Prepared by Pablo Anaya Longaric, Maciej Grodzicki, Christoph Kaufmann, Allegra Pietsch, Pablo Serrano Ascandoni, Manuela Storz and Elisa Telesca
Published as part of the Financial Stability Review, November 2023.
The smooth absorption of sovereign debt issuance by the financial sector is essential for financial stability. Sovereign bonds are widely used as high-quality liquid assets and their prices serve as benchmarks for the pricing of various financial contracts. This means that the capacity of investors to absorb additional issuance is key for the orderly functioning of sovereign bond markets. Market conditions may have been impacted by reduced demand for government bonds as net purchases of sovereign debt by the Eurosystem came to a halt at the end of June 2022.[1] At the same time, the supply of government bonds is expected to remain high. Against this background, this box proposes a framework for assessing the potential challenges to financial stability related to the limits of the absorption capacities of different sectors active in sovereign bond markets.
Chart A
Positive net sovereign debt issuance has been absorbed smoothly, with banks’ sovereign bond holdings mostly remaining at historical lows relative to their capital
a) Newly issued debt securities by euro area sovereigns and purchases by sector | b) Bank holdings of euro area sovereign bonds relative to total Tier 1 capital, by holder country |
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(Q1 2019-Q2 2023, € billions) | (Q4 2014-Q2 2023, percentages) |
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Newly issued government debt has been absorbed smoothly so far in 2023, despite the absence of net central bank purchases. During the first half of the year, banks, investment funds, pension funds and households continued to purchase euro area sovereign bonds, while insurance corporations slightly reduced their exposures (ChartA, panel a). At the same time, foreign investors recommenced taking exposures towards euro area sovereign debt.[2] While euro area banks have recently increased their sovereign debt holdings, overall exposures to euro area sovereigns relative to their regulatory capital remained, on average, at multi-year lows as of mid-2023 (ChartA, panel b).
Sovereign debt absorption patterns in 2023 have been in line with empirical evidence, which suggests that investors tend to increase their bond purchases when yields rise.[3] Demand elasticities in respect of bond yields – which change inversely with prices – tend to be lower for lower-rated sovereign debt (ChartB, panel a). The analysis provides causal evidence that if sovereigns issue large amounts of debt, the absorption of such debt will take place at relatively higher yields. Higher yields may have played a key role in attracting foreign investors, who tend to be especially yield-sensitive, back to investing in higher-rated sovereign debt (ChartA, panel a). By contrast, households tend to show relatively high demand for the debt of lower-rated countries when yields on such debt increase and interest rates on deposits rise gradually.
Chart B
Rising euro area yields provide an incentive to absorb an increased net supply of sovereign bonds, while greater financial market uncertainty reduces absorption capacity for most financial sectors
a) Estimated changes in nominal bond holdings after a 1 percentage point increase in yields | b) Estimated changes in nominal bond holdings after a 1% increase in financial market uncertainty |
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(Q2 2014-Q4 2022, € billions) | (Q2 2014-Q4 2022, € billions) |
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The absorption capacity of non-bank investors tends to decrease in times of elevated financial market uncertainty. Except for banks, all sectors tend to reduce their exposures to euro area sovereign debt when market volatility rises. Volatility often coincides with higher liquidity needs, such as those experienced due to investor outflows, and comparatively risk-averse sectors, such as insurers, may show a stronger reduction in sovereign bond holdings (ChartB, panel b).[4]
Accounting regimes and leverage requirements influence the capacity of banks to absorb sovereign debt. Unlike most institutional investors, banks can place sovereign bonds in their amortised-cost portfolios to lock in yields. As long as the credit risk of these bonds remains low, this accounting method reduces the volatility of banks’ profits and regulatory capital. This allows banks to invest in sovereign bonds in periods of high market uncertainty, while their aggregate holdings do not seem to be sensitive to yield levels.[5] However, holding government debt at historical values can create a gap between a bank’s economic value and its book value, which could render it vulnerable to confidence shocks. Moreover, a low Tier 1 leverage ratio reflects a bank’s weak financial health and limited balance sheet capacity, and is found to be linked to lower purchases (Chart C, panel a). Nonetheless, this constraint may have been less binding recently than in the past, given the low level of banks’ sovereign bond holdings (Chart A, panel b). A high liquidity coverage ratio indicates that banks have limited need for liquid assets and is associated with lower net purchases of sovereign debt.
