Rising to the challenge – Reserve management in an uncertain world

Amid unprecedented measures being taken by central banks and governments to combat the global Covid‑19 pandemic, BlackRock’s Stephan Meschenmoser, Laszlo Tisler and Crystal Wan compare and contrast BlackRock’s model portfolio against its high-grade government bond reference portfolio, update its portfolio construction methodologies and consider how to incorporate sustainability into the framework, and explore why certain new asset classes deserve a place in central banks’ reserve portfolios.

In many ways, this year’s safety, liquidity and return reserve portfolio exercise is different from previous editions dating back to 2013, when the series began. This analysis was conducted entirely remotely from BlackRock’s core places of operation, in our search for optimal reserve portfolio construction while navigating the global coronavirus (Covid‑19) pandemic. 

Indeed, 2019 brought market euphoria following episodes of difficulties in 2018; 2020 looked to have got off to a good start, but nothing prepared the world – or the capital markets – for what ensued. Stress scenarios were exceeded by realities, asset prices breached new highs and lows almost daily, and central banks and governments deployed unprecedented measures.

However, some things remain constant. For reserve managers, consciously and deliberately balancing volatility and liquidity constraints against realistic income objectives remains a reliable mantra. Amid such turbulence, this mantra is providing much-needed guidance on how to construct resilient reserve portfolios.

In this article, we describe the evolution of its model portfolio and reflects on how it has performed against its high-grade government bond reference portfolio. It updates its portfolio construction methodologies and considers how to incorporate sustainability into the framework. The feature then takes a deeper dive into some of the new asset classes added this year, investigating the reasons we believe they deserve a place in central banks’
reserve portfolios.

Portfolio construction

Official reserve managers need to consciously and deliberately balance volatility and liquidity constraints against realistic income objectives.

A BlackRock sponsored feature published in the May 2019 issue of Central Banking introduced an enhanced approach to constructing more resilient reserve portfolios by taking into account uncertainty and levels of conviction. Further key improvements this year aim to incorporate sustainability, more granular views, lower bounds for government bond yields and an increased focus on resilience and currency hedging.

One of the most significant considerations is sustainability. Some argue that, as sustainable assets exhibit a higher degree of resilience, investors should demand less financial return for holding them compared with less sustainable – or riskier – assets, all things being equal. While this could be true in a steady state where risks related to sustainability – or lack thereof – are fairly and fully priced into asset valuation, the world is a long way from it. In fact, we strongly believe we are at the start of a long tectonic shift driven by improving data and disclosure, investor and societal preferences, accelerated by regulation across the world that will reshape all asset prices, creating a ‘sustainability premia’ during this transition. 

This has significant implications for long-term expected returns and relative pricing of assets. A robust portfolio construction framework must take into consideration these impacts not only in return forecasts, but also throughout the allocation and implementation process. 

While the strategic asset allocation of our model portfolio only considers allocations to broad asset classes and macro factors, implementing these allocations through vehicles that incorporate environmental, social and governance considerations can be beneficial in volatile market environments – something already observed during recent episodes.

Another important update is the introduction of effective lower bounds for interest rates, which reflects the state of the world today. Indeed, with traditional reserve assets yielding lower for longer, it is important to consider the long-term implications if these assets can no longer serve as portfolio ballast against risk assets as effectively as before. In fact, taking lower bounds on interest rates into account during the portfolio construction process, we find that allocation to government bonds decreases by 3%.

We have also introduced several new asset classes, including real estate and infrastructure assets – together referred to here as ‘real assets’. We make an allocation to Chinese bonds in the portfolio, highlighting that these bonds are further away from their perceived lower bound but still offer attractive yield. Real assets are also present at 6% of the portfolio, reflecting the relatively beneficial risk/return trade off and diversification advantages. 

