1. Asset Valuation

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Purpose Framework Overview 1. Asset Valuation 2. Borrowing by Businesses and Households 3. Leverage in the Financial Sector 4. Funding Risk Near-Term Risks to the Financial System

1. Asset Valuation

Prices of risky assets generally rose further, and most valuations are high relative to history

Across most asset classes, valuation measures are high relative to historical norms. Since the May 2021 Financial Stability Report, equity prices rose further. While this increase is due, in part, to improved earnings expectations, the ratio of prices to forecasts of corporate earnings stands at the upper end of its historical distribution. Yields on long-term Treasury securities, corporate bonds, and leveraged loans remain at low levels relative to their historical ranges.

Supported by low mortgage rates and strong demand, house prices continued to rise at a rapid clip, outstripping increases in rents. Nonetheless, little evidence exists of widespread erosion in mortgage underwriting standards or speculative practices. However, with valuations at high levels, house prices could be particularly sensitive to shocks.

Aggregate commercial real estate (CRE) prices have continued to increase since May, rising further above their pre-pandemic levels. However, prices for the retail, hotel, and office sectors have remained roughly flat amid limited transaction volume since the onset of the pandemic. Farmland prices continued to be elevated relative to rents and incomes.

Fiscal and monetary policy accommodation, along with continued progress on vaccinations, continued to support a strong economic recovery. Nevertheless, uncertainty about the economic outlook and the course of the pandemic remained high. Some segments of the economy, such as energy, travel, and hospitality, remained particularly sensitive to pandemic-related developments. Since the previous report, the more transmissible Delta variant has further spread throughout the world. Despite the tragic human toll, the Delta variant has left a limited imprint on U.S. financial markets. Risk compensation remains low across sectors, which is often associated with elevated investor risk appetite. Consequently, asset prices may be vulnerable to significant declines should risk appetite fall, progress on containing the virus disappoint, or the recovery stall.

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

Table 1. Size of Selected Asset Markets

Item	Outstanding (billions of dollars)	Growth, 2020:Q2–2021:Q2 (percent)	Average annual growth, 1997–2021:Q2 (percent)
Equities	54,768	47.2	10.1
Residential real estate	44,489	12.0	6.0
Commercial real estate	21,788	6.8	7.0
Treasury securities	21,699	9.2	8.2
Investment‐grade corporate bonds	6,667	4.1	8.3
Farmland	2,597	1.6	5.1
High‐yield and unrated corporate bonds	1,630	4.9	6.9
Leveraged loans*	1,258	6.2	14.2

Price growth (real)
Commercial real estate**		5.8	2.7
Residential real estate***		11.2	2.5

Note: The data extend through 2021:Q2. Growth rates are measured from Q2 of the year immediately preceding the period through Q2 of the final year of the period. Equities, real estate, and farmland are at market value; bonds and loans are at book value.

* The amount outstanding shows institutional leveraged loans and generally excludes loan commitments held by banks. For example, lines of credit are generally excluded from this measure. Average annual growth of leveraged loans is from 2000 to 2021:Q2, as this market was fairly small before then.

** One-year growth of commercial real estate prices is from March 2020 to March 2021, and average annual growth is from 1998:Q4 to 2021:Q2. Both growth rates are calculated from value-weighted nominal prices deflated using the consumer price index (CPI).

*** One-year growth of residential real estate prices is from March 2020 to March 2021, and average annual growth is from 1997:Q4 to 2021:Q2. Nominal prices are deflated using the CPI.

Source: For leveraged loans, S&P Global, Leveraged Commentary & Data; for corporate bonds, Mergent, Inc., Corporate Fixed Income Securities Database; for farmland, Department of Agriculture; for residential real estate price growth, CoreLogic, Inc.; for commercial real estate price growth, CoStar Group, Inc., CoStar Commercial Repeat Sale Indices; for all other items, Federal Reserve Board, Statistical Release Z.1, "Financial Accounts of the United States."

