The shift from the lower-for-longer regime that prevailed since the early 2010s to higher-for-longer following the COVID crisis has led to a dramatic increase in the expected returns of fixed income assets. Given its traditionally low volatility when compared to listed equity, fixed income assets have become relatively more attractive in risk-adjusted terms. This provides reserve managers with an excellent opportunity to potentially generate adequate returns relative to previous investment regimes.
For instance, a short-duration global government bond portfolio resembling the composition of global FX reserves – largely USD, plus euro, sterling and yen – is expected to generate an average annual return of around 4% in the next five years, according to our estimates. Between 2009-2021, the same portfolio generated a return of less than 1%. A similar portfolio but with long-duration holdings is expected to generate a return of around 5% over the same period; nearly 1% higher than in 2009-21.
Higher returns are also expected for spread assets. An investment grade corporate bond portfolio is expected to generate a return of around 6% over the next five years, 5% higher than in 2020.
Emerging market debt (EMD) in hard currency is also expected to generate robust returns. According to our estimates, in a softish landing scenario this asset class could generate an annual return of nearly 9%. This expected return is higher than listed equity but with a much lower level of volatility.
EMD’s high return expectations also hold up across more pessimistic scenarios. The table below outlines the expected 5-year returns for EM hard currency debt under a number of different economic scenarios. The results show that even in the relatively downbeat recession and stagflation scenarios, nominal 5-year returns are expected to be relatively high when compared with historical returns.
For reserve managers, hard currency EMD could partly replace the return enhancement role played by listed equity with the advantage of lower volatility.