Investment-grade and high-yield credit continue to feature. While cognisant of reserve managers’ aversion to credit risk – and reputational risk related to it – an appropriately sized modest allocation could bring diversification benefits. We explicitly acknowledge the impact of the current market environment on high-yield returns; over the next year, we model defaults and downgrades similar to those that occurred during stress periods and return to our ‘standard’ default assumptions further out in the timeline. While not a common asset class for reserve portfolios, investors that can tolerate fallen angles in their portfolios until the market normalises could potentially help limit adverse return implications. 

Some reserve managers are also starting to worry about rising inflation risks – a new concern for many in this decade, as the seemingly bottomless fiscal and monetary policy response continue to enrich the economy with cash. We acknowledge this by increasing our premium for inflation risk in our capital markets assumptions, and suggest those concerned about inflation rising more than market expectation to overweight inflation-linked bonds within their allocation to Treasury bonds.

2020 model portfolio

Consistent with our exercises undertaken since 2013, this year we continue to model two portfolios with 50% liquidity floor – one targets 2.5% return while minimising risk (return targeting portfolio), the other looks to maximise return in adverse scenarios with a volatility ceiling of 4.6% (risk-constraint portfolio).  

While in 2019 the 2.5% return target could have been achieved by holding short-dated US Treasury bonds entirely, 2020 required more deliberation and trade-off between risk and liquidity. The 2.5% target return portfolio now includes 15% allocation to equity, 5% Chinese bonds, 15% credit and 2% emerging markets debt. The volatility of this year’s 2.5% portfolio hits 2.7%, compared with last year’s 2.3%.

The portfolio set out in figure 2 represents our strategic asset allocation for the 2020 risk-constrained portfolio. This portfolio has been created with an explicit focus on building resilience – with a one-year maximum drawdown of 1.7%, compared with 1.6% for the Group of 7 reference benchmark. 

While the maximum drawdown is higher than the benchmark, we believe this is a measured and necessary increase for an opportunity to achieve higher returns. It is worth noting we further reduced the portfolio risk to 3.5%, compared with 4.2% last year – well within the imposed 4.6% ceiling. Looking at risk through drawdown and conditional value-at-risk is better aligned with reserve manager objectives. 

The portfolio this year continues to make important allocations beyond traditional reserve portfolio asset classes. Allocating to assets such as equities, emerging markets, real assets and credit offer diversification benefits as well as higher potential returns over the long term. The expected return of the portfolio in average market conditions is +3.1%, with an expected return of +1.9% conditional on being in the bottom half of simulated scenarios, using our Capital Market Assumptions. Comparing these metrics against the expected outcomes for the G7 reference benchmark, one would expect that, in normal market conditions, the volatility-constrained portfolio should outperform the benchmark by +2.2%. Meanwhile, in the bottom half of all outcomes the portfolio is still expected to outperform the benchmark by +2.0%. By being explicitly concerned about the downside in the portfolio construction process we can better manage against the shocks and concerns relevant to reserve managers. 

Historic returns

This year has presented many challenges for investors across the investment universe. A global pandemic, and multitudes of unprecedented measures and market moves, all experienced within a short few weeks, have tested resilience of portfolios as well as investors’ bravery. This volatility is evident in the return of the model portfolios. 

Zooming in on 2020, in times when markets do not reward risk-taking, cash is king. For this reason, short-duration Treasuries (which the 2.5% target return portfolio consisted of last year) outperform longer duration Treasuries (such as the G7 portfolio) and diversified portfolios (such as the volatility-constrained portfolio), as observed. Our volatility-constrained portfolio underperformed the G7 government bond reference benchmark over the year to the end of April 2020 by -2.1%; the 2.5% target return portfolio slightly underperformed by -0.2%.

However, economic theory argues that, over the long term, including rewarded risks in a diversified fashion will result in better portfolio outcomes. This is also evident in the longer-term returns of the portfolios shown. Over a multiyear horizon – from November 30, 2013 to April 30, 2020 – the volatility-constrained portfolio has beaten the G7 benchmark by 1.1% annualised, and the 2.5% return target portfolio has beaten the G7 benchmark portfolio by 0.7% annualised.

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