Central bank reserve managers, notably those accumulating assets well above traditional import-coverage levels, should view investments in non-G7 currencies, corporate bonds, mortgage-backed securities and equities as alternatives to traditional ‘safe' G7 sovereign assets, according to investment managers speaking in a Central Banking On Air webinar.
The reason is that the relative riskiness of traditional reserve assets and alternatives assets has diminished significantly during the past five years, said participants in the ‘Should reserve managers invest in non-sovereign assets?' panel.
Gary Smith, global head of official institutions at BNP Paribas Investment Partners, said only two of the major currencies - sterling and Canadian dollar - still offered risk and reward characteristics at similar levels today as they did before the crisis. Others had either seen their spreads blow out, such as Italy, or their yields plunge despite credit rating downgrades.
"I don't think it is realistic for a central bank who doesn't like those five of the G7 to concentrate their entire investments in the two of the G7 that haven't changed fundamentally the nature of the investment return that they offer - so they are forced to look at new things," said Smith.
If you look at the longer-term fundamentals, even of Germany, where you have to pay for the privilege to lend them money - on a 20- to- 30- year view, the fundamentals there really are quite challenged
The longer-term security of even of some of the ‘safest' sovereign currencies has diminished, according to David Smart, global head of sovereign funds and supranationals at Franklin Templeton Investments. "If you look at the longer-term fundamentals, even of Germany, where you have to pay for the privilege to lend them money - on a 20- to- 30- year view, the fundamentals there really are quite challenged in terms of demographics and pension commitments, so the credits are not really very good and in our view do not justify the extraordinary premium they currently attract," said Smart.
While non-G7 sovereign investments remain the most likely investment class outside of traditional reserve currencies, other fixed income investments also have some attractive attributes as can equities, the panellists said.
However, Ulrik Walther, senior vice-president and head of Europe, the Middle East and Africa sovereign business at Pyramis Global Advisors, said reserve managers at central banks in countries with current account deficits should carefully review their liquidity requirements before investing in alternatives, a sentiment echoed by Smart. "You do not want to be having to sell less liquid asset classes in an emergency," he said.
Nonetheless, Smart believes corporate credit may perform relatively well in the current market climate. "[Given] the long grind out of over-indebtedness continues, world GDP growth is at the 2.5-3% level, where corporate credit has generally done very well," said Smart. "There is an attraction, but with a liquidity caveat."
Smith added that while the ability of sovereigns to print money reduced the likelihood of default versus corporate bonds "this is not necessarily good for the investor".
There was also a sentiment expressed by the three panellists that the ratings of some cash-rich corporates could "divorce" from sovereigns ratings at some point in the future - traditionally corporates do not have a higher rating than the sovereign statew where they are domiciled.
Smart added that US mortgage-backed securities can also look attractive given they are relatively liquid and offer some diversification benefits for reserve portfolios. However, he did not view European mortgages as attractive to reserve managers.
While equities traditionally are viewed as a far riskier asset class than sovereign fixed income instruments, the panellists said equity market liquidity has remained strong even during the most volatile times during the past five years. Some central banks, such as the Swiss National bank, have already shifted some of their investments into equity.
But Walther said one potential downside is that equity returns tend to be "correlated with currency returns".
The panellists - all representatives from the asset management industry - had mixed views about gold reserves.
‘Smoke and mirrors'
Smith said gold investments did appear to be uncorrelated to other asset classes and its liquidity "goes up during a crisis". But he believes some of the reports about central bank reserve investments in gold involved "smoke and mirrors".
"I do not dispute that central banks have been buying - there is no selling," he said, "[But] some stories you read talk about countries buying gold where that central bank is mandated to buy gold."
Walther added that his was always concerned about "an asset class that yields nothing and costs money to store". But the panellists highlighted that a negative real yield was also a problem with popular major currency sovereign bonds.
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