Reaching for yield: selected issues for reserve managers

Managers of official foreign exchange reserves have been facing historically low yields on highly rated government securities, the instruments to which they have traditionally devoted the bulk of their investment portfolios. In mid-August 2003, after eight weeks of rising long-term interest rates, the yield on the twoyear US Treasury note still stood at 1.86%, down from a peak of nearly 17% in 1981. It is true that much of the decline since 2001 had been the result of cuts in monetary policy rates, which had served to shift down whole yield curves. Nevertheless, even adjusting for the monetary policy cycle, yields in the major currencies have tended to be substantially lower in recent years compared to those in the previous decade. In these conditions, reserve managers have found themselves seeking instruments with higher yields in an effort to maintain the investment returns to which they had become accustomed. In considering higher-yielding alternative instruments, reserve managers must ask two basic questions. First, do higher yields actually lead to higher returns?2 Second, to the extent that higher expected returns are a compensation for taking on greater risk, what is the nature of the risk entailed? In this special feature, we focus on a few selected cases for which these questions seem particularly interesting. These cases involve three alternative portfolios that offer higher yields, namely a longer-duration portfolio, a corporate bond portfolio and a portfolio of higher-yielding currencies. We discuss the issue of increased risk-taking with respect to durations and corporate bonds. In the case of durations, we ask the specific question of whether the present low-yield environment implies a new trade-off between duration and volatility. In the case of corporate bonds, we focus on the challenge of managing a portfolio in which risk is characterised by low probabilities of heavy losses. We finally examine the question of yield and return with respect to currencies. Specifically, do higher yields offered by instruments in certain currencies tend to be offset by movements in exchange rates? In the discussions below, we limit ourselves to issues of strategic investment over the medium to long term. Hence, we conduct our analysis in terms of averages of returns and measures of risk over extended periods of time. This focus allows us to avoid the tactical question of timing, ie the issue of when precisely reserve managers should undertake a change in positions. Timing depends on when yields or spreads may be expected to rise or fall, and this is an issue on which we offer no guidance. Our focus on investment strategy also means saying nothing about issues of liquidity. While central banks often hold liquid reserves for intervention purposes, the reach for yield really pertains to the investment part of the portfolio.