1. Asset Valuations
Prices of risky assets have risen further on the improved economic outlook, and valuations are generally high
Broad equity market indexes have reached record highs in recent months. Yields on corporate bonds and leveraged loans remain at low levels relative to their historical ranges. Meanwhile, yields on long‐term Treasury securities have risen over the past few months but remain low by historical standards. Reflecting, in part, increased prices, some measures of risk compensation, which account for the still‐low level of interest rates, have decreased to levels that are low relative to their historical norms.
On balance, indicators of commercial real estate (CRE) valuations remain high; however, low transaction volumes—especially for distressed properties—may mask declines in commercial property values. Farmland prices remain elevated relative to rents and incomes. Supported by relatively low mortgage rates, house prices have continued to increase amid strong home sales.
Looking ahead, asset prices may be vulnerable to significant declines should investor risk appetite fall, progress on containing the virus disappoint, or the recovery stall. Some segments of the economy—such as energy, travel, and hospitality—are particularly sensitive to pandemic‐related developments.
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, Treasury securities, and CRE.
Table 1. Size of Selected Asset Markets
(billions of dollars)
|Average annual growth,
|Residential real estate||41,272||7.4||5.7|
|Commercial real estate||20,914||3.9||7.0|
|Investment‐grade corporate bonds||6,551||9.1||8.5|
|High‐yield and unrated corporate bonds||1,652||25.0||7.1|
|Price growth (real)|
|Commercial real estate**||7.5||2.8|
|Residential real estate***||7.7||2.3|
Note: The data extend through 2020:Q4. Growth rates are measured from Q4 of the year immediately preceding the period through Q4 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 2020:Q4, as this market was fairly small before then.
** One-year growth of commercial real estate prices is from December 2019 to December 2020, and average annual growth is from 1998:Q4 to 2020:Q4. Both growth rates are calculated from value-weighted nominal prices deflated using the consumer price index.
*** One-year growth of residential real estate prices is from December 2019 to December 2020, and average annual growth is from 1997:Q4 to 2020:Q4. Nominal prices are deflated using the consumer price index.
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; 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 and term premiums have risen but remain low
Since the previous report, yields on longer‐dated Treasury securities have moved up to their pre‐COVID levels (figure 1‐1). Model estimates of Treasury term premiums have also risen but are still negative, and implied volatility on long‐term interest rates has edged up (figures 1‐2 and 1‐3).3 The increases in yields and term premiums are consistent with market perceptions of an improved economic outlook, higher inflation expectations, and diminished downside risks from the pandemic. Still, Treasury yields remain low relative to their historical range, and an increase in term premiums, if not accompanied by a strengthening of the economic outlook, could put downward pressure on valuations in a variety of markets.
Measures of Treasury market functioning have generally been stable since the stresses of spring 2020 receded. However, on February 25, market liquidity deteriorated following a disappointing seven‐year Treasury note auction and an accompanying sharp increase in Treasury yields. Some liquidity metrics, such as market depth, deteriorated significantly (figure 1‐4).4 Market depth overall rebounded in subsequent weeks; however, for short‐ and medium‐dated securities, the recovery was uneven and slower on net. This event highlighted the importance of continued focus on Treasury market resilience. The FSOC recently called for an interagency effort to understand key causes of last year's Treasury market disruptions and to enhance market resilience.
Corporate bond spreads declined to low levels, while issuance remained solid
Since the November report, amid the increase in Treasury yields, yields on higher‐rated corporate bonds increased modestly, while yields on lower‐rated corporate bonds declined significantly (figure 1‐5). These movements left the spreads of lower‐rated corporate bond yields over comparable‐maturity Treasury yields very narrow relative to their historical distributions (figure 1‐6).5 Corporate bond spreads in sectors heavily affected by the pandemic—such as energy, airline, and hospitality—also declined but remain wider than average spreads across all industries. The excess bond premium, which is a measure that captures the gap between corporate bond spreads and expected credit losses, is at the bottom quintile of its historical distribution, suggesting elevated appetite for risk among investors (figure 1‐7).6
Corporate bond markets appear to have functioned smoothly since the November Financial Stability Report, and bid‐ask spreads remained within historical norms. The Federal Reserve's corporate credit emergency lending facilities, as well as several other facilities, expired at the end of last year and are no longer authorized to purchase eligible assets. This event left no imprint on markets.
