Over the last decade reserve managers have increased diversification. A growing number of central banks are now investing across a wider range of asset classes. According to the most recent UBS Reserve Management Survey, in 2020 more than 90% of central banks surveyed are invested in US agencies, two-thirds are invested in corporate bonds and nearly half of those central banks surveyed are eligible to invest in listed equities. Reserve managers’ portfolios look increasingly similar to those of other institutional investors such as pension and insurance funds.

The sharp market sell-off in February/March 2020 was the first big test of market stress faced by reserve managers since the 2008 financial crisis. And the test was successfully passed. According to the UBS RMS Survey, nearly half of central banks that are invested in equities rebalanced their equity holdings to return to their equity allocation target. And more importantly, while a shift to more ‘defensive’ assets is visible in 2020, the ‘secular’ trend towards diversification remains intact with equities now being an eligible asset class for about 45% of central banks, a new all-time high.

The diversification of reserves away from government bonds has been a winning strategy so far. Since 2009, according to our estimations, a liquid portfolio invested 50% into cash and government bonds from advanced economies, 35% into investment grade spread products and 15% into advanced economies’ listed equities which generated a return of more than 4%. Reserve managers adopting diversification have been able to fulfill their policy goals including liquidity preservation, capital protection and return.

While the inclusion of equity requires an increase in risk limits in terms of maximum drawdown, the volatility of the entire portfolio increases only slightly when compared to a fixed income-only portfolio. This is a result of benefits generated by the inclusion of equity in a portfolio dominated by fixed income assets.

So what’s next for reserve managers? The main challenge currently faced by reserve managers is the low yield environment. According to the UBS survey, the majority of institutions surveyed expect interest rates in the US and the euro area not to start rising before 2023 as central banks maintain a very loose monetary policy stance in the post-Covid world.

This will lead to a dramatic fall in returns on reserves when compared to the last decade as the fixed income boom ends. According to our estimates, in the next five years a portfolio invested into investment grade fixed income assets only will generate a return below 1%. Even a portfolio diversified into equities – as the one discussed above – will generate a return of less than 2%, less than half the return generated since 2009 and lower than inflation.

Reserve managers face a choice: either accept much lower returns than in past, failing to protect the real value of their reserves, or continue along the diversification path. Reserve managers who are pondering further diversification steps should consider: further diversifying away from advanced economies’ government bonds; increasing allocations to Chinese and other emerging markets bonds; increasing allocation to equities to above 20%.

Central banks with high levels of reserves and less liquidity constraints should consider allocations to real estate and infrastructure to enhance returns and generate further diversification benefits.

According to our estimates, over the next five years a portfolio with emerging market bonds (in hard currency) at 15% and equity at 20%, with the rest in government bonds and investment grade spread products, will generate a return of 2.4% with a volatility still below 5%. That is less than in the past, but capable of protecting the real value of accumulated reserves.

Massimiliano Castelli is Head of Strategy, Sovereign Institutions at UBS Asset Management.