Treasury yields remained low by historical standards

Since the previous report, yields on 10-year Treasury securities have remained unchanged, on net, amid a flattening of the yield curve; model estimates of Treasury term premiums have changed little on net (figures 1-1 and 1-2).³ Treasury yields are low relative to their historical ranges, and an increase in Treasury yields, if unaccompanied by a commensurate strengthening of the economic outlook, could put downward pressure on valuations in a variety of markets. However, a forward-looking measure of Treasury market volatility derived from options prices changed little since May, on net, and remains below the median of its historical distribution (figure 1-3). Measures of Treasury market functioning have been stable since the previous report. In particular, liquidity metrics, such as market depth, have remained stable since recovering from the brief period of stress in February 2021 (figure 1-4).⁴

Figure 1-1. Yields on Nominal Treasury Securities

Figure 1-2. Term Premium on 10-Year Nominal Treasury Securities

Figure 1-3. Implied Volatility of 10-Year Swap Rate

Corporate bond spreads changed little, and risk compensation remained low

Since the May 2021 report, yields on corporate bonds increased, on net, in line with those of comparable-maturity Treasury securities (figure 1-5). Consequently, spreads of corporate bond yields over comparable-maturity Treasury yields were little changed and remained very narrow relative to their historical distributions (figure 1-6).⁵ The excess bond premium, which is a measure that captures the gap between corporate bond spreads and expected credit losses, declined further from its level in May 2021 and now stands at the bottom decile of its historical distribution, suggesting elevated appetite for risk among investors (figure 1-7).⁶

Figure 1-6. Corporate Bond Spreads to Similar-Maturity Treasury
Securities

Corporate bond issuance remained robust, supported by low interest rates. The share of investment-grade issuance with the lowest investment-grade ratings remained at historically elevated levels. Within speculative-grade bonds, the share of new bonds with the lowest ratings continued to increase through the third quarter but remained at relatively low levels by historical standards. Across the ratings spectrum, the composition of newly issued corporate bonds has become riskier. Even so, the overall credit quality of outstanding bonds has improved since May, as the volume of credit rating upgrades has outpaced that of downgrades. Defaults and expected defaults have continued to decline since the May report.

Spreads on lower-rated leveraged loans in the secondary market were little changed, on net, since the spring and are below their median levels (figure 1-8). Investor sentiment in the leveraged loan market has remained optimistic since the previous report.

Figure 1-8. Secondary-Market Spreads of Leveraged Loans

Equity prices increased, and earnings expectations improved

Equity prices have increased notably, on net, since May 2021. The ratio of prices to forecasts of corporate earnings edged down, on net, as analysts revised their earnings expectations up (figure 1-9). Nevertheless, prices relative to earnings forecasts remained near the top of their historical distribution. Meanwhile, the difference between the forward earnings-to-price ratio and the expected real yield on 10-year Treasury securities—a rough measure of the compensation that investors require for holding stocks, known as the equity premium—has increased a touch since May (figure 1-10). In contrast to the signal from other valuation measures, this measure of the equity premium remained somewhat above its median, suggesting that equity investor risk appetite remained within historical norms. Option-implied volatility, a proxy for perceived uncertainty, briefly spiked a few times over the past six months and now stands below its median level (figure 1-11).

Figure 1-9. Forward Price-to-Earnings Ratio of S&P 500 Firms

Figure 1-10. Spread of Forward Earnings-to-Price Ratio of S&P
500 Firms to Expected 10-Year Real Treasury Yield

Nonprice measures suggest that investor appetite for equity risk appears to have moderated since last spring. While the pace of initial public offerings (IPOs) continued to be above its historical average, the volume of IPOs supported by special purpose acquisition companies—non-operating corporations created specifically to issue public equity and subsequently acquire an existing operating company—declined significantly from the high levels observed earlier this year, in part because of increased regulatory scrutiny.

