CONTRIBUTORS
Lawrence Hatheway
Global Investment Strategist
Franklin Templeton Institute
Karolina Kosinska, CIPM
Analyst
Franklin Templeton Institute
Brishni Mukhopadhyay, CFA
Product Specialist
Western Asset
Executive summary
Central bank reserve managers have specific requirements when compared to other institutional investors. They are tasked with meeting portfolio return objectives, but also with managing assets subject to liquidity and currency constraints. Strategic asset allocation for central banks often involves tranching reserve portfolios. Tranches include working capital, liquidity and investment “buckets,” each with varying requirements to meet expected cash flows, episodic needs for liquidity and overall investment objectives. Meeting these various objectives has important implications for the choice of investable assets (mostly fixed income) as well as for the duration, credit quality and currency composition of reserves.
Despite national variations among central bank reserve management objectives and policies, their decision-making can be evaluated within the context of portfolio theory. Specifically, risk-adjusted returns can be maximized subject to liquidity and currency allocation constraints.
In this paper, we evaluate central bank reserve manager portfolio performance in the context of maximizing returns subject to liquidity and currency allocation constraints.
Our key findings are as follows:
- While liquidity constraints may reduce expected risk-adjusted returns, in a broader context, those constraints can also improve long-term performance by reducing various forms of risk.
- Finding balance is critical. Modest relaxation of some liquidity restrictions is sufficient to deliver, on average, significantly higher expected returns.
- Restrictions on allocations to currencies are potentially more onerous for investment performance, even though they may be required to achieve other policy objectives (e.g., smoothing external debt servicing or balance of payments).
- In the context of the 2026 tactical asset allocation decision, we believe reserve managers should increase weightings relative to benchmark for mortgaged-backed securities and emerging market debt, while reducing allocations to investment- grade credit.
Overview
The paper explores a framework customized for reserve managers that incorporates flexible approaches to their investment objectives and constraints. It offers sensitivity analysis to provide quantitative estimates of trade-offs between investment objectives and liquidity, currency, or other constraints.
The paper is organized as follows. First, we consider the special case of reserve manage-ment, and how its objectives and constraints differ from other institutional investors. In particular, we underscore the importance of liquidity management. Second, we introduce our methodology to flexibly incorporate constraints into portfolio construction. Third, using that framework, we consider its application to benchmarking (strategic asset allocation) and for 2026 tactical asset allocation according to our investment views. Finally, we conclude with remarks about the sensitivity of portfolio outcomes to varying liquidity constraints.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Sovereign debt securities are subject to various risks in addition to those relating to debt securities and foreign securities generally, including, but not limited to, the risk that a governmental entity may be unwilling or unable to pay interest and repay principal on its sovereign debt. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.
WF: 9635658