Foreign exchange reserves are held to finance imports and pay foreign currency debts, and to provide a buffer against capital flight and sudden portfolio outflows – but they come with opportunity costs. Many countries hold an excessive amount, and strategic asset allocations are rarely challenged to improve efficiency or reduce costs that may be incurred through unnecessary constraints or biases.
Today, however, the threat of structurally higher inflation, tighter monetary policy in developed markets and rising rates are forcing a rethink. There are relatively simple ways to improve efficiency.
The following example describes a hypothetical reserve investor who built a simple portfolio of 50% global government bonds and 50% euro and dollar cash 20 years ago with the goal of outperforming a benchmark inflation index of one percentage point per year.
This portfolio easily outperformed its benchmark until around 2012. Thereafter, it struggled to keep pace as rates no longer had room to fall further and coupon and principal proceeds were steadily invested in low-yielding assets. At the end of 2021, its performance since inception was below benchmark.
We suggest that the investor redirect 20% of the portfolio to a conservative investment tranche, split between investment grade corporate bonds and US agency mortgage-backed securities. These assets have a shorter duration than the typical portfolio of government bonds, as well as some exposure to credit risk which would have helped to boost performance once rates approached the zero bound at the end of 2009. Accordingly, by the end of January 2022, the proposed award could have yielded up to 20 percentage points of cumulative return more than the initial award.
Volatility and maximum drawdown would also have been lower, but what about liquidity risk?
We applied haircuts to the value of the two portfolios using the high-quality liquid asset factors defined in the Basel III framework for measuring liquidity risk (Chart 1). These impose a valuation penalty that reflects the losses one could incur if one attempted to sell assets during a period of market stress. Since the initial allocation does not attract a penalizing HQLA discount, unlike corporate bonds and MBS, this is negative for the proposed allocation.
Figure 1. Diversification would have improved performance without unduly compromising liquidity
Portfolio valuations after HQLA discount, rebased on a value of 100 for the initial allocation as of January 31, 2001
Source: Neuberger Berman
Figure 2. Assumed HQLA haircuts for each asset class
Source: Bloomberg, Neuberger Berman
On day one, these discounts represented a 7.5% reduction in valuation across the entire portfolio. In June 2008, however, the superior overall performance of the proposed allocation began to close the gap. At the end of 2015, the proposed allocation would have had a higher value than the initial allocation, even after taking into account the heavy penalties of the HQLA discounts.
In other words, even with these tight haircuts, we can see that this hypothetical reserve investor can afford to trade at least some short-term liquidity for a likely improvement in long-term asset growth – unless he needs to liquidate 90% to 100% of his assets at once.
We offered a similar solution to an official institution that approached Neuberger Berman for help in early 2021. It managed a surprisingly large allocation to quasi-government bonds that was intended to achieve a modest yield boost while still preserving the liquidity of government bonds. We questioned this approach because quasi-government bonds have become quite illiquid in times of risk aversion – less liquid than investment-grade global corporate bonds or investment-grade securitized debt tranches, which have also tend to offer higher returns.
As with our hypothetical reserves investor, we were able to show this real-world investor how adding securitized credit would have increased yield with only a moderate increase in volatility, while diversifying with corporate bonds would have dramatically reduced volatility without giving up too much. improved performance.
These examples reflect the question we are increasingly asked by official institutions: how can we use more flexible credit allocation to maintain returns, within tight constraints of liquidity, drawdown risk, credit quality , duration and other parameters specific to our mandate? We think there is a lot to be done to make asset allocations more efficient – and once “the beta gets better”, the value-added potential of active management can be explored.
Jahangir Aka is Head of Official Institutions, Jon Jonsson is Senior Portfolio Manager, Multi-Sector Fixed Income, and Ziling Jiang is Head of Institutional Solutions EMEA, Neuberger Berman.
This article is an edited excerpt from Neuberger Berman’s white paper, “Could Your Beta be Better?”, published May 9, 2022.