Aggregate commercial real estate prices increased, although prices for sectors harder hit by the pandemic were little changed

Since the May Financial Stability Report, aggregate measures of CRE prices based on transactions have continued to increase, rising further above their pre-pandemic levels (figure 1-12). However, prices for properties in sectors harder hit by the pandemic, such as retail establishments, hotels, and offices, were little changed and remained close to their pre-pandemic levels. Historically low capitalization rates, which measure annual income relative to prices of commercial properties, point to high valuation pressures (figure 1-13). By contrast, the spreads of capitalization rates to Treasury yields remained close to or above their historical averages, suggesting that investors currently receive moderate compensation for holding CRE risk.

Figure 1-12. Commercial Real Estate Prices (Real)

Figure 1-13. Capitalization Rate at Property Purchase

Other indicators continue to show strains in some CRE markets compared with pre-pandemic levels. Vacancy rates in most sectors with available data are in line with pre-pandemic levels, but office vacancies are elevated and hotel occupancy rates remain depressed. Additionally, delinquency rates on mortgages in commercial mortgage-backed securities (CMBS) pools backed by properties in the lodging and retail sectors, which have suffered more from pandemic-related declines in income, are still elevated but have declined somewhat since the May report. Finally, the July Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) indicated that banks, on net, reported easier standards and stronger demand for most CRE loans over the second quarter of 2021 (figure 1-14). However, banks also reported that the level of standards for CRE loans remains tighter than before the pandemic.

Figure 1-14. Change in Bank Standards for Commercial Real Estate
Loans

Farmland prices remained high relative to rents

Farmland prices increased slightly at the national level through the first half of 2021 (figure 1-15). In midwestern states—where farmland values are more elevated than the national average—prices increased slightly more over the same period. Overall, the ratio of farmland prices to rents remained close to its historical highs (figure 1-16).

Figure 1-16. Farmland Price-to-Rent Ratio

House prices continued to increase, and valuations remained high relative to history

House prices have increased at a rapid pace since the previous report, supported by low mortgage rates and strong housing demand (figure 1-17). Nationwide, house price valuation measures have risen sharply since May (figure 1-18). These gains have been widespread, with price-to-rent ratios rising across geographically dispersed housing markets (figure 1-19). Even amid such rapid and widespread price growth, there is currently little indication of highly leveraged real estate investment activity or of a deterioration in underwriting standards. Taken together, these developments do not point to speculative activity as a primary driver of the recent house price growth.

Figure 1-17. Growth of Nominal Prices of Existing Homes

Figure 1-18. House Price Valuation Measure

Figure 1-19. Selected Local Housing Price-to-Rent Ratio Indexes

Retail Investors, Social Media, and Equity Trading

Retail investors and social media have been highlighted as key factors in episodes of "meme" stock volatility in equity markets in the first half of 2021. Longer-run changes in demographics, regulations, and technology as well as behavioral factors that could interact with these structural changes may have influenced recent trends in the demand for and supply of retail trading opportunities in equity markets.¹ To date, the broad financial stability implications of these developments have been limited, with bursts of retail-led trading volatility that have rapidly subsided. Still, the evolution of the effects of these changes warrants continued monitoring.

The revival of household financial risk appetite and stock market participation

Household financial risk appetite appears to be cyclical. Over the past three decades, a survey-based measure of the share of households reportedly willing to take financial risks reached a peak in 2001, hit a trough in 2009, and then rebounded notably. By 2019, the most recent survey, it was again approaching its 2001 peak (figure A).² Household direct stock ownership appears to follow risk appetite to some degree. Following a substantial, prolonged decline that started after the dot-com bubble burst in 2001, the share of households directly owning stocks stabilized and then rose appreciably from 2013 through 2019.³

Figure A. Household Willingness to Take Financial Risks and Direct
Stock Ownership

Because equities feature higher volatility and expected returns than many other financial assets, they tend to be more attractive to younger and less risk-averse investors. According to survey data, the share of younger consumers willing to take risks has been significantly higher than that for other age groups for decades. Relatedly, in recent years, the share of direct stock owners aged 35 or younger surged nearly 6 percentage points after 2013.

