To Bitcoin or not to Bitcoin? A Corporate Cash Question!

    In this post, I will bring together two disparate and very different topics that I have written about in the past. The first is the role that cash holdings play in a business, an extension of the dividend policy question, with an examination of why businesses often should not pay out what they have available to shareholders. In my classes and writing on corporate finance, I look at the motives for businesses retaining cash, as well as how much cash is too much cash. The second is bitcoin, which can be viewed as either a currency or a collectible, and in a series of posts, I argued that bitcoin can only be priced, not valued, making debates about whether to buy or not to buy entirely a function of perception. In fact, I have steered away from saying much about bitcoin in recent years, though I did mention it in my post on alternative investments as a collectible (like gold) that can be added to the choice mix. While there may be little that seemingly connects the two topics (cash and bitcoin), I was drawn to write this post because of a debate that seems to be heating up on whether companies should put some or a large portion of their cash balances into bitcoin, with the success of MicroStrategy, a high-profile beneficiary of this action, driving some of this push. I believe that it is a terrible idea for most companies, and before Bitcoin believers get riled up, my reasoning has absolutely nothing to do with what I think of bitcoin as an investment and more to do with how little I trust corporate managers to time trades right. That said, I do see a small subset of companies, where the holding bitcoin strategy makes sense, as long as there are guardrails on disclosure and governance.

Cash in a Going Concern

    In a world where businesses can raise capital (equity or debt) at fair prices and in a timely manner, there is little need to hold cash, but that is not the world we live in. For a variety of reasons, some internal and some external, companies are often unable or unwilling to raise capital from markets, and with that constraint in place, it is logical to hold cash to meet unforeseen needs. In this section, I will start by laying out the role that cash holdings play in any business, and examine how much cash is held by companies, broken down by groupings (regional, size, industry). 

A Financial Balance Sheet

    To understand the place of cash in a business, I will start with a  financial balance sheet, a structure for breaking down a business, public or private:

On the asset side of the balance sheet, you start with the operating business or businesses that a company is in, with a bifurcation of value into value from investments already made (assets-in-place) and value from investments that the company expects to make in the future (growth assets). The second asset grouping, non-operating assets, includes a range of investments that a company may make, sometimes to augment its core businesses (strategic investments), and sometimes as side investments, and thus include minority holdings in other companies (cross holdings) and even investments in financial assets. Sometimes, as is the case with family group companies, these cross holdings may be a reflection of the company's history as part of the group, with investments in other group companies for either capital or corporate control reasons. The third grouping is for cash and marketable securities, and this is meant specifically for investments that share two common characteristics - they are riskless or close to riskless insofar as holding their value over time and they are liquid in the sense that they can be converted to cash quickly and with no penalty. For most companies, this has meant investing cash in short-term bonds or bills, issued by either governments (assuming that they have little default risk) or by large, safe companies (in the form of commercial paper issued by highly rated firms). 

    Note that there are two sources of capital for any business, debt or equity, and in assessing how levered a firm is, investors look at the proportion of the capital that comes from each:

• Debt to Equity = Debt/ Equity
• Debt to Capital = Debt/ (Debt + Equity)

In fact, there are many analysts and investors who estimate these debt ratios, using net debt, where they net the cash holdings of a company against the debt, with the rationale, merited or not, that cash can be used to pay down debt.

• Net Debt to Equity = (Debt-Cash)/ Equity
• Debt to Capital = (Debt-Cash)/ (Debt + Equity)

All of these ratios can be computed using accounting book value numbers for debt and equity or with market value numbers for both. 

The Motives for holding Cash

    In my introductory finance classes, there was little discussion of cash holdings in companies, outside of the sessions on working capital. In those sessions, cash was introduced as a lubricant for businesses, necessary for day-to-day operations. Thus, a retail store that had scores of cash customers, it was argued, needed to hold more cash, often in the form of currency, to meet its transactional needs, than a company with corporate suppliers and business customers, with predictable patterns in operations. In fact, there were rules of thumb that were developed on how much cash a company needed to have for its operations. As the world shifts away from cash to digital and online payments, this need for cash has decreased, but clearly not disappeared. The one carve out is the financial services sector, where the nature of the business (banking, trading, brokerage) requires companies in the sector to hold cash and marketable securities as part of their operating businesses.

    If the only reason for holding cash was to cover operating needs, there would be no way to justify the tens of billions of dollars that many companies hold; Apple alone has often had cash balances that exceeded $200 billion, and the other tech giants are not far behind. For some companies, at least, the rationale for holding far more cash than justified by their operating needs is that it can operate as a shock absorber, something that they can fall back on during periods of crisis or to cover unexpected expenses. That is the reason that cyclical and commodity firms have often offered for holding large cash balances (as a percent of their overall firm value), since a recession or a commodity price downturn can quickly turn profits to losses.

   Using the corporate life cycle structure can also provide insight into how the motives for holding cash can change as a company ages.  

For start-ups, that are either pre-revenue or have very low revenues, cash is needed to keep the business operating, since employees have to be paid and expenses covered. Young firms that are money-losing and with large negative cash flows, hold cash to cover future cash flow needs and to fend off the risk of failure. In effect, these firms are using cash as life preservers, where they can make it through periods where external capital (venture capital, in particular) dries up, without having to sell their growth potential at bargain basement prices. As firms start to make money, and enter high growth, cash has use as a business scalar, for firms that want to scale up quickly. In mature growth, cash acquires optionality, useful in allowing the business to find new markets for its products or product extensions.  Mature firms sometimes hold cash as youth serum, hoping that  it can be used to make once-in-a-lifetime investments that may take them back to their growth days, and for declining firms, cash becomes a liquidation manager, allowing for the orderly repayment of debt and sale of assets.

    There is a final rationale for holding cash that is rooted in corporate governance and the control and power that comes from holding cash. I have long argued that absent pressure from shareholders, managers at most publicly traded firms would choose to return very little of the cash that they generate, since that cash balance not only makes them more sought after (by bankers and consultants who are endlessly inventive about uses that the cash can be put to) but also gives them the power to build corporate empires and create personal legacies.

Corporate Cash Holdings

    Given the multitude of reasons for holding cash, it should come as no surprise that publicly traded companies around the world have significant cash balances. Leading into July 2025, for instance, global non-financial-service firms held almost $11.4 trillion in cash and marketable securities; financial service firms held even more in cash and marketable securities, but those holdings, as we noted earlier, can represent their business needs. Using our earlier breakdown of the asset side of the balance sheet into cash, non-operating and operating assets, this is what non-financial service firms in the aggregate looked like in book value terms (global and just US firms):

Note that cash is about 11% of the book value of total assets, in the aggregate, for global firms, and about 9% of the book value of total assets, for US firms. Global firms do hold a higher percentage of their value in non-operating assets, but US firms are more active on the acquisition front, explaining why goodwill (which is triggered almost entirely by acquisitions) is greater at US firms.

    The typical publicly traded firm holds a large cash balance, but there are significant differences in cash holdings, by sector. In the table below, I look at cash as a percent of total assets, a book value measure, as well as cash as a percent of firm value, computed by aggregating market values:

As you can see, technology firms, which presumably face more uncertainty about their future hold far more cash as a percent of book value, but the value that the market attaches to their growth brings down cash as a percent of firm value. Utilities, regulated and often stable businesses, tend to hold the least cash, both in book and market terms. 

    Breaking down the sample by region, I look at cash holdings, as a percent of total assets and firms, across the globe:

The differences across the globe can be explained by a mix of market access, with countries in parts of the world where it can be difficult to access capital (Latin America, Eastern Europe, Africa) holding more cash. In addition, and corporate governance, with cash holdings being greater in parts of the world (China, Russia) where shareholders have less power over managers. 