Corporate bond issuance by both investment‐ and speculative‐grade firms has remained solid, as companies boosted their cash buffers and refinanced their debt at lower interest rates and longer maturities. The share of investment‐grade issuance with the lowest ratings has increased. However, within speculative‐grade bonds, the share of new bonds with the lowest ratings remained subdued through the first quarter of 2021. While the composition of new issues of investment‐grade bonds has become riskier, overall credit quality of outstanding bonds has improved since November as actual and expected defaults have declined.
Spreads on leveraged loans, in both the primary and secondary markets, have narrowed further since the fall (figure 1‐8). These spreads are now in the bottom quintile of their post‐2008 distributions.
Equity prices increased amid continued high volatility, and valuations continue to be supported in part by low interest rates
Equity prices have increased, on net, since November 2020. Forecasts of corporate earnings have risen roughly in line with equity prices, so the ratio of prices to forecasts of earnings remains near the top of its historical distribution (figure 1‐9). 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 risky stocks known as the equity premium—has declined since November (figure 1‐10). A lower equity premium generally indicates investors have a higher appetite for the risk of investing in equities. However, this measure of the equity premium remains above its historical median, suggesting that equity investor risk appetite, though higher since November by this measure, is still within historical norms. That said, this measure is close to its lowest level over the past 15 years. Option‐implied volatility, a proxy for perceived uncertainty, remains above pre‐pandemic levels (figure 1‐11).
In contrast to the mixed signals from price‐based measures, a number of nonprice measures suggest that investor appetite for equity risk is elevated relative to history. The pace of initial public offerings (IPOs) has increased to levels not seen since the 1990s. In addition, a rising share of IPOs is supported by special purpose acquisition companies (SPACs), which are nonoperating corporations created specifically to issue public equity and subsequently acquire an existing operating company. For a broader discussion of risk appetite, see the box "Vulnerabilities from Asset Valuations, Risk Appetite, and Low Interest Rates."
Assessing vulnerabilities from asset valuations is a part of the Federal Reserve's financial stability framework. High asset valuations, relative to the general level of interest rates and the income flows generated by different types of assets, suggest investors require less compensation for the risks they are taking and, thus, have elevated appetite for or willingness to invest in risky assets. At times when risk appetite is elevated, investors may take on excessive leverage or engage in other forms of risk‐taking, which are vulnerabilities that are addressed in other parts of the Federal Reserve's financial stability framework. In addition, should risk appetite decline from elevated levels, a broad range of asset prices could be vulnerable to large and sudden declines, which can lead to broader stress to the financial system.
In this discussion, we first provide a short primer on factors affecting asset prices. Next, we explore methods that are used to assess investor risk appetite, focusing on approaches that account for economic fundamentals. And, finally, motivated by the notable decline in interest rates over recent decades, we ask how persistently low interest rates might affect valuations and risk appetite.
Factors affecting asset prices
People and businesses invest now to receive income in the future. There are various theories explaining asset prices. According to a long‐standing theory, an asset's price should equal the expected discounted value today of future payoffs from holding assets—for example, interest payments from Treasury securities and corporate bonds as well as dividends from stocks.1 Investors also want to be compensated for the relative risk of their investments, so the expected rate of return will tend to be higher for riskier assets such as equities and corporate bonds than for Treasury securities. The difference in the expected returns between risky assets and Treasury securities is the risk premium investors expect to receive as compensation for the risk they take.
