Take more risks for higher returns

Central banks do have some options on how to deal with the debt burden which is a result of the global financial crisis submitsMr. Russell Silberston, Investec Head of Reserves Management.

Mr Russell Silberston, Head of Reserves Management, provided a range of Alternative Investment Options for Central Bank Reserves that support the central tenets of capital and liquidity preservation while delivering higher returns.

Using a disciplined approach, it is possible to answer the question of expanding risk budgets and broadening investment guidelines with reverence for these tenets – however, a redefinition of risk is required. The search for yield of the past five years has highlighted the vastly superior capital and fiscal stability available to investors in less traditional markets. Introducing Investec Asset Management’s Reserves Management S.A.F.E Framework (measuring a potential market’s Stability, Access, Feasibility and Efficiency for inclusion in a reserves portfolio) provided guidelines for enhancing returns through investing in “Growth” assets, while maintaining a resilient reserves portfolio biased towards assets with “Defensive” qualities.

Allocations are easily adjusted depending on the size, composition and use of a country’s reserves, as S.A.F.E highlights the appropriate universe by taking on the appropriate degree of liquidity, currency, interest rate or credit risk to enhance returns.

For conservative investors, such as central bank reserve managers, the implication is that if they want higher returns, they will have to take more risk. The only alternative is to be patient but the cost of this is large. In its purest form this risk takes four forms; currency, liquidity, interest rate and credit.

Currency Risk

Historically, only the US Dollar and Japanese Yen have displayed defensive behaviour, in that they are negatively correlated to ‘risk’ assets. Accessing a wider range of currencies will enhance returns but will also increase the volatility of these returns. A well-diversified approach can help improve this risk versus return payoff. Indeed, in recent years, evidence from the IMF’s Currency Composition of Official Foreign Exchange Reserves database suggest this is exactly what reserve managers have been doing, with solid increases in Australian and Canadian dollar holdings.

Liquidity Risk

Liquidity is a nebulous concept; it is conditional on market circumstances and only a few select government bond markets can be considered to be truly liquid. However, if reserve managers choose to compromise their need for liquidity, there are several sovereign issuers, which display low volatility, good market size, plenty of issues suitable for conservative investors and reasonable market costs.

Interest Rate Risk

Investors are generally compensated for lending their money for longer periods. Since 1999, the average monthly return on the Bank of America Merrill Lynch 1-3 years US treasury index has been 0.29% whereas the average return on the equivalent 5-7 year index has been 0.46%. However, the variations around these returns in the former are far greater. Bonds have been in a secular bull market and risk from current yield levels may well be asymmetric. Over a twelve month investment horizon, a rise in market yields might lead to market losses. For buy and hold investors, it could be argued that this does not matter.

Credit Risk

Depending on circumstances, a case can be made for investing a portion of reserves in emerging market debt, which typically has lower credit ratings than advanced economies. The secular bullish story is positive, with high growth potential, better demographics, lower debt burdens and high productivity potential. However, recent experience, with a major sell-off experienced has seen market practitioners become more discriminating in allocating to individual countries. However, with yields 4.5% above developed market bonds, investors are at least being compensated for the higher credit risk they may experience.