    Given the earlier discussion of how the motives for holding cash can vary across the life cycle, I broke the sample down by age decile, with age measured from the year of founding, and looked at cash holdings, by decile:

The results are mixed, with cash holdings as a percent of total assets being higher for the younger half of the sample (the top five deciles) than for the older half, but the is no discernible pattern, when cash is measured as a percent of firm value (market). Put simple, companies across the life cycle hold cash, though with different motives, with the youngest firms holding on to cash as lifesavers (and for survival) and the older firms keeping cash in the hopes that they can use it to rediscover their youth.

The Magic of Bitcoin

    I have been teaching and working with investments now for four decades, and there has been no investment that has received as much attention from both investors and the financial press, relative to its actual value, as has bitcoin. Some of the draw has come from its connections to the digital age, but much of it has come from its rapid rise in price that has made many rich, with intermittent collapses that have made just as many poor. I am a novice when it comes to crypto, and while I have been open about the fact that it is not my investment preference, I understand its draw, especially for younger investors.

The Short, Eventful History of Bitcoin

    The origin story for Bitcoin matters since it helps us understand both its appeal and its structure. It was born in November 2008, two months into one of the worst financial crises of the last century, with banks and governments viewed as largely responsible for the mess. Not surprisingly, Bitcoin was built on the presumption that you cannot trust these institutions, and its biggest innovation was the blockchain, designed as a way of crowd-checking transactions and preserving transaction integrity. I have long described Bitcoin as a currency designed by the paranoid for the paranoid, and I have never meant that as a critique, since in the  untrustworthy world that we live in, paranoia is a justifiable posture.

    From its humble beginnings, where only a few (mostly tech geeks) were aware of its existence, Bitcoin has accumulated evangelists, who argue that it is the currency of the future, and speculators who have used its wild price swings to make and lose tens of millions of dollars. In the chart below, I look at the price of bitcoin over the last decade, as its price has increased from less than $400 in September 2014 to more than $110,000 in June 2025:

Along the way, Bitcoin has also found some acceptance as a currency, first for illegal activities (drugs on the Silk Road) and then as the currency for countries with failed fiat currencies (like El Salvador), but even Bitcoin advocates will agree that its use in transactions (as the medium of exchange) has not kept pace with its growth as a speculative trade. 

Pricing Bitcoin

    In a post in 2017,  I divided investments into four groups - assets that generate cash flows (stocks, bonds, private businesses), commodities that can be used to produce other goods  (oil, iron ore etc), currencies that act as mediums of exchange and stores of value and collectibles that are priced based on demand and supply:

You may disagree with my categorization, and there are shades of gray, where an investment can be in more than one grouping. Gold, for instance, is both a collectible of long standing and a commodity that has specific uses, but the former dominates the latter, when it comes to pricing. In the same vein, crypto has a diverse array of players, with a few meeting the asset test and some (like ethereum) having commodity features. The contrast between the different investment classes also allows for a contrast between investing, where you buy (sell) an investment if it is under (over) valued, and trading, where you buy (sell) an investment if you expect its price to go up (down). The former is a choice, though not a requirement, with an asset (stocks, bonds or private businesses), though there may be others who still trade that asset. With currencies and collectibles, you can only trade, making judgments on price direction, which, in turn, requires assessments of mood and momentum, rather than fundamentals. 

    With bitcoin, this classification allows us to cut through the many distractions that pop up during discussions of its pricing level, since it can be framed either as a currency or a collectible, and thus only priced, not valued. Seventeen years into its existence, Bitcoin has struggled on the currency front, and while there are pockets where it has gained acceptance, its design makes it inefficient and its volatility has impeded its adoption as a medium of exchange. As a collectible, Bitcoin starts with the advantage of scarcity, restricted as it is to 21 million units, but it has not quite measured up, at least so far, when it comes to holding its value (or increasing it) when financial assets are in meltdown mode. In every crisis since 2008, Bitcoin has behaved more like risky stock, falling far more than the average stock, when stocks are down, and rising more, when they recover. I noted this in my posts looking at the performance of investments in both the first quarter of 2020, when COVID laid waste to markets, and in 2022, when inflation ravaged stock and bond markets. That said, it is still early in its life, and it is entirely possible that it may change its behavior as it matures and draws in a wider investor base. The bottom line is that discussions of whether Bitcoin is cheap or expensive are often pointless and sometimes frustrating, since it depends almost entirely on your perspective on how the demand for Bitcoin will shift over time. If you believe that its appeal will fade, and that it will be displaced by other collectibles, perhaps even in the crypto space, you will be in the short selling camp. If you are convinced that its appeal will not just endure but also reach fresh segments of the market, you are on solid ground in assuming that its price will continue to rise. It behooves both groups to admit that neither has a monopoly on the truth, and this is a disagreement about trading and not an argument about fundamentals.

The MicroStrategy Story

    It is undeniable that one company, MicroStrategy, has done more to advance the corporate holding of Bitcoin than any other, and that has come from four factors;

1. A stock market winner: The company's stock price has surged over the last decade, making it one of the best performing stocks on the US exchanges:
   
    It is worth noting that almost all of the outperformance has occurred in this decade, with the winnings concentrated into the last two years. 
2. With the rise (increasingly) tied to Bitcoin: Almost all of MicroStrategy’s outperformance has come from its holdings of bitcoin, and not come from improvements in business operations. That comes through in the graph below, where I look at the prices of MicroStrategy and Bitcoin since 2014:
   
   
     Note that MicroStrategy’s stock price has gone from being slightly negatively correlated with Bitcoin’s price between 2014-2018 to tracking Bitcoin in more recent years.
3. And disconnected from operations: In 2014, MicroStrategy was viewed and priced as a software/services tech company, albeit a small one with promise. In the last decade, its operating numbers have stagnated, with both revenues and gross profits declining, but during the same period, its enterprise value has soared from $1 billion in 2014 to more than more than $100 billion in July 2025:
   
   
   It is clear now that anyone investing in MicroStrategy at its current market cap (>$100 billion) is making a bitcoin play.
4. With a high-profile "bitcoin evangelist" as CEO:  MicroStrategy’s CEO, Michael Saylor, has been a vocal and highly visible promoter of bitcoin, and has converted many of his shareholders into fellow-evangelists and convinced at least some of them that he is prescient in detecting price movements. In recent years, he has been public in his plans to issue increasing amounts of stock and using the proceeds to buy more bitcoin.

In sum, MicroStrategy is now less a software company and more a Bitcoin SPAC or closed-end fund, where investors are trusting Saylor to make the right trading judgments on when to buy (and sell) bitcoin, and hoping to benefit from the profits. 

The “Put your cash in bitcoin” movement

     For investors in other publicly traded companies that have struggled delivering value in their operating businesses, MicroStrategy’s success with its bitcoin holdings seems to indicate a lost opportunity, and one that can be remedied by jumping on the bandwagon now. In recent months, even high profile companies, like Microsoft, have seen shareholder proposals pushing them to abandon their conventional practice of holding cash in liquid and close-to-riskless investments and buying Bitcoin instead. Microsoft’s shareholders soundly rejected the proposal, and I will start by arguing that they were right, and that for most companies, investing cash in bitcoin does not make sense, but in the second part, I will carve out the exceptions to this rule.