For assets such as publicly traded equities and corporate bonds, it can be difficult to tell the relative contribution of risk premiums and expected future income in causing changes in asset valuations at any point in time. An increase in asset prices might reflect higher expected future payoffs; a decline in the overall level of interest rates, which raises the current value of those future payoffs; a fall in risk premiums; or a combination of these factors.
Asset prices and risk appetite
The Federal Reserve closely monitors measures of risk premiums, which help indicate whether investor risk appetite is rising or falling. When risk appetite is higher, risk premiums are lower, prices of risky assets are higher, and the odds of a large and potentially destabilizing fall in asset prices increases. High risk appetite can also prompt businesses and households to take on more leverage and induce banks and other lenders to increase their risk‐taking.
The risk premium for an asset varies over time and, unlike the price of an asset, cannot be directly observed. Thus, the Federal Reserve takes into account a large set of indicators that provide signals about risk premiums. For example, one measure of the risk premium investors require for holding stocks is the difference between the "earnings yield," which is the ratio of earnings to stock prices, and the long‐term real interest rate. This equity risk premium captures the earnings investors expect to receive by holding equities compared with what they would receive by holding a less risky investment in long‐term government bonds.2 The left panel of figure A shows the distribution of monthly readings on this measure over the past three decades, ordered from low to high. The arrow in the figure shows the most recently available reading. According to this measure, the equity risk premium is around its historical center, suggesting that risk appetite is fairly typical.
The right panel shows the distribution of a related measure for the corporate bond market: the excess bond premium.3 This measure captures a component of corporate bond yields that is not explained by risk‐free rates or default risk. By construction, this measure has a historical average of zero. When it is below zero, risk appetite is above that average. As in the left panel, the arrow shows the most recent value, which is not just negative but among the lowest recorded in recent decades, indicating high risk appetite.
The two panels of figure A thus give very different signals about risk appetite based on asset prices. They illustrate why the Federal Reserve also reviews indicators not directly related to an asset's price but that have been associated with periods of elevated risk appetite in the past, such as measures related to trading patterns, underwriting standards, issuance, or investor leverage. For example, indicators pointing to elevated risk appetite in equity markets in early 2021 include the episodes of high trading volumes and price volatility for so‐called meme stocks—stocks that increased in trading volume after going viral on social media.4 Elevated equity issuance through SPACs also suggests a higher‐than‐typical appetite for risk among equity investors (figure B).5
Asset prices and persistently low risk‐free interest rates
In recent decades, risk‐free interest rates have declined notably, partly because of a decline in the neutral rate of interest, or the interest rate consistent with the economy being at full employment with 2 percent inflation. Even before the pandemic, a number of estimates found that the neutral rate of interest had declined in recent decades. The decline in the neutral rate of interest likely reflects persistent structural factors such as demographic changes and low productivity growth. While actual interest rates fluctuate with the economic cycle, their trends tend to be driven by the neutral rate of interest. In other words, when, as now, the neutral rate of interest is low, market interest rates also tend to be low.
The connections between persistently low interest rates and risk premiums are not well understood. Persistently low interest rates might contribute to the buildup of financial vulnerabilities through a variety of channels. Because low interest rates tend to be driven by changes in the structure of the economy that reduce expected returns in many asset classes, low interest rates could lead some financial intermediaries to invest in higher‐risk assets to meet fixed return targets.6 By reducing uncertainty about monetary policy, low interest rates could also mute financial market volatility, which could contribute to a buildup in leverage if investors become complacent.7 Beyond asset valuations, low rates could encourage household borrowing, including through mortgages. Higher household borrowing can support spending and economic activity, but excessive borrowing can increase financial vulnerabilities.
At the same time, persistently low interest rates can also reduce financial vulnerabilities—for example, by supporting lower debt service payments. There is also some evidence that unexpected monetary policy easing leads to lower risk premiums, a key channel through which accommodative monetary policy can support the economy.8 However, even large changes in interest rates due to unexpected changes in monetary policy have been found to have only modest effects on equity, corporate bond, and house prices when compared to the overall variation in these asset prices.9
Given these challenges in assessing vulnerabilities associated with risk appetite and asset valuations, the Federal Reserve's financial stability monitoring tracks a wide range of measures related to risk‐taking across financial markets and institutions as well as the resilience of the system to potential drops in asset prices.