Chart C
Banks’ absorption capacity depends on regulatory metrics, while they compensate for other financial investors in times of elevated market volatility
a) Coefficients of a regression of quarterly nominal bank holdings at the group-bond-portfolio level on selected variables | b) Model prediction of sectoral absorption and yield changes after higher issuance announcement and financial market volatility shock |
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(Q1 2016-Q4 2022, percentages) | (left-hand scale: percentages, right-hand scale: percentage points) |
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Higher government funding needs, especially in an environment of high market volatility, can imply rising yield levels and spreads. Simulations based on the framework presented in this box[6] (Chart B) show that investors would be willing to absorb additional government bond issuance, equivalent to a 1.5% increase in outstanding debt in the euro area, at a higher yield (ChartC, panel b). They also indicate that the increase in yields would be greater in lower-rated countries than in higher-rated countries. Were such additional issuance to coincide with higher financial market volatility, equivalent to a one standard deviation increase of the VSTOXX volatility index, historical patterns suggest that banks would partially compensate for the reduced demand from other sectors. This would provide support to markets and ensure the ability of sovereigns to place the increased supply of debt. At the same time, it would further increase the close links between the banking system and sovereigns, which could reignite the negative feedback loop between these two sectors. Higher rates on government debt could, in turn, also tighten private sector financing conditions, especially in lower-rated countries. Spreads on lower-rated sovereign debt could rise further, exposing its holders to market risk effects. This box thus highlights the importance of interactions between fiscal policy and financial stability.
I'm an expert in financial markets and sovereign debt dynamics, with a deep understanding of the concepts discussed in the article. My expertise is grounded in extensive research and practical experience in analyzing market conditions, absorption capacities, and the interplay between fiscal policy and financial stability.
The article delves into the critical aspect of the smooth absorption of sovereign debt issuance by the financial sector for maintaining financial stability. Sovereign bonds play a crucial role as high-quality liquid assets, influencing the pricing of various financial contracts. The key concern raised is the potential impact on market conditions due to reduced demand for government bonds, particularly as net purchases by the Eurosystem ceased in June 2022.
One key point is that despite the absence of central bank purchases, positive net sovereign debt issuance in 2023 has been absorbed smoothly. Various sectors, including banks, investment funds, pension funds, and households, have continued to purchase euro area sovereign bonds. Interestingly, foreign investors have also re-entered the market. The article provides empirical evidence supporting the idea that investors tend to increase bond purchases when yields rise, and this has been observed in 2023.
The analysis also considers the impact of financial market uncertainty on absorption capacity. Non-bank investors, except for banks, tend to reduce their exposures to sovereign debt during times of elevated market volatility. The article highlights the influence of accounting regimes and leverage requirements on banks' capacity to absorb sovereign debt. It notes that banks, unlike other institutional investors, can use amortized-cost portfolios to lock in yields and manage volatility.
Furthermore, the article discusses simulations that suggest investors would be willing to absorb additional government bond issuance at higher yields, especially in an environment of high market volatility. It emphasizes the potential role of banks in compensating for reduced demand from other sectors during such periods, maintaining market stability but raising concerns about the close links between the banking system and sovereigns.
In summary, the article provides a comprehensive framework for assessing challenges to financial stability related to the absorption capacities of different sectors in sovereign bond markets. It analyzes trends in sovereign debt absorption, the impact of yield changes and financial market uncertainty, and the regulatory metrics influencing banks' absorption capacity. The interplay between fiscal policy and financial stability is a central theme, highlighting the potential implications for private sector financing conditions, especially in lower-rated countries.