Market structure changes

Along with the rise in risk appetite and the growing share of younger retail investors, access to retail equity trading opportunities has expanded over the past decade. One factor contributing to this expansion has been the elimination of trading commissions at major retail brokerages for both stocks and options.⁴ Many years of growing revenues from payment for order flow (PFOF) helped set the stage for this development.⁵ PFOF is the compensation that brokerage firms receive for directing orders to venues for trade execution. Retail investor trading flows can help market makers facilitate the execution of institutional trading flows, thereby promoting market liquidity.⁶

The structure of the current market for order flow was heavily influenced by a series of regulations adopted between 2005 and 2010 that allows retail brokers to choose the venues where customer orders are executed so long as customers receive the "national best bid or offer" price or better.⁷ Since 2010, several off-exchange venues, including those run by Citadel, Virtu Financial, and others, have emerged and thrived. Over the past two years, the PFOF paid to some of the largest retail brokers was in large part paid by these off-exchange venues (figures B and C).

Figure B. Payment for Order Flow Paid to Selected Retail Brokers

Figure C. Payment for Order Flow Paid by Selected Venues

Aggregate PFOF levels for the retail brokerage firms in figure B have recently fallen below the record highs from earlier in 2021, as have trading volumes. However, on a per-share basis, PFOF (not shown) has continued to rise, which in part reflects a shift in the volumes mix toward options trades, where per-share PFOF is highest.

Trading apps and social media effects on market access and investor behavior

In addition to eliminating commissions, retail brokerages have shifted how retail investors access and communicate about equity markets by introducing mobile trading apps. While the services offered on some of the most popular apps are similar to those provided by a traditional stockbroker, these apps make investing more accessible, in part by offering a wider range of products, including the opportunity to easily trade fractions of equity shares or crypto-assets. The apps also make trading more visually appealing. Many apps have color-coded graphical layouts that highlight stock movements, mark trading milestones, and have animations celebrating a user's first stock purchase. With their ease of access and engaging graphics, such apps can make trading seem like a game, particularly for younger or less experienced investors.⁸ Consistent with this interface style, among users of trading apps, the average age of account holders is 30 years, and nearly half of them self-identify as first-time investors.⁹

The widespread use of large, open social media platforms has also shaped how some retail equity investors communicate about markets. Recent academic papers have shown that social media can increase the information flow to retail investors as well as the amount of "noise" in markets from retail investor trading.¹⁰ In addition, social media can contribute to an "echo chamber" in which retail investors find themselves communicating most frequently with others with similar interests and views, thereby reinforcing their views, even if these views are speculative or biased.¹¹ More generally, social media platforms allow a single comment or post to reach millions of people and potentially affect market sentiment dramatically within a short period.

The January 2021 meme stock episodes offer a case study for the interaction of social media and stock prices. Twitter posts spiked in late January on days when daily trading volumes for GameStop (GME), as well as other meme stocks, rose sharply (figure D). These spikes also coincided with a jump in intraday volatility, as the daily standard deviation of one-minute price changes increased more than 10-fold from less than 0.25 percent to greater than 2.5 percent. Coincident with the dramatically higher price volatility, intraday trading flows for meme stocks (such as GME and AMC Entertainment Holdings [AMC]) became much more correlated, as illustrated in figure E.¹² Higher flow correlations have the potential to amplify liquidity shortages in equity markets and may lead to price dislocations if sufficiently large.

D. GameStop Stock Price and Twitter Mentions of GameStop

Accessible Version | Return to text

Note: There is a vertical line marked at January 22, 2021 to mark when Twitter posts spiked alongside a sharp rises in trading volumes for GameStop and other meme stocks.

Source: For Twitter mentions, Twitter, Inc., enterprise-level application programming interface; for GameStop stock price, Bloomberg.