1. Discounting refers to the formula for determining the current value of a payment or stream of payments in the future. The discount rate for a risky asset equals the interest rate on a safe asset plus a risk premium, which compensates investors for the risk of losses from holding the risky asset. An alternative theory for asset prices is that an asset price today reflects market participants' estimate of what a potential buyer might be willing to pay for the asset tomorrow. Return to text
2. This indicator is a rough measure of the premium that investors require for holding risky corporate equities. The first step in its calculation is to take the ratio of firm earnings to stock prices as a proxy for expected equity returns. This ratio is calculated as the expected (or "forward") earnings of S&P 500 firms based on analyst estimates, divided by the price of the index. In the second step, the expected equity risk premium is calculated as the earnings yield less the expected 10‐year real Treasury yield as a proxy for expected excess equity returns over a risk‐free rate. Although this indicator provides useful information on the compensation for risk demanded by equity investors, alternative risk premium measures can be constructed using different models and assumptions. Considering a range of these measures can provide valuable additional insights into risk appetite and equity valuation pressures. Return to text
3. See Simon Gilchrist and Egon Zakrajšek (2012), "Credit Spreads and Business Cycle Fluctuations," American Economic Review, vol.102 (June), pp. 1692–720. See also note 6 in the main text. This measure captures a component of corporate bond yields that is not explained by risk‐free rates or default risk. Return to text
4. One such episode occurred in January 2021, when social media activity contributed to extreme fluctuations in stock prices for some companies, resulting in substantial losses for some investors. Return to text
5. SPAC issuance volume remained strong, but, going forward, the pace is reportedly expected to moderate, and the post‐IPO performance of recently issued SPACs has weakened. SPAC issuance took off in mid‐2020 around the exceptional performance of some high‐profile names (for example, DraftKings), with some commentators arguing that SPACs offer a more efficient way to go public than the traditional IPO. However, some academics find that SPACs have substantially higher costs and suggest that the advantages of SPACs may be due to the lower disclosure requirements imposed by law when a company is acquired by a public SPAC, as opposed to undertaking a traditional IPO. See Minmo Gahng, Jay R. Ritter, and Donghang Zhang (2021), "SPACs," unpublished paper, January (revised March 2021); and Michael Klausner, Michael Ohlrogge, and Emily Ruan (forthcoming), "A Sober Look at SPACs," Yale Journal on Regulation. Recent statements issued by the Securities and Exchange Commission highlighted accounting challenges that may be common in SPACs, potential liability risks of SPACs under securities laws, and additional scrutiny that investors might want to use before investing in SPACs. Return to text
6. For example, one study provides evidence that "lower for longer" announcements led to higher risk‐taking by MMFs; see Marco Di Maggio and Marcin Kacperczyk (2017), "The Unintended Consequences of the Zero Lower Bound Policy," Journal of Financial Economics,vol. 123 (January), pp. 59–80. Regarding the connections between low interest rates and risk‐taking by intermediaries, see also Claudio Borio and Haibin Zhu (2012), "Capital Regulation, Risk‐Taking and Monetary Policy: A Missing Link in the Transmission Mechanism?" Journal of Financial Stability, vol. 8 (December), pp. 236–51; Nuno Coimbra and Hélène Rey (2019), "Financial Cycles with Heterogeneous Intermediaries," NBER Working Paper Series 23245 (Cambridge, Mass.: National Bureau of Economic Research, January), https://www.nber.org/papers/w23245; and Lina Lu, Matthew Pritsker, Andrei Zlate, Kenechukwu Anadu, and James Bohn (2019), "Reach for Yield by U.S. Public Pension Funds," Finance and Economics Discussion Series 2019‐048 (Washington: Board of Governors of the Federal Reserve System, June), https://dx.doi.org/10.17016/FEDS.2019.048. Return to text
