In this era of very low yields and slowly rising official interest rates, fixed income investors are finding that the returns from their portfolios are under pressure. This is especially true of official sector investors such as central banks, whose asset allocations have traditionally been toward the lower-risk, shorter-duration end of the spectrum, and whose returns as a consequence have tended to be lower than other less risk-averse investors. As circumstances change, investors, particularly those in charge of central bank reserves, are looking to maximize return wherever possible through higher risk investments, and, most notably, in mortgage backed securities.

Traditional Approach to Reserves Management and a Changing Environment
In the past, central banks have accepted lower returns for less risk as part of the traditional trade-off they make between security and liquidity on the one hand, and return on the other. Reserves have been seen primarily as a policy tool, and return has usually been relegated to the third of the three objectives. This did not mean central banks ignored return completely; indeed, they have been some of the most active managers of their assets within their tight self-constraints, with great attention paid to wringing even comparatively modest amounts of extra basis points out of their portfolios. Traditionally, their favoured approach could best be characterised as an incremental one: emphasis was placed on maximising the efficiency of their portfolio management, including the use of arbitrage techniques, efficient cash management, and securities lending. All of these fell squarely within reserves managers' core competencies, and did not significantly extend either the scope or the risks of the reserves management task.

Unfortunately, this incremental nature extended to the amount of extra return as well. Simply put, the limited amount of extra risk central banks were taking did not deliver more than a limited amount of extra return. More recently, the great increase in reserves levels – up over 65% in the last four years alone and now approaching $4 trillion for all central banks combined – has led to a corresponding increase in the focus on return. In many cases, especially but not exclusively in Asia, reserves have now grown past the point where they can be considered solely a policy tool, and they have begun to take on some of the characteristics of a national store-of-wealth fund. As such, and with increasing public interest in the performance of central banks, the pressure is on central bank reserves managers to generate significantly higher returns from the national assets they are responsible for. This cannot be done solely by the incremental approach of the past.

An Increasing Appetite for Risk
Instead, central banks are increasingly widening the set of asset classes in which they are prepared to invest, and in the process, taking considerably more risk in their portfolios. A recent survey by Central Banking Publications¹ shows a widespread move to lower-rated bonds and a greater use of spread products. More significantly, fully three-quarters of all the central banks surveyed said they had introduced new asset classes to their investment management processes in the last 12 to 24 months.

This appetite for more diversified portfolios, including asset classes which have traditionally been seen as “off limits” for central banks, shows no signs of diminishing. Some central banks are actively adding equity exposure to their reserves, while a few central banks are even considering alternative investments such as hedge funds. But these remain the minority, and for most central banks, fixed income investments remain their métier. Foremost among the new fixed income asset classes attracting attention is the US Mortgage Backed Securities (MBS) market.

Mortgage Backed Securities Appeal to Risk Averse
The MBS market has attracted the interest of central banks for a number of reasons. On the basis of its sheer size alone, it cannot be ignored. It is the largest sector of the US domestic fixed income market and over one and a half times the size of the Treasury market, and increasingly, moves in the MBS market are influencing Treasuries as well as the other way round. So simply to stay abreast of developments in their core Treasury holdings, reserves managers are increasingly finding they need to study and understand MBS as well.

But what has really caught reserves managers” interest is the combination of security, liquidity, and return that MBS provide. Their security is excellent: all MBS are rated AAA/Aaa by S&P and Moody”s, respectively, and they have very stable credit characteristics. In addition, the liquidity of MBS is, at times, better even than that in the Treasury market itself – MBS generally trade on one-fourth of 1/32, and very large trade size is possible. Nor do these qualities come at the expense of return. As Figure 1 shows, MBS have a track record of adding extra return over that provided by similar duration Treasuries, and importantly, this is true both in times of falling rates (when MBS traditionally do well) and in times of rising rates, such as the present environment, when they might be expected to perform less well.

The robustness of the MBS market is excellent, and the performance and resilience of the market after recent market shocks such as the Long-Term Capital Management collapse and the aftermath of September 11, 2001 bettered even that of the Treasury market itself. Another attractive quality of the MBS market is their low correlation with other fixed income asset classes such as Treasuries, and their superior Sharpe Ratios (as shown in Figure 2). Together, these mean that the diversification and risk-adjusted return potential provided by MBS is excellent.

Some Considerations for the Investor
MBS are challenging to master, and not every central bank will feel able to include them in their reserves portfolios. Operational complexities on the settlement side alone have discouraged many in the past – though we at SSgA have observed a growing trend for central banks to consider outsourcing complex asset classes to external fund managers.

In today's world of very low yields, diversification is more important than ever in the search for adequate return, and strategies such as MBS are increasingly valuable for those charged with the responsibility of running large fixed income portfolios. This is true not least for central banks, and reserves managers are turning in growing numbers to active consideration of MBS for inclusion in the range of management options that are used for the assets under their control.

¹See “RBS Reserves Management Trends 2005”, edited and published by Central Banking Publications Ltd. Obtainable via www.centralbanking.co.uk.
² Historic performance is not necessarily indicative of future performance, which could vary substantially. The index returns are unmanaged and do not reflect the deduction of any fees or expenses. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. All trademarks are the property of their respective owners.

This material is for your private information. The views expressed are the views of John Nugee only through the period ended April 1, 2005 and are subject to change based on market and other conditions. The opinions expressed may differ from those with different investment philosophies. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is no guarantee of future results.

Posted On: May 12, 2005