The General Principle: No to Bitcoin

    As a general rule, I think it is not only a bad idea for most companies to invest their cash in bitcoin, but I would go further and also argue that they should banned from doing so. Let me hasten to add that I would make this assertion even if I was bullish on Bitcoin, and my argument would apply just as strongly to companies considering moving their cash into gold, Picassos or sports franchises, for five reasons:

1. Bitcoin does not meet the cash motives: Earlier in this post, I noted the reasons why a company  holds cash, and, in particular, as a shock absorber, steadying a firm through bad times. Replacing low-volatility cash with high-volatility bitcoin would undercut this objective, analogous to replacing your shock absorbers with pogo sticks. In fact, given the history of moving with stock prices, the value of bitcoin on a company's balance sheet will dip at exactly the times where you would need it most for stability. The argument that bitcoin would have made a lot higher returns for companies than holding cash is a non-starter, since companies should hold cash for safety.
2. Bitcoin can step on your operating business narrative: I have long argued that successful businesses are built around narratives that incorporate their competitive advantages. When companies that are in good businesses put their cash in bitcoin, they risk muddying the waters on two fronts. First, it creates confusion about why a company with a solid business narrative from which it can derive value would seek to make money on a side game. Second, the ebbs and flows of bitcoin can affect financial statements, making it more difficult to connect operating results to story lines. 
3. Managers as traders? When companies are given the license to move their cash into bitcoin or other non-operating investments, you are trusting managers to get the timing right, in terms of when to buy and sell these investments. That trust is misplaced, since top managers (CEOs and CFOs) are for the most part terrible traders, often buying at the market highs and selling at lows.
4. Leave it to shareholders: Even if you are unconvinced by the first three reasons, and you are a bitcoin advocate or enthusiast, you will be better served pushing companies that you are a shareholder in, to return their cash to you, to invest in bitcoin, gold or any other investment at your chosen time. Put simply, if you believe that Bitcoin is the place to put your money, why would you trust corporate managers to do it for you?
5. License for abuse: I am a skeptic when it comes to corporate governance, believing that managerial interests are often at odds with what's good for shareholders. Giving managers the permission to trade crypto tokens, bitcoin or other collectibles can open the door for self dealing and worse. 

While I am a fan of letting shareholders determine the limits on what managers can or cannot do, I believe that the SEC (and other stock market regulators around the world) may need to become more explicit in their rules on what companies can (and cannot) do with cash.

The Carveouts

    I do believe that there are cases when you, as a shareholder, may be at peace with the company not only investing cash in bitcoin, but doing so actively and aggressively. Here are four of my carveouts to the general rule on bitcoin:

1. The Bitcoin Savant: In my earlier description of MicroStrategy, I argued that shareholders in MicroStrategy have not only gained immensely from its bitcoin holdings, but also trust Michael Saylor to trade bitcoin for them. In short, the perception, rightly or wrongly, is that Saylor is a bitcoin savant, understanding the mood and momentum swings better than the rest of us. Generalizing, if a company has a leader (usually a CEO or CFO) who is viewed as someone who is good at gauging bitcoin price direction, it is possible that shareholders in the company may be willing to grant him or her the license to trade bitcoin on their behalf.  This is, of course, not unique to bitcoin, and you can argue that investors in Berkshire Hathaway have paid a premium for its stock, and allowed it leeway to hold and deploy immense amounts of cash because they trusted Warren Buffett to make the right investment judgments. 
2. The Bitcoin Business: For some companies, holding bitcoin may be part and parcel of their business operations, less a substitute for cash and more akin to inventory. PayPal and Coinbase, both of which hold large amounts of bitcoin, would fall into this carveout, since both companies have business that requires that holding.
3. The Bitcoin Escape Artist: As some of you may be aware, I noted that Mercado Libre, a Latin American online retail firm, is on my buy list, and it is a company with a fairly substantial bitcoin holding. While part of that holding may relate to the operating needs of their fintech business, it is worth noting that Mercado Libre is an Argentine company, and the Argentine peso has been a perilous currency to hold on to, making bitcoin a viable option for cash holdings. Generalizing, companies in countries with failed currencies may conclude that holding their cash in bitcoin is less risky than holding it in the fiat currencies of the locations they operate in.
4. The Bitcoin Meme: There is a final grouping of companies that I would put in the meme stock category, with AMC and Gamestop heading that list. These companies have operating business models that have broken down or have declining value, but they have become, by design or through accident, trading plays, where the price bears no resemblance to operating fundamentals and is instead driven by mood and momentum. If that is the case, it may make sense for these companies to throw in the towel on operating businesses entirely and instead make themselves even more into trading vehicles by moving into bitcoin, with the increased volatility adding to their "meme" allure.

Even with these exceptions, though, I think that you need guardrails before signing off on opening the door to letting companies hold bitcoin.

1. Shareholder buy-in: If you are a publicly traded company considering investing some or much of the company's cash in bitcoin, it behooves you to get shareholder approval for that move, since it is shareholder cash that is being deployed. 
2. Transparency about Bitcoin transactions/holdings: Once a company invests in bitcoin, it is imperative that there be full and clear disclosure not only on those holdings but also on trading (buying and selling) that occurs. After all, if it is a company's claim that it can time its bitcoin trades better than the average investor, it should reveal the prices at which it bought and sold its bitcoin. 
3. Clear mark-to-market rules: If a company invests its cash in bitcoin, I will assume that the value of that bitcoin will be volatile, and accounting rules have to clearly specify how that bitcoin gets marked to market, and where the profits and losses from that marking to market will show up in the financial statements. 

As bitcoin prices rise to all time highs, there is the danger that regulators and rule-writers will be lax in their rule-writing, opening the door to corporate scandals in the future.

Cui Bono?

    Bitcoin advocates have been aggressively pushing both institutional investors and companies to include Bitcoin in their investment choices, and it is true that at least first sight, they will benefit from that inclusion. Expanding the demand for bitcoin, an investment with a fixed supply, will drive the price upwards, and existing bitcoin holders will benefit. In fact, much of the rise of bitcoin since the Trump election in November 2024 can be attributed to the perception that this administration will ease the way for companies and investors to join in the crypto bonanza.

    For bitcoin holders, increasing institutional and corporate buy-in to bitcoin may seem like an unmixed blessing, but there will be costs that, in the long run, may lead at least some of them to regret this push:

1. Different investor base: Drawing in institutional investors and companies into the bitcoin market will not only change its characteristics, but put traders who may know how to play the market now at a disadvantage, as it shifts dynamics.
2. Here today, gone tomorrow? Bitcoin may be in vogue now, but what will the consequences be if it halves in price over the next six months? Institutions and companies are notoriously ”sheep like” in their behavior, and what is in vogue today may be abandoned tomorrow. If you believe that bitcoin is volatile now, adding these investors to the mix will put that volatility on steroids.
3. Change asset characteristics: Every investment class that has been securitized and brought into institutional investing has started behaving like a financial asset, moving more with stocks and bonds than it has historically. This happened with real estate in the 1980s and 1990s, with mortgage backed securities and other tradable versions of real estate, making it far more correlated with stock and bonds, and less of a stand alone asset. 

If the end game for bitcoin is to make it millennial gold, an alternative or worthy add-on to financial assets, the better course would be steer away from establishment buy-in and build it up with an alternative investor base, driven by different forces and motives than stock and bond markets. 

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The (Uncertain) Payoff from Alternative Investments: Many a slip between the cup and the lip?

    It is true that most investing lessons are directed at those who invest only in stocks and bonds, and mostly with long-only strategies. It is also true that in the process, we are ignoring vast swaths of the investment universe, from other asset classes (real estate, collectibles, cryptos) to private holdings (VC, PE) to strategies that short stocks or use derivatives (hedge funds). These ignored investment classes are what fall under the rubric of alternative investments, and while many of these choices have been with us for as long as we have had financial markets, they were accessible to only a small subset of investors for much of that period. In the last two decades, alternative investments have entered the mainstream, first with choices directed at institutional investors, but more recently, in offerings for individual investors. Without giving too much away, the sales pitch for adding alternative investments to a portfolio composed primarily of stocks and bonds is that the melding will create a better risk-return tradeoff, with higher returns for any given risk level, albeit with two different rationales. The first is that they have low correlations with financial assets (stocks and bonds), allowing for diversification benefits and the second is investments in some of these alternative asset groupings have the potential to earn excess returns or alphas. While the sales pitch has worked, at least at the institutional level, in getting buy-in on adding alternative investments, the net benefits from doing so have been modest at best and negative at worst, raising questions about whether there need to be more guardrails on getting individual investors into the alternative asset universe.

The Alternative Investment Universe

    The use of the word "alternative" in the alternative investing pitch is premised on the belief that much of investing advice is aimed at long-only investors allocating their portfolios between traded stocks, bonds and cash (close to riskless and liquid investments). In that standard investment model, investors choose a stock-bond mix, for investing, and use cash as a buffer to bring in not only liquidity needs and risk preferences, but also views on stock and bond markets (being over or under priced):

The mix of stocks and bonds is determined both by risk preferences, with more risk taking associated with a higher allocation to stocks, and market timing playing into more invested in stocks (if stocks are viewed as under priced) or more into bonds (if stocks are over priced and bond are viewed as neutral investments). 

