Foreign exchange reserves are a necessary burden, particularly for emerging economies that can be particularly exposed to capital flight and dollar or euro-denominated debt liabilities. They have been important for preventing and mitigating crises, but they also impose opportunity costs at both the national and global levels—especially when investment return comes second to safety and capital preservation.
Strategic benchmarks and asset allocations are seldom interrogated to improve efficiency or cut the costs that can be incurred by unnecessary constraints or biases. Now, however, a dramatic decline in yields and credit spreads in global fixed income, compounded by the threat of structurally higher inflation and rising rates, is forcing many reserves investors to reconsider their strategies.
In this article, we consider the substantial enhancement that can be made with some relatively straightforward adjustments, such as setting aside a tranche of reserves for conservative multi-asset credit investment. Drawing upon some of our own practical experience, we also suggest that further enhancements can be achieved with more active and tailored strategies.
Executive Summary
- Foreign exchange reserves can be an important buffer against currency crises, but they impose opportunity costs that we believe could be prudently mitigated with adjustments to strategic asset allocation.
- We present a hypothetical reserves investor that has held a portfolio of global government bonds and euro and U.S. dollar cash for 20 years, which has recently fallen behind its performance benchmark.
– Putting 20% of these “Liquidity” assets into an “Investment” tranche split between corporate bonds and mortgage-backed securities (MBS) would have maintained outperformance over the benchmark.
– We apply a stringent illiquidity haircut to this portfolio to show how limited the additional liquidity risk would have been in the early years of the holding period, and how it would have disappeared completely within 15 years. - We describe a real reserves investor whose benchmark was allocated to G10 government and quasi-sovereign bonds, which asked us to model alternative portfolios for it to consider, backtested for 15 years.
– We removed the quasi-sovereign bonds and showed how adding securitized credit would have raised the return of the portfolio, while diversifying with corporate bonds would have reduced the volatility without giving up too much of the enhanced return. - We briefly describe two additional real-world case studies:
– Building a model credit portfolio for an investor seeking to outperform the Special Drawing Rights (SDR) interest rate with short duration and no foreign exchange risk.
– Modelling an addition of emerging markets debt and bank credit to enable an investor to shorten the duration of its portfolio in order to meet an expected shortfall threshold in a rising interest rate environment. - We believe all four cases illustrate how revisiting strategic asset allocation benchmarks can help to enhance risk-adjusted return without compromising risk management, particularly as we move into a challenging period of higher inflation and rising rates.
Diversification Does Not Unduly Compromise Valuation, Even After Adjustment With High Quality Liquid Assets Haircuts
Source: Bloomberg, Neuberger Berman. Data as of January 31, 2022. Indices used: Bloomberg Global Aggregate Treasuries Total Return Index USD Unhedged; Barclays Benchmark Overnight USD Cash Index; Barclays 3-Month Euribor Cash Index; Bloomberg Global Aggregate Credit Total Return Index USD Unhedged; Bloomberg U.S. Mortgage Backed Securities Index Total Return USD Unhedged. For illustrative purposes only. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.
