Cash Management: How to Make Cash Work Harder Against Inflation
Inflation drags down cash performance, so investors must find ways to make cash work harder for yield while still preserving capital. Learn about an approach to potentially gain critical ground against inflation by organizing your cash based on when it’s needed and casting a wider net of short-term investments.
Inflation’s Attack on Cash
No economic variable has triggered more volatility for investors over the past year than inflation, in particular in the U.S. and Europe where it is at multi-decade highs. While investors thought inflation caused by pandemic-related supply disruptions would eventually settle down, the war in Ukraine triggered soaring commodity prices and forced investors to recalibrate their assumptions. High inflation has sparked aggressive responses from central banks globally, increasing interest rates and volatility for stocks and bonds.
There is no greater adversary to the value of your cash than spiraling inflation, which makes holding onto cash with little or no return a drag on investment performance. We think that now is the time to make cash work harder. A cash segmentation strategy offers a way to do this.
What Is Cash Segmentation?
With cash segmentation, investors can increase returns to mitigate the impact of inflation by looking beyond bank deposits or money market funds. By investing in short-term securities and taking incrementally more credit and duration risk, investors are able to target greater yield by allocating cash that is not needed to meet day-to-day business spending.
To accomplish this, cash segmentation divides the cash pool into three segments: operational, reserve and strategic. The operational segment covers day-to-day spending, requiring bank deposits or investments in low-risk money market funds which can be converted into cash from one to 30 days. The reserve segment is for intermediate or undefined spending needs in the next six months to a year. A conservative ultra-short strategy with slightly less liquidity than money market funds and somewhat higher yields may fit in this segment. The strategic segment covers cash needs expected in a year to 18 months, which allows for investment in an ultra-short strategy that seeks higher yield while still maintaining a focus on capital preservation.
The Importance of Accurate Cash Flow Forecasts
The level of cash-segmentation sophistication investors, such as corporate treasurers, can achieve relies on their ability to forecast their cash flow accurately. Forecasts define the amount of cash to allocate to each of the three buckets (a name we use for cash segments). If forecasts are inaccurate, there’s risk of liquidating a portion of a cash portfolio that had been allocated to the longer term buckets.
If an investor can’t forecast more than 30 days out, that’s operational cash. That’s where money market funds may be the most suitable investment. Any forecast between six months and a year enables them to add a bucket for reserve cash for conservative ultra-short strategies. Finally, if an investor can forecast cash flow beyond a year, that opens up the strategic cash bucket for longer maturity ultra-short strategies.
Beyond the Yield: Improving Risk Management
Investors who can add incrementally more duration and credit risk in their cash holdings through segmentation may also improve diversification. Money market funds focus heavily on investing in short-term debt from the financial sector because it’s the most available option. But investors who can invest in short-term debt that matures in more than a year have more opportunity to diversify into other sectors. Longer maturity funds such as ultra-short bond funds can hold non-financial debt to potentially spread risk, which may serve especially well in times of crisis.
Using money market funds and ultra-short bond funds in a diversified portfolio of investments, enabled by a cash segmentation strategy, may help lower risk while maintaining liquidity.
The Fight Against Inflation
We think a cash segmentation strategy enables investors to maintain a diversified portfolio of short-term investments to optimize yields, while still maintaining appropriate levels of risk, in an environment of high inflation and volatility. For those somewhat overwhelmed by how to start implementing such a strategy, asset managers can provide tools and expertise as a first step towards unlocking a customized cash segmentation strategy.
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