Figure E. Intraday Flow Correlations of GameStop and AMC Entertainment
Holdings

Implications for financial stability

To date, the broad financial stability implications of changes in retail equity investor characteristics and behaviors have been limited, as recent episodes of meme stock volatility did not leave a lasting imprint on broader markets. However, a few areas should be monitored. First, younger stock investors tend to have more leveraged household balance sheets. The median leverage ratios of younger retail investors are more than double those of all investors, leaving these investors potentially more vulnerable to large swings in stock prices, as they have a larger debt service burden. Moreover, this vulnerability is amplified, as investors are now increasingly using options, which can often boost leverage and amplify losses.

Second, episodes of heightened risk appetite may continue to evolve with the interaction between social media and retail investors and may be difficult to predict. A potentially destabilizing outcome could emerge if elevated risk appetite among retail investors retreats rapidly to more moderate levels.

Third, the risk-management systems of the relevant financial institutions may not be calibrated for the increased volatility or financial losses that could result from the trends highlighted here. More frequent episodes of higher volatility may require further steps to ensure the resilience of the financial system.

1. In parallel to the equity market developments, and perhaps sharing some of the same underlying drivers, there have been episodes of volatility in crypto-asset markets. However, the view into these markets is limited, and therefore this discussion focuses on equity market developments. Return to text

2. The Survey of Consumer Finances (SCF), conducted by the Federal Reserve Board every three years, collects comprehensive data on household balance sheets and attitudes toward various financial and credit markets. The SCF asks its respondents to choose from the following four options that best describe their willingness to take financial risks:

take substantial financial risks expecting to earn substantial returns
take above-average financial risks expecting to earn above-average returns
take average financial risks expecting to earn average returns
not willing to take any financial risks

A household is defined as willing to take financial risks if it chooses one of the first two options. Return to text

3. The SCF data showed an increase in direct stock ownership between 2016 and 2019 (the most recent survey). In addition, the University of Michigan Surveys of Consumers indicated that broad stock ownership (including ownership through mutual funds or retirement accounts), which also began to rise in 2016, continued to increase appreciably through the summer of 2021. Return to text

4. Robinhood was the first large broker offering commission-free trading in late 2014, as reported in Josh Constine (2014), "Robinhood Launches Zero-Fee Stock Trading App," TechCrunch, December 11, https://techcrunch.com/2014/12/11/robinhood-free-stock-trading. Many other large brokers have since eliminated retail trading commissions starting with the Charles Schwab Corporation in late 2019, as reported in Business Wire (2019), "In Conjunction With Chuck Schwab's New Book ‘ Invested,' Schwab Removes the Final Pricing Barrier to Investing Online by Eliminating U.S. Stock, ETF and Options Commissions," Business Wire, October 1, https://www.businesswire.com/news/home/20191001005489/en/In-Conjunction-With-Chuck-Schwab%E2%80%99s-New-Book-%E2%80%9CInvested%E2%80%9D-Schwab-Removes-the-Final-Pricing-Barrier-to-Investing-Online-by-Eliminating-U.S.-Stock-ETF-and-Options-Commissions. Return to text

5. For a detailed discussion on PFOF, see Securities and Exchange Commission (2016), "Certain Issues Affecting Customers in the Current Equity Market Structure," memorandum, SEC, Division of Trading and Markets, January 26, https://www.sec.gov/spotlight/equity-market-structure/issues-affecting-customers-emsac-012616.pdf. Return to text

6. See Robert A. Korajczyk and Dermot Murphy (2019), "High Frequency Market Making to Large Institutional Trades," Review of Financial Studies, vol. 32 (3), pp. 1034–67. Return to text

7. See, for example, the SEC's final rule for Regulation NMS from 2005 at 17 C.F.R. pts. 200, 201, 230, 240, 242, 249, and 270 (2005), https://www.sec.gov/rules/final/34-51808.pdf. Return to text