    This framework accommodates a range of choices, from the purely mechanical (like the much touted 60% stocks/40% bonds mix) to more flexible, where allocations can vary across time and be a function of market conditions. This general framework allows for variants, including different view on markets (from those who believe that markets are efficient to stock pickers and market timers) as well as investors with very different time horizons and risk levels. However, there are clearly large segments of investing that are left out of this mix from private businesses (since they are not listed and traded) to short selling (where you can have negative portfolio weights not just on individual investments but on entire markets) to asset classes that are not traded. In fact, the best way to structure the alternative investing universe if by looking at alternatives through the lens of these missing pieces.

1. Long-Short

   In principle, there is little difference between being long on an investment and holding a short position, with the only real difference being in the sequencing of cash flows, with the former requiring a negative cash flow at the time of the action (buying the stock or an asset) and a positive cash flow in a subsequent period (when it is sold), and the latter reversing the process, with the positive cash flow occurring initially (when you sell a stock or an asset that you do not own yet) and the negative cash flow later. That said, they represent actions that you would take with diametrically opposite views of the same stock (asset), with being long (going short) making sense on assets where you expect prices to go up (down). In practice, though, regulators and a subset of investors seem to view short selling more negatively, often not just attaching loaded terms like "speculation" to describe it, but also adding restrictions of how and when it can be done.

    Many institutional investors, including most mutual, pension and endowment funds, are restricted from taking short positions on investments, with exceptions sometimes carved out for hedging. For close to a century, at least in the United States, hedge funds have been given the freedom to short assets, and while they do not always use that power to benefit, it is undeniable that having that power allows them to create return distributions (in terms of expected returns, volatility and other distributional parameters) that are different from those faced by long-only investors. Within the hedge fund universe, there are diverse strategies that not only augment long-only strategies (value, growth) but also invest across multiple markets (stocks, bonds and convertibles) and geographies.

    The opening up of derivatives markets has allowed some investors to create investment positions and or structured products that use options, futures, swaps and forwards to create cash flow and return profiles that diverge from stock and bond market returns. 

2. Public-Private

    While much of our attention is spent on publicly traded stocks and bonds, there is a large segment of the economy that is composed of private businesses that are not listed or traded. In fact, there are economies, especially in emerging markets, where the bulk of economic activity occurs in the private business space, with only a small subset of businesses meeting the public listing/trading threshold. Many of these private businesses are owned and funded by their owners, but a significant proportion do need outside equity capital, and historically, there have been two providers:

• For young private businesses, and especially those that aspire to become bigger and eventually go public, it is venture capital that fills the void, covering the spectrum from angel financing for idea businesses to growth capital for firms further along in their evolution. From its beginnings in the 1950s, venture capital has grown bigger and carries more heft, especially as technology companies have come to dominate the market in the twenty first century.
• For more established private businesses, some of which need capital to grow and some of which have owners who want to cash out, the capital has come from private equity investors. Again, while private equity has been part of markets for a century or more, it has become more formalized and spread its reach in the last four decades, with the capacity to raise tens of billions of dollars to back up deal making.

On the debt front, the public debt and bank debt market is supplemented by private credit,  where investors pool funds to lend to private businesses, with negotiated rates and terms. again a process that has been around a while, but one that has also become formalized and a much larger source of funds. Advocates for private credit investing argue that it can be value-adding partly because of the borrower composition (often cut off from other sources of credit, either because of their size or default history) and partly because private credit providers can be more discerning of true default risk. Even as venture capital, private equity and private credit have expanded as capital sources, they remained out of reach for both institutional and individual investors until a couple of decades ago, but are now integral parts of the alternative investing universe.

3. Asset classes

    Public equity and debt, at least in the United States, cover a wide spectrum of the economy, and by extension, multiple asset classes and businesses, but there are big investment classes that are either underrepresented in public markets or missing.

• Real estate: For much of the twentieth century, real estate remained outside the purview of public markets, with a segmented investor base and illiquid investments, requiring localized knowledge. That started to change with the creation of real estate investment trusts, which securitized a small segment of the market, creating liquidity and standardized units for public market investors. The securitization process gained stream in the 1980s with the advent of mortgage-backed securities. Thus, real estate now has a presence in public markets, but that presence is far smaller than it should be, given the value of real estate in the economy.
• Collectibles: The collectible asset class spans an array of investment, most of which generate little or no cash flows, but derive their pricing from scarcity and enduring demand. The first and perhaps the longest standing collectible is gold, a draw for investors during inflationary period or when they lose faith in fiat currencies and governments. The second is art, ranging from paintings from the masters to digital art (non-fungible tokens or NFTs), that presumably offers owners not just financial returns but emotional dividends. At the risk of raising the ire of crypto-enthusiasts, I would argue that much of the crypto space (and especially bitcoin) also fall into this grouping, with a combination of scarcity and trading demand determining pricing. 

Institutional and individual investors have dabbled with adding these asset classes to their portfolios, but the lack of liquidity and standardization and the need for expert assessments (especially on fine art) have limited those attempts.

The Sales Pitch for Alternatives

    The strongest pitch for adding alternative investments to a portfolio dominated by publicly traded stocks and bonds comes from a basic building block for portfolio theory, which is that adding investments that have low correlation to the existing holdings in a portfolio can create better risk/return tradeoffs for investors. That pitch has been supplemented in the last two decades with arguments that alternative investments also offer a greater chance of finding market mistakes and inefficiencies, partly because they are more likely to persist in these markets, and partly because of superior management skills on the part of alternative investment managers, particularly hedge funds and private equity.

The Correlation Argument

    Much of portfolio theory as we know it is built on the insight that combining two investments that are not perfectly correlated with each other can yield mixes that deliver higher returns for any given level of risk than holding either of the investments individually. That argument has both a statistical basis, with the covariance between the two investments operating as the mechanism for the risk reduction, and an economic basis that the idiosyncratic movements in each investment can offset to create a less risky combination. 

    In that vein, the argument for adding alternative investments to a portfolio composed primarily of stocks and bonds rests on a correlation matrix of stocks and bonds with alternative investments (hedge funds, private equity, private credit, fine art, gold and collectibles):

Guggenheim Investments

While the correlations in this matrix are non-stationary (with the numbers changing both with time periods used and the indices that stand in for the asset classes) and have a variety of measurement issues that I will highlight later in this post, it is undeniable that they at least offer a chance of diversification that may not be available in a long-only stock/bond portfolio.

    Using historical correlations as the basis, advocates for alternative investments are able to create portfolios, at least on paper, that beat stock/bond combinations on a risk/return tradeoff, as can be see in this graph:

EquityMultiple Investment Partners, Green Street Advisors, and JPMorgan Asset Management

Note that the comparison is to a portfolio composed 60% of stocks and 40% of bonds, a widely used mix among portfolio managers, and in each of the cases, adding alternative investments to that portfolio results in a mix that yields  higher returns with lower risk.

The Alternative Alpha Argument

    The correlation-based argument for adding alternative investments to a portfolio is neither new nor controversial, since it is built on core portfolio theory arguments for diversification. For some advocates of alternative investments, though, that captures only a portion of the advantage of adding alternative investments. They argue that the investment classes from alternative investments draw on, which include non-traded real estate, collectibles and private businesses (young and old), are also the classes where market mistakes are more likely to persist, because of their illiquidity and opacity, and that alternative asset managers have the localized knowledge and intellectual capacity to find and take advantage of these mistakes. The payoff from doing so takes the form of "excess returns" which will supplement the benefits that flow from just diversification.

