Foreign institutional investors, monetary policy, and reaching for yield

Summary

Focus

Foreign institutional investors have played an increasingly important role in the US dollar (USD) bond market over time. Against this background, this paper conceptually and empirically analyses the investment behaviour of foreign institutional investors in the USD bond market, focusing on euro area investment funds.

Contribution

We highlight a new hedging channel of monetary policy transmission operating through foreign institutional investors. This channel arises from the widespread practice of hedging currency risk using rolling short-term foreign exchange derivatives which expose foreign investors to a maturity mismatch when investing in long-term USD bonds. This gives rise to an erosion of the hedged yield earned on USD bonds when US monetary policy tightens and induces a reach for yield in order to bolster portfolio returns. The hedging channel works in the opposite direction to the classical risk-taking channel for domestic US investors, which is associated with less reaching for yield when monetary policy is tightened.

Findings

We use security-level data of euro area investment funds' bond holdings to empirically test the implications of the hedging channel for investors' reaching for yield in the USD bond market. We find that euro area investment funds rebalance their portfolios towards USD bonds with higher yields and higher credit spreads when US monetary policy is tightened. This is in line with the implications of the hedging channel. We further find that USD bond purchases by euro area investment funds, induced by the reach for yield, have meaningful effects on bond prices. This implies that such purchases affect conditions in the USD bond market.

Abstract

This paper uses security-level data of euro area investment funds' bond holdings to analyze their reaching for yield in the US dollar bond market. We find that they rebalance their US dollar bond portfolios toward higher yielding, riskier bonds when US monetary policy tightens, reflecting the effects of foreign exchange hedging. The effect is driven by the practice of hedging currency risk through rolling short-term hedging contracts. This gives rise to an erosion of the hedged yield earned on US dollar bonds when US monetary policy tightens and hedging costs increase, inducing reaching for yield in order to bolster portfolio returns. The hedging channel of monetary transmission is diametrically opposed to the classical risk-taking channel operating through US dollar-based investors, where a monetary tightening is associated with less reaching for yield. We further find that the US dollar bond purchases by euro area investment funds induced by their reaching for yield have meaningful effects on bond prices, implying that they affect conditions in the US dollar bond market.

JEL classification: E43, E52, G11, G12, G15, G23

Keywords: monetary policy, foreign institutional investors, FX hedging, US dollar bond market