8. See Robert W. Cook (2021), "Statement Before the Financial Services Committee U.S. House of Representatives," May 6, https://www.finra.org/media-center/speeches-testimony/statement-financial-services-committee-us-house-representatives. The SEC requested information and comment on "gamification" and related practices; comments closed on October 1, 2021. See Securities and Exchange Commission (2021), "Request for Information and Comments on Broker-Dealer and Investment Adviser Digital Engagement Practices, Related Tools and Methods, and Regulatory Considerations and Potential Approaches; Information and Comments on Investment Adviser Use of Technology to Develop and Provide Investment Advice," File No. S7-10-21, August 27, with an associated press release at https://www.sec.gov/news/press-release/2021-167. Return to text

9. See Robinhood (2021), "Letter of Acceptance, Waiver, and Consent (AWC) No. 2020066971201," June 30, https://www.finra.org/sites/default/files/2021-06/robinhood-financial-awc-063021.pdf. Return to text

10. See, for example, Gregory W. Eaton, T. Clifton Green, Brian Roseman, and Yanbin Wu (2021), "Zero-Commission Individual Investors, High Frequency Traders, and Stock Market Quality," SSRN working paper (Rochester, N.Y.: SSRN, February; revised April). In the financial market research, "noise traders" refers to investors who make transaction decisions based on factors they believe to be helpful but, in reality, give them no better returns than random choices. Return to text

11. See, for example, J. Anthony Cookson, Joseph Engelberg, and William Mullins (2020), "Echo Chambers," SSRN working paper (Rochester, N.Y.: SSRN, June; revised January 2021). Return to text

12. The correlations analysis compares the direction of the trading flows ((buy flows – sell flows) / total flows) every minute between AMC and GME stocks each day using data from TAQ (Trade and Quote database). Return to text

The Role of Foreign Investors in the March 2020 Turmoil in the U.S. Treasury Market

The U.S. Treasury market is critical to the overall functioning of the financial system and to the effective transmission of monetary policy to the broader economy. U.S. Treasury securities are among the most liquid securities in the world and play critical roles as safe investments, collateral for secured credit, and pricing benchmarks for dollar loans and fixed-income securities. In March 2020, as the effects of the COVID-19 pandemic on financial markets intensified, the U.S. Treasury market experienced severe dislocations, and market functioning became unusually strained amid intense and widespread selling pressures. These selling pressures contrasted sharply with typical market dynamics in previous instances of severe global financial stress in which many investors sought to buy U.S. Treasury securities. Although many different types of market participants contributed to the selloff of U.S. Treasury securities, this discussion focuses on the important role of foreign investors.¹

Foreign investors are large holders of U.S. Treasury securities

Foreign investors held $7.2 trillion of U.S. Treasury securities as of the second quarter of 2021, almost 30 percent of the total amount outstanding (figure A). Foreign official institutions—mostly central banks and sovereign wealth funds—are the largest foreign holders of U.S. Treasury securities, accounting for almost 60 percent of foreign holdings. Foreign private investors, including nonfinancial investors, banks, and nonbank financial institutions (NBFIs), hold the remainder and have increased their share in recent years.²

Figure A. Foreign Holdings of U.S. Treasury Securities

Foreign investors played a large role in the U.S. Treasury market selloff in March 2020

Foreign investors sold $287 billion of U.S. Treasury securities in the first quarter of 2020, accounting for about 37 percent of total net sales of these securities in that quarter (figure B). Net sales of U.S. Treasury securities by foreign investors exceeded net sales by U.S. mutual funds ($266 billion) and by the U.S. household sector ($224 billion), which includes U.S.-domiciled hedge funds.

Figure B. Net Purchases of U.S. Treasury Securities by U.S. and
Foreign Holders

Estimates of monthly transactions show that foreign investors made record net sales of almost $420 billion of U.S. Treasury securities in March 2020; this amount is substantially higher than the $287 billion total for the first quarter because foreign investors purchased U.S. Treasury securities in January and February.³ More than half of net foreign sales in March 2020 came from official investors. Additionally, investors from EMEs, which include large official investors, accounted for 55 percent of net foreign sales of U.S. Treasury securities in March 2020 despite accounting for only 45 percent of total foreign holdings.

