Global or regional safe assets: Evidence from bond substitution patterns

Summary

Focus

An important channel of monetary policy transmission both domestically and internationally is through the portfolio rebalancing of international investors between safe and riskier assets. In this paper, I characterise this rebalancing in international bond markets by directly estimating the demand for global government and corporate bonds by mutual funds domiciled in the US and the euro area between 2007 and 2020. This includes both how much funds adjust their bond holdings in response to changes in the respective bond returns ("own elasticities") as well as what other bonds they rebalance to ("substitution elasticities"). To do this, I combine broader and more granular data on investor bond holdings than previous literature with a methodology tailored to allow flexible substitution between different bonds.

Contribution

The substitution elasticities are the first such estimates in global bond markets at a granular bond level. They vary in the cross-section of international bonds as well as over time and thus offer a new and more systematic approach to capturing portfolio rebalancing than traditional approaches, which trace flows to different securities in the immediate aftermath of asset purchase programmes. They inform us about one channel of international monetary policy spillovers.

Findings

Investors are less willing to part with bonds normally perceived as safe assets – US Treasuries and German bunds – despite declining returns than they are when risky bond returns decline. But not all safe assets are the same. The estimated bond substitution elasticities reveal that when US Treasury returns increase, funds decrease their exposure to risky and emerging market bonds the most. In contrast, a rise in German government bond returns triggers sales of primarily euro area bonds, issued by sovereigns with a high credit rating. Hence, US Treasuries play a global role in international portfolios, while bunds have a regional role. Finally, I document that portfolio rebalancing between safe and risky bonds deteriorates in periods of heightened market stress. This "flight to safety" makes monetary policies that directly target the interest rate on safe assets less effective during financial turmoil.

Abstract

This paper provides novel empirical evidence on portfolio rebalancing in international bond markets through the prism of investors' demand for bonds. Using a granular dataset of global government and corporate bond holdings by mutual funds domiciled in the world's two largest currency areas, I estimate heterogeneous and time varying demand elasticities for bonds. Safe assets such as US Treasuries or German Bunds face especially inelastic demand from investment funds compared to riskier bonds. But spillovers from these safe assets to global bond markets are strikingly different. Funds substitute US Treasuries with global bonds, including risky corporate and emerging market bonds, whereas German Bunds are primarily substitutable within a narrow set of euro area safe government bonds. Substitutability deteriorates in times of stress, impairing the transmission of monetary policy.

JEL classification: F30, G11, G15

Keywords: international finance, portfolio choice, safe assets