Optimal portfolio allocation in a world without Treasury securities
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Antulio N. Bomfim is a Senior Economist in the research staff at the Board of Governors of the Federal Reserve System in Washington, DC. His main areas of interest include asset pricing (especially with regard to the term structure of interest rates and related derivatives), monetary policy and macroeconomics. He did his graduate studies in economics and mathematical finance at the Universities of Maryland (USA) and Oxford (UK). Senior Economist, Monetary and Financial Market Analysis, Mail Stop 74, Division of Monetary Affairs, Federal Reserve Board, Washington, DC 20551, USA Tel: ⫹1 (202) 736 5619; Fax: ⫹1 (202) 452 2301; e-mail: [email protected]
Abstract If current financial market trends persist, US Treasury securities are bound to account for an increasingly smaller share of the fixed-income market in the USA. This paper examines the extent to which investors’ portfolio allocation decisions are likely to be affected by the relative reduction in the stock of federal government debt. The analysis suggests only small effects for most investors, especially, as is effectively the case for many institutional investors, when a no-short-sales constraint is in place. Under such circumstances, highly conservative investors — whose portfolios have risk-return characteristics akin to money market instruments — and very aggressive investors — who hold mostly equities — stand to be the least affected by the removal of Treasuries from the pool of investable assets. The analysis abstracts from indirect beneficial effects on investors from a Treasury debt pay-off, such as the potential for greater productivity growth (and faster wealth accumulation) as more resources are freed up for investment in the private sector. Keywords: CAPM, risk, corporate securities, government debt
Introduction In the late 1990s, there was much debate about the economic implications of a potentially shrinking stock of US government debt, eg Wojnilower (2000) and Reinhart and Sack (2000). While the recent recession and increased defence-related government spending in the USA have led to a return to deficits and to substantial revisions to the fiscal outlook of the US Government, most analysts still agree that the share of US Treasury securities in the domestic
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Journal of Asset Management
Vol. 4, 1, 10–21
fixed-income market will continue to decrease in the years to come. This paper examines the extent to which investors’ portfolio allocation decisions are likely to be affected by these trends. In particular, are non-government securities, such as corporate bonds, close enough substitutes to Treasuries that investors could easily and costlessly move out of Treasuries and maintain the current risk–return profile of their portfolios? The answer that this paper provides to
䉷 Henry Stewart Publications 1479-179X (2003)
Optimal portfolio allocation
the above question comes in two parts: first, it estimates the extent to which the risk–return trade-offs facing investors in the market place are likely to be affected by the removal of Treasury sec
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