7. Relatedly, low volatility could lead to higher leverage for intermediaries that face value‐at‐risk constraints. See Tobias Adrian and Hyun Song Shin (2014), "Procyclical Leverage and Value‐at‐Risk," Review of Financial Studies, vol. 27 (February), pp. 373–403. Return to text
8. See Mark Gertler and Peter Karadi (2015), "Monetary Policy Surprises, Credit Costs, and Economic Activity," American Economic Journal: Macroeconomics, vol. 7 (January), pp. 44–76; Simon Gilchrist, David López‐Salido, and Egon Zakrajšek (2015), "Monetary Policy and Real Borrowing Costs at the Zero Lower Bound," American Economic Journal: Macroeconomics,vol. 7 (January), pp. 77–109; and Samuel G. Hanson and Jeremy C. Stein, "Monetary Policy and Long‐Term Real Rates," Journal of Financial Economics, vol. 115 (March), pp. 429–48. Return to text
9. For example, estimates from a range of models indicate that for every 100 basis point decline in the general level of interest rates, house prices increase over the course of several years by roughly 2 to 4 percentage points. By comparison, between 2000 and 2006, house prices increased between 40 and 70 percent, depending on the house price measure used. For further discussion, see Jonathan Goldberg, Elizabeth Klee, Edward Simpson Prescott, and Paul Wood (2020), "Monetary Policy Strategies and Tools: Financial Stability Considerations," Finance and Economics Discussion Series 2020‐074 (Washington: Board of Governors of the Federal Reserve System, August), https://dx.doi.org/10.17016/FEDS.2020.074. Return to text
Commercial real estate valuation pressures appear to remain high
Disruptions caused by the pandemic continue to make it difficult to assess valuations in the CRE sector. Since the November report, CRE price indexes based on transactions recovered from their decline early last year, suggesting elevated pressures (figure 1‐12). Furthermore, capitalization rates, which measure annual income relative to prices of commercial properties, have continued to tick down (figure 1‐13). However, other measures suggest market participants perceive values as having fallen over the past year. For example, an index of the prices of CRE properties administered by real estate investment trusts (REITs), which supplements observed transactions with appraisal information, remains below pre‐pandemic levels.7 Similarly, stock prices of REITs that invest in harder‐hit commercial property sectors have increased since November but generally remain below their respective pre‐pandemic levels.
Other indicators continue to show strains in CRE markets. Vacancy rates continue to increase, and rent growth has declined further. Additionally, delinquency rates on commercial mortgage‐backed securities (CMBS), which usually contain riskier loans, remain elevated. Finally, the January Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) indicated that banks, on net, reported weaker demand for most CRE loans and tighter lending standards in the fourth quarter of 2020 (figure 1‐14).
Farmland prices remain high relative to rents
Farmland prices continued their slow decline at the national level—and at a slightly faster pace in several midwestern states—through the second quarter of 2020 (figure 1‐15). Recent estimates from Reserve Bank surveys suggest prices edged up in the second half of 2020 in the midwestern states where farmland values are more elevated. Overall, the ratio of farmland prices to rents remained elevated relative to historical norms (figure 1‐16).
House price growth continued to increase, and valuations appear high relative to history
The average growth rate of home prices increased significantly since the previous report (figure 1‐17). Nationwide, house price valuation measures moved up but remain well below the peak of the mid‐2000s (figure 1‐18). House price increases are widespread across regions and property types, and price‐to‐rent ratios also generally increased across regional markets (figure 1‐19).
Low levels of interest rates have likely supported robust housing demand. However, downside risks to the sector remain, given the unusually large number of mortgage loans in forbearance programs and the uncertainty around their ultimate repayment.
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
7. The Green Street price index remained below its pre‐pandemic level in February. This index is appraisal based, using both sales and nonsales information to track prices of properties managed by REITs. Return to text