    This alpha argument is often heard most frequently with those advocating for adding hedge funds, venture capital and private equity to conventional portfolios, where the perception of superior investment management persists, but is that perception backed up by the numbers? In the graph below, I reproduce a study that looks at looked at 20-year annualized returns, from 2003 to 2022, on many alternative asset classes:

Opto Insights

Given the differences in risk across alternative investment classes, the median returns themselves do not tell us much about whether they earn excess returns, but two facts come through nevertheless. The first is that the variation across managers within investment classes is significant in both private equity and venture capital. The second, and this is not visible in this graph, is that persistence in outperformance is more common in venture capital and private equity than it is in public market investors, with winners more likely to continue winning and losers dropping out. I expanded on some of the reasons for this persistence, at least in venture capital, in a post from some years ago.

   The bottom line is that there is some basis for the argument that as investment classes, hedge funds, private equity and venture capital, generate excess returns, albeit modest, relative to other investors, but it is unclear whether these excess returns are just compensation for the illiquidity and opacity that go with the investments that they have to make. In addition, given the skewed payoffs, where there are a few big and persistent winners, the median hedge fund, private equity investor or venture capitalist may be no better at generating alpha than the average mutual fund manager.

The Rise of Alternative Investing

    No matter what you think of the alternative investing sales pitch, it is undeniable that it has worked, at least at the institutional investor level, for some of its adopted, especially in the last two decades. In the graph below, for instance, you can track the rise of alternative investments in pension fund holdings in this graph (from KKR):

Source: KKR

That move towards alternatives is not just restricted to pension funds, as other allocators have joined the mix:

Source: KKR

Some of the early movers into alternative asset classes were lauded and used as role models by others in the space. David Swensen, at Yale, for instance, burnished a well-deserved reputation as a pioneer in investment management by moving Yale's endowment into private equity and hedge funds earlier than other Ivy League schools, allowing Yale to outpace them in the returns race for much of this century:

As other fund managers have followed Yale into the space, that surge has been good for private equity and hedge fund managers, who have seen their ranks grow (both in terms of numbers and dollar value under management) over time.

Where's the beef?

    As funds have increased their allocations to alternative investments, drawn by the perceived gains on paper and the success of early adopters, it is becoming increasingly clear that the results from the move have been underwhelming. In short, the actual effects on returns and risk from adding alternative investments to portfolios are not matching up to the promise, leading to questions of why and where the leakage is occurring.

 

The Questionable Benefits of Alternative Investing

    In theory and principle, adding investments from groupings of investments that are less correlated with stocks and bonds should yield benefits for investors, and at least in the aggregate, over long time periods that may hold. Cambridge Associates, in their annual review of endowments, presents this graph of returns and standard deviations, as a function of how much each endowment allocated to private investments over a ten-year period (from 2012-2022):

Cambridge Associates

With the subset of endowments that Cambridge examined, both annual returns and Sharpe ratios  were higher at funds that invested more in private investments (which incorporates much of the alternative investment space). Those results, though, have been challenged by others looking at a broader group of funds. In an article in CFA magazine, Nicolas Rabener looked at the two arguments for adding hedge funds to a portfolio, i.e., that they increase Sharpe ratios and reduce drawdowns in fund value during market downturns, and found both absent in practice:

Nicolas Ramener, CFA Institute

With hedge funds, admittedly just one component of alternative investing, Rabener finds that notwithstanding the low correlations that some hedge fund strategies have with a conventional equity/bond portfolio, there is no noticeable improvement in Sharpe ratios or decrease in drawdowns from adding them to the portfolio.

    Richard Ennis, a long-time critic of alternative investing, has a series of papers that question the benefits to funds from adding them to the mix. 

Richard Ennis, SSRN

In the Ennis sample, the excess returns become more negative as the allocation to alternative investments is increased, undercutting a key sales pitch for the allocation. While alternative investing advocates will take issue with the Ennis findings, on empirical and statistical bases, even long-term beneficiaries from alternative investing seem to have become more skeptical about its benefits over time. In a 2018 paper, Fragkiskos, Ryan and Markov noted that among Ivy League endowments, properly adjusting for risk causes any benefits in terms of Sharpe ratios, from adding alternative investments to the mix, to disappear. In perhaps the most telling sign that the bloom is off the alternative investing rose, Yale's endowment announced its intent to sell of billions of dollars of private equity holdings in June 2025, after years of under performance on its holdings in that investment class.

Correlations: Real and Perceived

    At the start of this post, I noted that a key sales pitch for alternative investments is their low correlation with stock/bond markets, and to the extent that this historical correlations seem to back this pitch, it may be surprising that the actual results don't measure up to what is promised. There are two reasons why these historical correlations may be understated for most  private investment classes:

1. Pricing lags; Unlike publicly traded equities and bonds, where there are observable market prices from current transactions, most private assets are not liquid and the pricing is based upon appraisals. In theory, these appraisers are supposed to mark-to-market, but in practice, the pricing that they attach to private assets lag market changes. Thus, when markets are going up or down quickly, private equity and venture capital can look like they are going up or down less than public equity markets, but that is because of the lagged prices. 
2. Market crises: While correlations between investment classes are often based upon long periods, and across up and down markets, the truth is that investors care most about risk (and correlations) during market crises, and many investment classes that exhibit low correlation during sideways or stable markets can have lose that feature and move in lock step with public markets during crisis. That was the case during the banking crisis in the last quarter of 2008 and during the COVID meltdown in the first quarter of 2020, when funds with large private investment allocations felt the same drawdown and pain as funds without that exposure.

In my view, this understatement of correlation is most acute in private equity and venture capital, which are after all equity investments in businesses, albeit private, instead of public. It is less likely to be the case for truly differentiated investment classes, such as gold, collectibles and real estate, but even here, correlations with public markets have risen, as they have become more widely held by funds. With hedge funds, it is possible to construct strategies that should have lower correlation with public markets, but some of these strategies can have catastrophic breakdowns (with the potential for wipeout) during market crises.

Illiquidity and Opacity (lack of transparency)

    Even the strongest advocates for alternative investments accept that they are less liquid than public market investments, but argue that for investors with long time horizons and clearly defined cash flow needs (like pension and endowment funds), that illiquidity should not be a deal breaker. The problem with this argument is that much as investors like to believe that they control their time horizons and cash needs, they do not, and find their need for liquidity rising during acute market crises or panics. The other problem with illiquidity is that it manifests in transactions costs, manifesting both in terms of bid-ask spreads and in price impact that drains from returns.

    The other aspect of the private investment market that is mentioned but then glossed over is that many of its vehicles tend to be opaque in terms of governance structure and reporting. Investors, including many large institutional players, that invest in hedge funds, private equity and venture capital are often on the outside looking in, as deals get structured and gains get apportioned. Again, that absence of transparency may be ignored in good times, but could make bad times worse.

Disappearing Alphas

    When alternative investing first became accessible to institutional investors, the presumption was that market-beating opportunities abounded in private markets, and that hedge fund, private equity and venture capital managers brought superior abilities to the investment game. That may have been true then, but that perception has faded for many reasons. First, as the number of funds and money under management in these investment vehicles has increased, the capacity to make easy money has also faded, and in my view, the average venture capital, private equity or hedge fund manager is now no better or worse than the average mutual fund manager. Second, the investment game has also become more difficult to win, as the investment world has become flatter, with many of the advantages that fund managers used to extract excess returns dissipating over time. Third, the entry of passive investment vehicles like exchange traded funds (ETFS) that can spot and replicate active investors who are beating the market has meant that excess returns, even if present, do not last for long.

    With hedge funds, the fading of excess returns over time has been chronicled. Sullivan looked at hedge funds between 1994 and 2019 and noted that even by 2009, the alpha had dropped to zero or below:

Sullivan, Hedge fund alpha: Cycle or Sunset

In a companion paper, Sullivan also noted another phenomenon undercutting the benefits of adding hedge funds to a public market portfolio, which is that correlations between hedge fund returns and public market returns have risen over time from 0.65 in the 1990s to 0.87 in the last decade.

    With private investment funds, the results are similar, when performance is compared over time. A paper looking at private equity returns over time concluded that private equity returns, which ran well above public market returns between 1998 and 2007, have started to resemble public market returns in most recent years.

