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Norges Bank recommends changes to bond benchmark index for sovereign wealth fund

Norges Bank has made a number of recommendations to the Norwegian Ministry of Finance regarding the management guidelines for bonds within the country's sovereign wealth fund.

The proposals were made in a letter signed by Norges Bank Gov. Oystein Olsen and Yngve Slyngstad, CEO of Norges Bank Investment Management, which runs the assets of the 7.7 trillion Norwegian kronor ($987 billion) Government Pension Fund Global, Oslo.

The fund's benchmark index for bonds consists of 23 currencies. The bank recommended that the number of currencies in the index is reduced, a move that "will have little impact on risk in the overall benchmark index." The index currently includes emerging market currencies, but Norges Bank said it has "found that the current index presents a number of operational challenges," with currencies moving in and out of the index. "For a large fund, it is a challenge to adjust the portfolio to sudden changes of this kind in a cost-effective manner."

"The bank's proposed changes to the management guidelines reflect the purpose of the bond investments, clarify the role of the benchmark index in the fund's management, and pave the way for the best possible portfolio," said the letter.

The ministry should go "back to a specific list of currencies for the bond index rather than leaving this decision to the index supplier … An index consisting of bonds issued in dollars, euros and pounds alone will be sufficiently liquid and investible for the fund." Currencies should be assigned weights based on the size of the country's GDP, the letter said. This kind of allocation would see a 54% weighting to U.S. dollars, 38% to euros and 8% to British pound sterling.

Further, emerging market bonds should be removed from the benchmark index. "It should be left to the bank to establish systematic strategies for investing in high-yield currencies," said the letter.

Another recommendation is that the benchmark index for bonds should only comprise nominal government bonds issued in currencies on a currency list. Corporate bonds — which make up 30% of the current bond index — should be removed from the benchmark index. "In the same way as with investments in emerging market bonds, it should be left to the bank to establish systematic strategies for earning a risk premium in the corporate bond market," said the letter. However, should the ministry wish to provide further guidance, the letter suggested a proportion of the fund that may be invested in corporate bonds be specified. Corporate bond rebalancing should take place annually, rather than monthly.

Another recommendation regards the maturity of the bond index, which the letter said should be managed. "We recommend setting an upper limit for maturity of around 10 years for bonds included in the index. A shorter maturity will help reduce uncertainty about the fund's volatility."

The fund had a 32.4% allocation to fixed income as of June 30. The letter is available on NBIM's website.