As part of its response to the turmoil in the U.S. Treasury market, on March 31, 2020, the Federal Reserve established the FIMA (Foreign and International Monetary Authorities) Repo Facility, which allowed foreign monetary authorities to access dollars for liquidity purposes without having to sell their U.S. Treasury securities and thereby contributed to the stabilization of the U.S. Treasury market.⁴ This facility was made a standing facility in July 2021.⁵

Central banks in emerging market economies sold U.S. Treasury securities to support their currencies, provide dollar liquidity to domestic residents, and build precautionary dollar cash buffers

Financial stresses in EMEs ratcheted up substantially as concerns about COVID-19 started to escalate in mid-February 2020. EME equity prices tumbled, and sovereign spreads rose sharply. Portfolio outflows from EMEs surpassed those observed during the Global Financial Crisis and previous episodes of EME financial stress (in dollar terms and relative to GDP), and many EME currencies depreciated sharply against the dollar. EME central banks liquidated assets held as foreign exchange reserves, including U.S. Treasury securities, at a rapid pace to mitigate currency depreciation pressures and to provide foreign currency liquidity to domestic firms and financial institutions.

At the same time that they were selling U.S. Treasury securities, some official entities increased their cash and deposits in the United States, suggesting that their sales were also partly used to build dollar cash buffers amid a widespread surge in demand for liquidity.

Large outflows from foreign-domiciled funds that invest in U.S. bonds led some of these funds to disproportionately sell U.S. Treasury securities because of their liquidity

To explore some of the factors that drove sales of U.S. Treasury securities by foreign private investors in March 2020, we examine institution-level data on portfolio holdings for foreign-domiciled open-end bond funds.⁶ We focus on bond mutual funds because, as noted in previous Financial Stability Reports, rapid redemptions from these types of funds contributed to the market turmoil at the start of the pandemic.

Foreign-domiciled bond funds invest in a broad range of bonds—U.S., foreign, corporate, and government—including U.S. Treasury securities. Foreign-domiciled funds that invest solely in U.S. government securities experienced inflows in March 2020 (figure C), suggesting that concerns about the U.S. Treasury market were not significant drivers of outflows from foreign-domiciled funds. By contrast, other foreign-domiciled bond funds that invest in a broad range of U.S. securities experienced large outflows during this period.

Figure C. Cumulative Net Flows to Foreign-Domiciled Bond Funds

Open-end funds offer daily liquidity to investors, but they invest in a range of assets with different levels of liquidity. When faced with large redemptions, funds may need to sell assets, and they may choose to sell their most liquid securities first to limit the effect of these sales on prices. Liquidity management practices at foreign-domiciled bond mutual funds could have led them to disproportionately sell U.S. Treasury securities in response to redemptions, as these securities were probably the most liquid assets in their portfolios.

To understand whether foreign-domiciled funds did indeed disproportionately sell U.S. Treasury securities in response to outflows, we analyze the sensitivity of fund holdings of different types of securities to net outflows in March 2020 for 840 foreign-domiciled open-end bond funds.⁷ If these funds had sold all asset holdings in proportion to outflows (keeping portfolio weights unchanged), then investor redemptions equivalent to 1 percent of fund assets would have led to a reduction of 1 percent in each portfolio holding, including U.S. Treasury security holdings. The results show that fund asset sales were not proportional to holdings at the beginning of the month; rather, outflows led to greater net sales of more liquid securities. For instance, estimates indicate that outflows equivalent to 1 percent of fund assets are associated with a reduction in U.S. Treasury security holdings of about 1.5 percent, compared with a reduction of only 0.6 percent in corporate bond holdings (figure D). These results suggest that sales of U.S. Treasury securities by foreign-domiciled bond funds were not necessarily motivated by a desire to rebalance their portfolios away from these securities. Rather, because of the depth and liquidity of the U.S. Treasury market, foreign-domiciled funds sold Treasury securities to raise cash to meet redemptions. Available evidence shows that U.S.-domiciled bond mutual funds behaved in a similar manner in March 2020, disproportionately selling U.S.Treasury securities in response to net outflows.⁸