Ilmanen, Chandra and McQuinn

The positive notes in both hedge funds and private equity, as we noted in an earlier section on venture capital, is that while the typical manager in each group has converged to the average, the best managers in these groups have shown more staying power than in public markets. Put simple, the hope is that you can invest your money with these superior managers, and ride their success to earn more than you would have earned elsewhere, but there is a catch even with that scenario, which we will explore next.

The Cost Effect

   Let's assume that even with fading alphas and higher correlations with public markets, some hedge funds and private market investors still provide benefits to funds invested primarily in public markets. Those benefits, though, still come with significant costs, since the managers of these alternative investment vehicles charge far more for their services than their equivalents in public markets. In general, the fees for alternative investments are composed of a management fee, specified as a percent of assets under management, and a performance fee, where the alternative investment manager gets a percent of returns earned over and above a specified benchmark. In the two-and-twenty model that many hedge and PE fund models used to adhere to, the fund managers collect 2% of the assets under management and 20% of returns in excess of the benchmark. Both numbers have been under downward pressure in recent years, as alternative investing has spread:

Even with the decline, though, these costs represent a significant drag on performance, and  the chances of gaining a net benefit from adding an alternative investing class to a fund drop towards zero very quickly.

An Epitaph for Alternative Investing?

    It is clear, looking at the trend lines, that the days of easy money for those selling alternative investments as well as those buying these investments have wound down. Even  savvy institutional investors, who have been long-term believers in the benefits of alternative investing, are questioning whether private equity, hedge funds and venture capital have become too big and are too costly to be value-adding. As institutional investors become less willing to jump into the alternative investing fray, it looks like individual investors are now being targeted for the alternative investing sales pitch, and as with all things investing, I would suggest that buyer beware, and that investors, institutions and individual, keep the following in mind, when listening to alternative investing pitches:

1. Be picky about alternatives: Given that the alpha pitch (that hedge fund and private equity managers deliver excess returns) has lost its heft, it is correlations that should guide investor choices on alternative investments. That will reduce the attractiveness of private equity and venture capital, as investment vehicles, and increase the draw of some hedge funds, gold and many collectibles. As for cryptos, the jury is still out, since bitcoin, the highest profile component, has behaved more like risky equity, rising and falling with the market, than a traditional collectible.
2. Avoid high-cost and exotic vehicles: Investing is a tough enough game to win, without costs, and adding high cost vehicles makes it even more difficult. At the risk of drawing the ire of some, I would argue that any endowment or pension fund managers who pay two-and-twenty to a hedge fund, no matter how great its track record, first needs their heads examined and then summarily fired. On a related noted, alternative investments that are based upon strategies that are so complex that neither the seller nor buyer has an intuitive sense of what exactly they are trying to do should be avoided.
3. Be realistic about time horizon and liquidity needs: As noted many times through this post, alternative investing, no matter how well structured and practiced, will come with less liquidity and transparency than public investing, making it a better choice for investors with longer time horizons and well-specified cash needs. On this front, individual investors need to be honest with themselves about how susceptible they are to panic attacks and peer-group pressure, and institutional investors have to recognize that their time horizons are determined by their clients, and not by their own preferences.
4. Be wary of correlation matrices and historical alphas: The alternative investing sales pitch is juiced by correlation matrices (indicating that the alternative investing vehicle in question does not move with public markets) and historic alphas (showing that vehicle delivering market beating risk/return tradeoffs and Sharpe ratios). If there is one takeaway from this post, I hope that it is that historical correlations, especially when you have non-traded investments at play, are untrustworthy and that alphas fade over time, and more so when the vehicles that delivered them are sold relentlessly.

YouTube video

Sovereign Ratings, Default Risk and Markets: The Moody's Downgrade Aftermath!

 I was on a family vacation in August 2011 when I received an email from a journalist asking me what I thought about the S&P ratings downgrade for the US. Since I stay blissfully unaware of most news stories and things related to markets when I am on the beach, I had to look up what he was talking about, and it was S&P's decision to downgrade the United States, which had always enjoyed AAA, the highest sovereign rating  that can be granted to a country, to AA+, reflecting their concerns about both the fiscal challenges faced by the country, with mounting trade and budget deficits, as well as the willingness of its political institutions to flirt with the possibility of default. For more than a decade, S&P remained the outlier, but in 2023, Fitch joined it by also downgrading the US from AAA to AA+, citing the same reasons. That left Moody's, the third of the major sovereign ratings agencies, as the only one that persisted with a Aaa (Moody's equivalent of AAA) for the US, but that changed on May 16, 2025, when it too downgraded the US from Aaa (negative) to Aa1 (stable). Since the ratings downgrade happened after close of trading on a Friday, there was concern that markets would wake up on the following  Monday (May 19) to a wave of selling, and while that did not materialize, the rest of the week was a down week for both stocks and US treasury bonds, especially at the longest end of the maturity spectrum. Rather than rehash the arguments about US debt and political dysfunction, which I am sure that you had read elsewhere, I thought I would take this moment to talk about sovereign default risk, how ratings agencies rate sovereigns, the biases and errors in sovereign ratings and their predictive power, and use that discussion as a launching pad to talk about how the US ratings downgrade will affect equity and bond valuations not just in the US, but around the world.

Sovereign Defaults: A History

    Through time, governments have often been dependent on debt to finance themselves, some in the local currency and much in a foreign currency. A large proportion of sovereign defaults have occurred with foreign currency sovereign borrowing, as the borrowing country finds itself short of the foreign currency to meet its obligations. However, those defaults, and especially so in recent years, have been supplemented by countries that have chosen to default on local currency borrowings. I use the word "chosen" because most countries  have the capacity to avoid default on local currency debt, being able to print money in that currency to pay off debt, but chose not to do so, because they feared the consequences of the inflation that would follow more than the consequences of default.

BoC/BoE Sovereign Default Database

While the number of sovereign defaults has ebbed and flowed over time, there are two points worth making about the data. The first is that, over time, sovereign defaults, especially on foreign currency debt, have shifted from bank debt to sovereign bonds, with three times as many sovereign defaults on bonds than on bank loans in 2023. The second is that local currency defaults are persistent over time, and while less frequent than foreign currency defaults, remain a significant proportion of total defaults.

    The consequences of sovereign default have been both economic and political. Besides the obvious implication that lenders to that government lose some or a great deal of what is owed to them, there are other consequences. Researchers who have examined the aftermath of default have come to the following conclusions about the short-term and long-term effects of defaulting on debt:

1. Default has a negative impact on the economy, with real GDP dropping between 0.5% and 2%, but the bulk of the decline is in the first year after the default and seems to be short lived.
2. Default does affect a country’s long-term sovereign rating and borrowing costs. One study of credit ratings in 1995 found that the ratings for countries that had defaulted at least once since 1970 were one to two notches lower than otherwise similar countries that had not defaulted. In the same vein, defaulting countries have borrowing costs that are about 0.5 to 1% higher than countries that have not defaulted. Here again, though, the effects of default dissipate over time.
3. Sovereign default can cause trade retaliation. One study indicates a drop of 8% in bilateral trade after default, with the effects lasting for up to 15 years, and another one that uses industry level data finds that export-oriented industries are particularly hurt by sovereign default.
4. Sovereign default can make banking systems more fragile. A study of 149 countries between 1975 and 2000 indicates that the probability of a banking crisis is 14% in countries that have defaulted, an eleven percentage-point increase over non-defaulting countries.
5. Sovereign default also increases the likelihood of political change. While none of the studies focus on defaults per se, there are several that have examined the after-effects of sharp devaluations, which often accompany default. A study of devaluations between 1971 and 2003 finds a 45% increase in the probability of change in the top leader (prime minister or president) in the country and a 64% increase in the probability of change in the finance executive (minister of finance or head of central bank).

In summary, default is costly, and countries do not (and should not) take the possibility of default lightly. Default is particularly expensive when it leads to banking crises and currency devaluations; the former has a longstanding impact on the capacity of firms to fund their investments whereas the latter create political and institutional instability that lasts for long periods.

