A Big Institutional Investor Now Hoards Physical Cash Because of Negative Rates

And what this move means for gold
March 17, 2016 Updated: March 18, 2016

Institutional investing is easy. Portfolio managers and chief investment officers of large insurance companies or pension funds often don’t have much choice.

After all, their investment behavior is determined by often strict mandates, which prohibit a large deviation of certain positions against the benchmark, or ban investing in certain assets altogether.

This is one of the reasons why so many of these institutions readily invest in government bonds, which have a negative yield, which means the institution has to pay for lending out money. As of February, around $7 trillion, or 30 percent, of all government bonds had a negative yield, according to Bloomberg calculations.

Total institutional assets and where they are invested. (Hewitt ennisknupp)

So it is quite remarkable that the world’s largest reinsurance company, Munich Re AG, is now bucking the trend and investing more in gold and physical cash to avoid paying a penalty for saving.

The company has around $250 billion in assets and just added an eight-figure amount in physical cash to its gold holdings.

“We are just trying it out, but you can see how serious the situation is,” Chief Executive Nikolaus von Bomhard said at a news conference on March 16.

Bound By The Mandate

Most of the large fixed-income or bond investors are bound by their mandates to invest a portion of their assets in highly rated (AAA) securities. After the financial crisis, there aren’t that many of those around, so those securities which have a high rating get bid up to a point where it pays to be borrowing. Author and financial journalist James Grant calls this “the destruction of savings.”

Apart from their mandates, fund managers are also motivated to invest in a way that will not get them fired when things go wrong. In institutional investing, you can be wrong, as long as most other people are wrong as well. This incentive of avoiding career risk enforces the herd behavior seen in financial markets.

Gold is the high yield asset, zero is greater than negative.
— James Rickards, Author of 'Currency Wars'

You will get a pat on the back and maybe a higher bonus if you go against the grain and make more money than the rest of your peers, but you will get fired if your portfolio is losing money when everybody else is doing well. So as long as everybody is accepting negative interest rates, there is no problem—after all, it’s mostly other people’s (i.e. the client’s) money, anyway.

No Gold

Institutions have previously shunned physical cash and gold because of storage costs, which range between 0.5 percent and 1 percent per year, depending on the amount you store.

Hewitt ennisknupp, a market intelligence firm, excluded gold and physical cash altogether in its 2014 report on where institutions invest their money (more than $100 trillion in total), apparently because the data wasn’t available.

“In our analysis, we have used 21 asset classes for inclusion in the global market portfolio. Our selection of asset classes was driven by factors like availability of data (e.g., we have excluded categories like farmland and gold), usage by the institutional investor community, and finally the desire to capture the global capital market as much as possible.”

Other estimates have put the total institutional allocation to gold and gold mining shares to less than 0.3 percent or $300 billion according to the 2014 numbers.

Most of the $7.4 trillion worth of physical bullion are stashed as official reserves or in the hands of private citizens, like the 20,000 tonnes the Indian people hold—the largest private gold hoard in the world.

Negative Rate Game Changer

What happens, however, if institutions change their minds in the face of negative interest rates?

“If gold has zero yield [excluding storage costs] and bank deposits have a negative yield, gold is the high yield asset. Zero is greater than negative 40 basis points, so gold is the high-yield asset,” said James Rickards, author of “The New Case for Gold,” in a recent interview.

In terms of physical cash versus gold, gold holds more value per unit of space, especially if larger denomination notes, like the 500 Euro note will be banned in the future. In theory, storage costs should be cheaper for gold.  

So even while rates were still moderately positive, a 2014 study by Mercer consulting suggested a 3-5 percent allocation to gold for the institutional portfolio to reduce volatility and enhance returns for a standard institutional portfolio.

If institutions wanted to allocate only 5 percent (or $5 trillion) to physical gold, there simply would not be enough to buy at this price. The market size of only $7.4 trillion and a large part is not for sale, like the Indian gold hoard.

Another possibility to invest would be via derivatives or Exchange Traded Funds, but Mercer doesn’t recommend it:

“Therefore, if gold is being considered as a form of monetary insurance, holding allocated physical gold might represent the most logical means of achieving this objective,” it states in its report.

What if other institutions follow Munich Re and also follow Mercer’s advice? Rickards says: “They’re going to dump paper money and get into gold to preserve wealth.”