Figure D. Sensitivity of Foreign-Domiciled Bond Fund Holdings
to Net Outflows in March 2020

1. For a retrospective on the March2020 turmoil in the Treasury market and the roles of different market participants, including hedge funds, mortgage real estate investment trusts, principal trading firms, and dealers, see the box "A Retrospective on the March 2020 Turmoil in Treasury and Mortgage-Backed Securities Markets" in Board of Governors of the Federal Reserve System (2020), Financial Stability Report (Washington: Board of Governors, November), pp. 32–38, https://www.federalreserve.gov/publications/files/financial-stability-report-20201109.pdf. Return to text

2. Foreign NBFIs include central counterparties, exchange-traded funds, hedge funds, insurance companies, mutual funds, and pension funds. Return to text

3. These estimates are based on data from the Treasury International Capital (TIC) system. See Carol Bertaut and Ruth Judson (2014), "Estimating U.S. Cross-Border Securities Positions: New Data and New Methods," International Finance Discussion Papers 1113 (Washington: Board of Governors of the Federal Reserve System, August), https://www.federalreserve.gov/pubs/ifdp/2014/1113/ifdp1113.pdf. Many hedge funds and other investment funds that serve U.S. investors are domiciled in Caribbean offshore financial centers and thus their holdings of U.S. Treasury securities are classified as foreign in the TIC data. Net sales of U.S. Treasury securities by entities located in Caribbean offshore financial centers are estimated to have totaled less than $30 billion in March 2020, so excluding these jurisdictions would not materially change the aggregate estimates of net foreign sales. Return to text

4. The FIMA Repo Facility allows foreign monetary authorities to temporarily exchange their U.S. Treasury securities with the Federal Reserve for dollars (a repurchase agreement), thus giving these authorities access to dollar liquidity when needed. This facility complemented the additional provision of dollar funding through the expansion and enhancement of dollar liquidity swap lines announced by the Federal Reserve and several other central banks during the third week of March 2020 by extending access to dollar liquidity to a broader range of countries. See https://www.newyorkfed.org/markets/central-bank-and-international-account-services. Return to text

5. For the announcement, see Board of Governors of the Federal Reserve System (2021), "Statement Regarding Repurchase Agreement Arrangements" press release, July 28, https://www.federalreserve.gov/newsevents/pressreleases/monetary20210728b.htm. Return to text

6. Because of data limitations, it is not possible to get a comprehensive breakdown of foreign private investors' holdings of U.S. Treasury securities by type of investor (for example, deposit-taking institutions, insurance companies, pension funds, and nonfinancial corporations). Institution-level data provide only a very partial picture of these holdings. Sales of U.S. Treasury securities by the foreign-domiciled bond funds included in our analysis totaled only $11 billion in March 2020, compared with total estimated sales by foreign private investors of almost $190 billion. Return to text

7. The 840 foreign-domiciled bond funds in this sample are those with a reported investment mandate for either U.S. or global bonds and data available on returns and portfolio holdings for February and March 2020 from Morningstar, Inc. These funds had total net assets of $460 billion dollars at the end of February 2020. Figure C incorporates a larger sample of funds with data on daily flows available from EPFR Global, with total net assets of $1.3 trillion at the end of February 2020. Return to text

8. See Yiming Ma, Kairong Xiao, and Yao Zeng (2020), "Mutual Fund Liquidity Transformation and Reverse Flight to Liquidity," Jacobs Levy Equity Management Center for Quantitative Financial Research Paper (Philadelphia: The Wharton School, University of Pennsylvania, July; revised April 2021). Return to text

References

3. Treasury term premiums capture the difference between the yield that investors require for holding longer-term Treasury securities and the expected yield from rolling over shorter-dated ones. Return to text

4. Market depth indicates the quantity of an asset available to buy or sell at the best posted bid and ask prices. Return to text

5. 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

6. 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

Last Update: November 16, 2021

Financial Stability Report