Sovereign Ratings: Measures and Process

    Since few of us have the resources or the time to dedicate to understanding small and unfamiliar countries, it is no surprise that third parties have stepped into the breach, with their assessments of sovereign default risk. Of these third-party assessors, bond ratings agencies came in with the biggest advantages:

1. They have been assessing default risk in corporations for a hundred years or more and presumably can transfer some of their skills to assessing sovereign risk.
2. Bond investors who are familiar with the ratings measures, from investing in corporate bonds, find it easy to extend their use to assessing sovereign bonds. Thus, a AAA rated country is viewed as close to riskless whereas a C rated country is very risky. 

Moody’s, Standard and Poor’s and Fitch’s have been rating corporate bond offerings since the early part of the twentieth century. Moody’s has been rating corporate bonds since 1919 and started rating government bonds in the 1920s, when that market was an active one. By 1929, Moody’s provided ratings for almost fifty central governments. With the Great Depression and the Second World War, investments in government bonds abated and with it, the interest in government bond ratings. In the 1970s, the business picked up again slowly. As recently as the early 1980s, only about thirteen  governments, mostly in developed and mature markets, had ratings, with most of them commanding the highest level (Aaa). The decade from 1985 to 1994 added 34 countries to the sovereign rating list, with many of them having speculative or lower ratings and by 2024, Moody's alone was rating 143 countries, covering 75% of all emerging market countries and almost every developed market. 

Not only have ratings agencies become more active in adding countries to their ratings list, but they have also expanded their coverage of countries with more default risk/ lower ratings.  In fact, the number of Aaa rated countries was the same in 1985, when there were thirteen rated countries, as in 2025, when there were 143 rated countries. In the last two decades, at least five sovereigns, including Japan, the UK, France and now the US, have lost their Aaa ratings.  In addition to more countries being rated, the ratings themselves have become richer. Moody’s and S&P now provide two ratings for each country – a local currency rating (for domestic currency debt/ bonds) and a foreign currency rating (for government borrowings in a foreign currency). 

    In assessing these sovereign ratings, ratings agencies draw on a multitude of data, quantitative and qualitative. Moody's describes its sovereign ratings process in the picture below:

The process is broad enough to cover both political and economic factors, while preserving wiggle room for the ratings agencies to make subjective judgments on default that can lead to different ratings for two countries with similar economic and political profiles. The heat map below provides the sovereign ratings, from Moody's, for all rated countries the start of 2025:

Moody's sovereign ratings

Note that the greyed out countries are unrated, with Russia being the most significant example; the ratings agencies withdrew their rating for Russia in 2022 and not reinstated it yet. There were only a handful of Aaa rated countries, concentrated in North America (United States and Canada), Northern Europe (Germany, Scandinavia), Australia & New Zealand and Singapore (the only Aaa-rated Asian country. In 2025, there have been a eight sovereign ratings changes, four upgrades and four downgrades, with the US downgrade from Aaa to Aa1 as the highest profile change

With the US downgrade, the list of Aaa-rated countries has become shorter, and as Canada and Germany struggle with budget imbalances, the likelihood is that more countries will drop off the list.

Sovereign Ratings:  Performance and Alternatives

    If sovereign ratings are designed to measure exposure to default risk, how well do they do? The answer depends on how you evaluate their performance. The ratings agencies provide tables that list defaults by rating that back the proposition that sovereign ratings and default are highly correlated. A Moody's update of default rates by sovereign ratings classes, between 1983 and 2024, yielded the following:

Default rates rise as sovereign ratings decline, with a default rate of 24% for  speculative grade sovereign debt (Baa2 and below) as opposed to 1.8% for investment grade (Aaa to Baa1) sovereign debt.

    That said, there are aspects of sovereign ratings that should give pause to anyone considering using them as their proxy for sovereign default, they do come with caveats and limitations:

1. Ratings are upward biased: Ratings agencies have been accused by some of being far too optimistic in their assessments of both corporate and sovereign ratings. While the conflict of interest of having issuers pay for the rating is offered as the rationale for the upward bias in corporate ratings, that argument does not hold up when it comes to sovereign ratings, since not only are the revenues small, relative to reputation loss, but a proportion of sovereigns are rated for no fees.
2. There is herd behavior: When one ratings agency lowers or raises a sovereign rating, other ratings agencies seem to follow suit. This herd behavior reduces the value of having three separate ratings agencies, since their assessments of sovereign risk are no longer independent.
3. Too little, too late: To price sovereign bonds (or set interest rates on sovereign loans), investors (banks) need assessments of default risk that are updated and timely. It has long been argued that ratings agencies take too long to change ratings, and that these changes happen too late to protect investors from a crisis.
4. Vicious Cycle: Once a market is in crisis, there is the perception that ratings agencies sometimes overreact and lower ratings too much, thus creating a feedback effect that makes the crisis worse. This is especially true for small countries that are mostly dependent on foreign capital for their funds.
5. Regional biases: There are many, especially in Asia and Latin America, that believe that the ratings agencies are too lax in assessing default risk for North America and Europe,  overrating countries in  those regions, while being too stringent in their assessments of default in Asia, Latin America and Africa, underrating countries in those regions. 

In sum, the evidence suggests that while sovereign ratings are good measures of country default risk, changes in ratings often lag changes on the ground, making them less useful to lenders and investors.

    If the key limitation of sovereign ratings is that they are not timely assessors of country default risk, that failure is alleviated by the development of the sovereign CDS market, a market where investors can buy insurance against country default risk by paying an (annualized) price. While that market still has issues in terms of counterparty risk and legal questions about what comprises default, it has expanded in the last two decades, and at the start of 2025, there were about 80 countries with sovereign CDS available on them. The heat map below provides a picture of sovereign (10-year)  CDS spreads on January 1, 2025:

As you can see, even at the start of 2025, the market was drawing a distinction between  the safest Aaa-rated countries (Scandinavia, Switzerland, Australia and New Zealand), all with sovereign CDS spreads of 0.20% or below, and more risky Aaa-rated countries (US, Germany, Canada). During 2025, the market shocks from tariff and trade wars have had an effect, with sovereign CDS spreads increasing, especially in April. The US, which started 2025 with a sovereign CDS spread of 0.41%, saw a widening of the spread to 0.62% in late April, before dropping back a bit in May, with the Moody's downgrade having almost no effect on the US sovereign CDS spread.

The US Downgrade: Lead-in and Aftermath

    With that background on sovereign default and ratings, let's take a look at the story of the moment, which is the Moody's downgrade of the US from Aaa to Aa1. In the weeks since, we have not seen a major upheaval in markets, and the question that we face as investors and analysts is whether anything of consequence has changed as a result of the downgrade.

The Lead-in

    As I noted at the start of this post, Moody's was the last of the big three sovereign ratings agencies giving the United States a Aaa rating, with S&P (in 2011) and Fitch (in 2023) having already downgraded the US. In fact, the two reasons that both ratings agencies provided at the time of their downgrades were rising government debt and politically dysfunction were also the reasons that Moody's noted in their downgrade. On the debt front, one of the measures that ratings agencies use to assess a country's financial standing is its debt to GDP ratio, and it is undeniable that this statistic has trended upwards for the United States:

The ramping up of US debt since 2008 is reflected in total federal debt rising from 80% of GDP in 2008  to more than 120% in 2024. While some of the surge in debt can be attributed to the exigencies caused by crises (the 2008 banking crisis and the 2020 COVID bailouts), the troubling truth is that the debt has outlasted the crises and blaming the crises for the debt levels today is disingenuous. 

