital funds. Investors have to
wait ever longer to get their money back.
In the meantime their portfolios are
vulnerable to a sharp rise in interest
rates. A simple way to mitigate this risk
is to hold more cash.
The concept of “duration” is a useful
one in this regard. Duration is a measure
of a bond’s lifespan. It is related to, butsubtlydifferent from, the maturity of a
bond. Duration takes into account that
some of what is due to bondholders—the
annual interest, or “coupon”—is paid out
sooner than the principal, which is hand
ed over when the bond matures. The lon
ger you have to wait for coupon and prin
cipal payments, the longer the duration. It
is also a gauge of how much the price of a
bond changes as interest rates shift. The
greater a bond’s duration, the more sensi
tive it is to a rise in interest rates.
You can also think of equity invest
ment in duration terms. Take the familiar
priceearnings ratio, or pe, the price paid
by investors for a given level of stockmark
et earnings. The idea is that if a stock has a
peof ten, based on recent earnings, it
would take ten years to earn back the
outlay of an investor who buys the stock
today, assuming earnings stay constant. If
the pe is 20, it would take 20 years. The pe
is thus a crude measure of the stock’s
duration. On this basis, American stocks
in aggregate have rarely had a longer dura
tion. The cyclically adjusted priceearn
ings ratio, a valuation measure popularised by Robert Shiller of Yale University,
is now close to 40. It was higher only at
the giddy height of the dotcom boom in
19992000.
The rationale for longerduration
assets is a familiar one. Real longterm
interest rates are about as low as they
have ever been. As a consequence in
vestment returns even in the distant
future, once discounted, have a high
value today. It is not just stocks. Property
is valued at a steep price relative to the
stream of future rents. Investors are
piling into privateequity and venture
capital funds that won’t pay out for a
decade or more. Everyone, it seems, is
long duration. But with longer duration
comes a greater risk that unexpectedly
aggressive interestrate rises will lead to
a collapse in asset values.
A typical investment portfolio of
stocks, bonds and property is vulnerable
to this risk. There are not too many good
ways to hedge it. Buying insurance in the
options market against a stockmarket
crash is expensive and fiddly.
This is where cash comes in. Cash is
by definition a shortduration asset.
Were interest rates to go up sharply, cash
holders would get the benefit quickly
even as other assets suffer. So as the
duration of your portfolio rises, it makes
sense to raise your cash holdings too. By
precisely how much will depend, as ever,
on your risk appetite. Just as you are
advised to sell down your stocks to the
level where a night’s rest is assured, you
might also build up your cash holdings
to the sleeping point.
Of course, such a strategy comes with
an opportunity cost. As long as asset
markets continue to boom, cash will be a
drag on your portfolio. So be it. Missing
out on some returns is the price you pay
for mitigating duration risk. Buttonwood For the duration
Why cash is now more appealing as a portfolio asset