Bank of Lithuania is improving investment policy to effectively manage investment risk and earn higher return in the longer term
Aiming at maximum diversification of investment risk, the Bank of Lithuania upgraded its strategic asset allocation and decided to set up a reserve portfolio consisting of safest investments in US dollars so as to ensure a sufficient amount of official foreign reserves and liquidity. The risk budget of the Bank of Lithuania investment portfolio was also increased – the limit for potential negative return over a rolling one-year horizon was raised from EUR 100 million to EUR 150 million.
‘The situation in debt markets forces us to search for new sources of return, hence we supplemented the investment portfolio with new types of securities, while at the same time enhancing diversification. New, albeit somewhat riskier, types of securities should boost investment returns in the medium term, whereas better diversification should help to achieve this with only a moderate increase in short-term risk,’ said Tomas Garbaravičius, Member of the Board of the Bank of Lithuania.
The Bank of Lithuania invests financial assets with the aim of diversifying risk and increasing expected return over a rolling three-year investment horizon. Due to potentially higher returns in the medium-term, the Bank of Lithuania tolerates the risk of short-term loss, the size of which, with high probability, should not exceed the risk budget predefined in the investment policy. The risk budget shows the highest potential loss over a rolling one-year horizon at a 95 per cent confidence level.
Currently, the yields of debt securities perceived as safe haven investments are particularly low or even negative. In addition, the probability of an upswing in interest rates and, in turn, a fall in debt securities prices is increasing. As a result, even improved diversification of higher-yielding assets in the investment portfolio cannot fully outweigh the higher risk of an investment loss.
‘Taking into account the practices adopted by developed countries with free-floating exchange rates and in order to clarify the objectives of the investment portfolio, we have created a separate reserve portfolio consisting of the safest and most liquid investments in US dollars,’ said Tomas Garbaravičius.
The size of the reserve portfolio will approximate USD 1 billion, i.e. roughly one-fifth of the total Bank of Lithuania non-monetary policy financial assets projected at the end of this year. Given the purpose of the portfolio, its currency risk will not be hedged and, therefore, substantial fluctuations of the portfolio’s value in euros are possible.
In 2014–2016, Bank of Lithuania investment returns totalled EUR 198 million. Over the three quarters of 2017, the investment result was negative (EUR –15.1 million). This outcome was largely determined by the 13 per cent depreciation of the US dollar against the euro, whereas returns on equities and bonds had to some extent mitigated the negative result.
With the view of better diversification and higher expected return over the medium term, the Bank of Lithuania added inflation-linked US government securities and US corporate debt securities to its strategic asset allocation. Next year the Bank of Lithuania plans to start investing in mortgage-backed securities issued by US government agencies. It will also continue working on the creation and development of quantitative investment strategies. These and other measures are foreseen in the Bank of Lithuania’s strategic directions for 2017–2020 that were approved at the beginning of this year.
‘While optimising the strategic asset allocation, we were among the first central banks to implement the modern risk parity approach, which ensures equal allocation of risk across the set of risk factors and increases the stability of strategic asset allocation during the times of financial market turmoil, as well as allows for higher expected returns in the medium and longer term,’ said Jonas Kanapeckas, Head of the Risk Management and Reporting Division of the Bank of Lithuania.
The Bank of Lithuania – the central bank of the country – manages financial assets that have been accumulated after the restoration of Lithuania’s independence. This is the largest investment portfolio in Lithuania. In 2014–2016, the Bank of Lithuania’s own financial assets amounted to EUR 3.3 billion on average. The main objective of holding financial assets is to ensure the stability of the financial system in Lithuania and the euro area and provide a buffer against economic and financial shocks as well as other extraordinary circumstances. Income generated from investment is used to finance Bank of Lithuania activities. The bulk of earned profit is transferred to the state budget.