    The problem with the debt-to-GDP measure of sovereign fiscal standing is that it is an imperfect indicator, as can be seen in this list of countries that scored highest and lowest on this measure in 2023:

IMF

Many of the countries with the highest debt to GDP ratios would be classified as safe and some have Aaa ratings, whereas very few of the countries on the lowest debt to GDP list would qualify as safe. Even if it it the high debt to GDP ratio for the US that triggered the Moody's downgrade, the question is why Moody's chose to do this in 2025 rather than a year or two or even a decade ago, and the answer to that lies, I think, in the political component. A sovereign default has both economic and political roots, since a government that is intent on preserving its credit standing will often find ways to pay its debt and avoid default. For decades now, the US has enjoyed special status with markets and institutions (like ratings agencies), built as much on its institutional stability (legal and regulatory) as it was on its economic power. The Moody's downgrade seems to me a signal that those days might be winding down, and that the United States, like the rest of the world, will face more accountability for lack of discipline in its fiscal and monetary policy.

Market Reaction

    The ratings downgrade was after close of trading on Friday, May 16, and there was concern about how it would play out in markets, when they opened on Monday, May 19. US equities were actually up on that day, though they lost ground in the subsequent days:

If equity markets were relatively unscathed in the two weeks after the downgrade, what about bond markets, and specially, the US treasury market? After all, an issuer downgrade for any bond is bad news, and rates should be expected to rise to reflect higher default risk:

While rates did go up in the the first few days after the downgrade, the effect was muddled by the passage of a reconciliation bill in the house that potentially could add to the deficit in future years. In fact, by the May 29, 2025, almost all of the downgrade effect had faded, with rates close to where they were at the start of the year.

    You may be surprised that markets did not react more negatively to the ratings downgrade, but I am not for three reasons:

1. Lack of surprise effect: While the timing of the Moody's downgrade was unexpected, the downgrade itself was not surprising for two reasons. First, since S&P and Fitch had already downgraded the US, Moody's was the outlier in giving the US a Aaa rating, and it was only a matter of time before it joined the other two agencies. Second, in addition to reporting a sovereign rating, Moody's discloses when it puts a country on a watch for a ratings changes, with positive (negative) indicating the possibility of a ratings upgrade (downgrade). Moody's changed its outlook for the US to negative in November 2023, and while the rating remained unchanged until May 2025, it was clearly considering the downgrade in the months leading up to it.
2. Magnitude of private capital: The immediate effect of a sovereign ratings downgrade is on government borrowing, and while the US does borrow vast amounts, private capital (in the form of equity and debt) is a far bigger source of financing and funding for the economy. 
3. Ratings change: The ratings downgrade ws more of a blow to pride than to finances, since the default risk (and default spread) difference between an Aaa rating and a Aa1 rating is small. Austria and Finland, for instance, had Aa1 ratings in May 2025, and their ten-year bonds, denominated in Euros, traded at a spread of about 0.15- 0.20% over the German ten-year Euro bond; Germany had a Aaa rating.

Consequences for valuation and investment analysis

   While the immediate economic and financial consequences of a downgrade from Aaa to Aa1 will be small, there are implications for analysts around the world. In particular, analysts will have to take steps when working with US dollars that they may already be taking already when working with most other currencies in estimating basic inputs into financial analysis.

    Let's start with the riskfree rate, a basic building block for estimating costs of equity and capital, which are inputs into intrinsic valuation. In principle, the riskfree rate is what you will earn on a guaranteed investment in a currency, and any risk premiums, either for investing in equity (equity risk premium) or in fixed income securities (default spreads), are added to the riskfree rate. It is standard practice in many textbooks and classrooms to use the government bond rate as the risk free rate, but that is built on the presumption that governments cannot default (at least on bonds issued in the local currency). Using a Aaa (AAA) rating as a (lazy) proxy for default-free, that is the rationale we used to justify government bond rates as riskfree rates at the start of 2025, in Australian, Singapore and Canadian dollars, the Euro (Germany). Swiss francs and Danish krone. As we noted in the first section, the assumption that governments don't default  is violated in practice, since some countries choose to default on local currency bonds, rather than face up to inflation. If that is the case, the government bond rate is no longer truly a riskfree rate, and getting to a riskfree rate will require netting out a default spread from the government bond rate:

Risk free rate = Government Bond rate − Default spread for the government 

The default spread can be estimated either from the sovereign bond rating (with a look up table) or a sovereign CDS spread, and we used that process to get riskfree in rates in a  host of currencies, where local currency government bonds had default risk, at the start of 2025:

Thus, to get a riskfree rate in Indian rupees, Brazilian reals or Turkish lira, we start with government bonds in these currencies and net out the default spreads for the countries in question. We do this to ensure that we don't double count country risk by first using the government bond (which includes default risk) as a riskfree rate and then using a larger equity risk premium to allow for the same country risk.  

    Now that the US is no longer Aaa rated, we have to follow a similar process to get a riskfree rate in US dollars:

• US 10-year treasury bond rate on May 30, 2025  = 4.41%
• Default spread based on Aa1 rating on May 30, 2025  = 0.40%
• Riskfree rate in US dollars on May 30, 2025 = US 10-year treasury rate - Aa1 default spread = 4.41% - 0.40% = 4.01%

This adjustment yields a riskfree rate of 4.01% in US dollars, and it is also built on the presumption that the default spread manifested after the Moody's downgrade on May 16, when the more realistic reading is that US treasury markets have been carrying a  default spread embedded in them for years, and that we are not making it explicit.

    The ratings downgrade for the US will also affect the equity risk premium computations that I use to estimate the cost of equity for companies. As some of you who track my equity risk premiums by country know, I estimate an equity risk premium for the S&P 500, and at least until the start of this year, I used that as a premium for all mature markets (with a AAA (Aaa) rating as the indicator of maturity). Thus, countries like Canada, Germany, Australia and Singapore were all assigned the same premium as that attributed to the S&P 500. For countries with ratings below Aaa, I added an "extra country risk premium"  computed based upon the default spreads that went with the country ratings:

With the ratings downgrade, I will have to modify this process in three ways. The first is that when computing the equity risk premium for the S& P 500, I will have to net out the adjusted riskfree rate in US dollars rather than the US treasury rate, yielding a higher equity risk premium for the US. Second, for Aaa rated countries, to the extent that they are safer than the US will have to be assigned an equity risk premium lower than the US, with the adjustment downward reflecting the Aa1 rating for the US. The third is that for all other countries, the country risk premium will be computed based upon the the their default spreads and the equity risk premium estimated for Aaa rated countries (rather than the US equity risk premium):

How will the cost of equity for a firm with all of its revenues in the United States be affected as a consequence? Let's take three companies, one below-average risk, one average-risk and one above average risk, and compute their costs of equity on May 30, 2025, with and without the downgrade factored in:

As you can see, the expected return on the S&P 500 as of May 30, 2025, reflecting the index level then and the expected cash flows, is 8.64%. Incorporating the effects of the downgrade changes the composition of that expected return, resulting in a lower riskfree rate (4.01% instead of 4.41%) and a higher equity risk premium (4.63% instead of 4.23%). Thus, while the expected return for the average stock remains at 8.64%, the expected return increases slightly for riskier stocks and decreases slightly for safer stocks, but the effects are so small that investors will hardly notice. If there is a lesson for analysts here, it is that the downgrade's effects on the discount rates (costs of equity and capital) are minimal, and that staying with the conventional approach (of using the ten-year US treasury bond rate as the riskfree rate and using that rate to compute the equity risk premium) will continue to work.

Conclusion

    The Moody's ratings downgrade of the US made the news, and much was made of it during the weekend that followed. The financial and economic consequences, at least so far, have been inconsequential, with equity and bond markets shrugging off the downgrade, perhaps because the surprise factor was minimal. The downgrade also has had only a minimal impact on costs of equity and capital for US companies, and while that may change, the changes will come from macroeconomic news or from crises. For the most part, analysts should be able to continue to work with the US treasury rate as a riskfree rate and forward-looking equity risk premiums, as they did before the downgrade. With all of that said, though, the Moody's action does carry symbolic weight, another indicator that US exceptionalism, which allowed the US to take economic and fiscal actions that would have brought blowback for other countries, especially in emerging markets, is coming to an end. That is healthy, in the long term, for both the United States and the rest of the world, but it will come with short term pain.

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