Board of Governors of the Federal Reserve System

1. Asset Valuations

Asset prices have generally increased since May, and, when adjusted for low interest rates, valuation pressures appear roughly in line with their historical norms

At the time of the May Financial Stability Report, improvements in investor risk sentiment and market functioning had started to boost asset prices. Over the past six months, asset prices in key markets have continued to rise in light of the rebound in economic activity, policy actions to mitigate the financial amplification of the COVID-19 shock, and investor optimism. The U.S. broad-market stock price index has risen substantially from its low point this year and touched record highs in recent months, although volatility remains high and there is considerable uncertainty about the path of earnings. Spreads on corporate bonds and leveraged loans have decreased significantly. After accounting for the low level of interest rates, however, measures of the compensation for risk are roughly in line with their historical norms.

Prices for commercial properties have started to fall, although they remain elevated relative to incomes. Low transaction volumes—especially for distressed properties—make commercial property valuations particularly difficult to judge. Farmland prices remain elevated relative to rents and incomes. Supported by low mortgage rates, housing prices have increased along with strong home sales.

Asset prices remain vulnerable to significant declines, given a high degree of uncertainty around the course of the pandemic and the pace of the recovery

Prompt and forceful policy responses—including fiscal stimulus, lower interest rates, and various asset purchase and emergency lending programs—have supported a stronger-than-expected economic recovery. However, uncertainty remains high, and investor risk sentiment could shift swiftly should the economic recovery prove less promising or progress on containing the virus disappoint. Some segments of the economy, such as energy as well as travel and hospitality, are particularly vulnerable to a prolonged pandemic. Within CRE, retail, office, and lodging properties exhibit the highest vulnerability.

Table 1 shows the size of the asset markets discussed in this section. The largest asset markets are those for residential real estate, corporate public equities, CRE, and Treasury securities.

Table 1. Size of Selected Asset Markets

Treasury yields are near historical lows

Treasury yields across the maturity spectrum have generally changed little since May and are near historical lows (figure 1-1). Model estimates of Treasury term premiums remain at record lows (figure 1-2).³ The low yields of longer-dated Treasury securities and historically low term premiums are consistent with market expectations for interest rates to be low for a long time. In addition, a forward-looking measure of Treasury market volatility derived from options prices dropped to a historical low, in sharp contrast to the turmoil in March (figure 1-3).

Federal Reserve actions, including asset purchases, continue to sustain the functioning of Treasury markets. Measures that capture the market's ability to absorb large orders without significant price disruptions, such as the quantity of outstanding offers to buy and sell Treasury securities, have largely recovered to pre-pandemic levels (figure 1-4).

Corporate debt market spreads returned to historical norms, market functioning improved, and issuance resumed

Supported by very low Treasury yields, yields on corporate bonds dropped to historically low levels (figure 1-5). Spreads of yields on corporate bonds over comparable-maturity Treasury yields narrowed considerably and stand at about their historical medians (figure 1-6).⁴ However, spreads in sectors heavily affected by the pandemic, such as the energy, airline, and leisure industries, remain quite elevated. Reflecting a pickup in risk appetite, the excess bond premium—measured as the gap between corporate bond spreads and expected credit losses—fell below its historical median (figure 1-7).⁵

The announcement of a range of measures to support market functioning and the flow of credit in late March, particularly the corporate credit facilities, led to significant improvement in corporate bond market functioning and provided a backstop to support borrowing by corporations (see the box "Federal Reserve Actions and Facilities to Support Households, Businesses, and Municipalities during the COVID-19 Crisis"). Bid-ask spreads have tightened.

Corporate bond issuance by both investment- and speculative-grade firms has been very strong, as companies have increased their cash buffers and refinanced their debt at lower interest rates and longer maturities. Despite the decline in spreads and the increase in new issuance, corporate credit quality has deteriorated since May—as evidenced by defaults and firm ratings downgrades—though it has shown some signs of stabilization in recent months.

Spreads on leveraged loans in the secondary market have tightened significantly since the spring and are now close to their post-2008 medians (figure 1-8). Spreads on newly issued leveraged loans have also tightened.

Equity prices rose sharply, with higher valuations supported, in part, by low interest rates

Valuations in equity markets have risen substantially as equity prices have continued to move up since the previous Financial Stability Report. Prices relative to forecasts of corporate earnings have also risen considerably and are currently near the top of their historical distribution, even though there is significant uncertainty in the earnings outlook among market participants (figure 1-9). However, while the gap between the forward earnings-to-price ratio and the expected real yield on 10-year Treasury securities—a rough measure of the premium that investors require for holding risky corporate equities—has declined since May, it remains above its historical median due to the low level of Treasury yields (figure 1-10). This development suggests that investor risk appetite, though higher since May, is still within historical norms.

While equity price volatility has fallen since the late spring, it remains elevated by historical standards. Further, option-implied volatility, a close proxy for expected volatility, did not fall as much as realized volatility (figure 1-11). Elevated volatility and the divergence between expected and realized volatility suggest investors are pricing in concerns about downside risks and considerable uncertainty about future outcomes.

Prices of commercial properties are still elevated relative to incomes

Since the May Financial Stability Report, CRE prices have declined moderately (figure 1-12). However, capitalization rates, which measure annual income relative to prices for recently transacted commercial properties, have remained near historically low levels, suggesting elevated valuation pressures may still exist (figure 1-13).⁶

Evidence of significant strains are present in other data sources. Vacancy rates have turned higher, and rent growth has either slowed or turned negative. Prices of real estate investment trusts (REITs) that invest in lodging and retail properties remain well below their pre-pandemic levels, although prices of those that invest in industrial properties have somewhat recovered since the spring. Additionally, delinquency rates on CMBS, which normally contain riskier loans, have spiked. Finally, the July Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) indicated that a major fraction of banks reported weaker demand for CRE loans and tighter lending standards, on net, in the second quarter of 2020 (figure 1-14).

Farmland prices remain high relative to rents

According to data through the second quarter of 2020, farmland prices continued to decline modestly at the national level and at a slightly faster pace in several midwestern states, where prices were more elevated (figure 1-15). Despite the declines, farmland prices remain high relative to rents (figure 1-16).

House price growth accelerated over the summer, while the price-to-rent ratio remains slightly above its long-run trend

Since the previous Financial Stability Report, average house price growth has accelerated somewhat (figure 1-17). Nationwide, prices appear to be a little above their long-run average relationship with property rents (figure 1-18). Housing price-to-rent ratios continued to vary significantly across regional markets (figure 1-19).

The strength in the housing sector reflects robust demand from households and is being supported by the low level of interest rates. However, downside risk remains, given the unusually large number of mortgage loans in forbearance programs and the uncertainty around their ultimate repayment.

 

References

 

 3. Treasury term premiums capture the difference between the yield that investors require for holding longer-term Treasury securities—for which realized returns are more sensitive to risks from future inflation or volatility in interest rates than the realized returns of shorter-term securities—and the expected yield from rolling over shorter-dated ones. Return to text

 4. Spreads between yields on corporate bonds and comparable-maturity Treasury securities reflect the extra compensation investors require to hold debt that is subject to corporate default or liquidity risks. Return to text

 5. For a description of the excess bond premium, see Simon Gilchrist and Egon Zakrajšek (2012), "Credit Spreads and Business Cycle Fluctuations," American Economic Review, vol. 102 (June), pp. 1692–720. Return to text

 6. Capitalization rates reflect the reported incomes used for underwriting loans on new transactions. They therefore represent a selected sample of properties and, as transaction volumes remain depressed, may not reflect the loss of income other data sources are reporting. Return to text