The European Central Bank published a Working Paper (No 3159) under its Lamfalussy Fellowship Programme presenting new evidence on how international investors rebalance bond portfolios in response to changes in safe-asset returns. Estimating time-varying demand and substitution elasticities from mutual fund holdings, the paper finds that US Treasuries and German Bunds face especially inelastic demand, but their spillovers to the broader bond market differ sharply: funds substitute away from US Treasuries into a wide set of global bonds (including risky corporate and emerging market bonds), while German Bunds are mostly substitutable within a narrow pool of euro area high-credit-quality sovereign bonds. The analysis uses granular holdings data on over 11,000 mutual funds domiciled in the US and euro area, covering about 5,000 bond portfolios with a face value of USD 74 trillion (nearly 60% of global debt securities outstanding). Identification relies on exogenous variation in bond returns around Federal Reserve and ECB monetary policy announcements. The paper reports that substitutability deteriorates in periods of market stress, consistent with “flight to safety”, weakening monetary policy transmission via portfolio rebalancing; a hypothetical USD 100 billion Fed Treasury purchase is associated with funds reallocating USD 27 billion into BBB-rated US corporate bonds in low-stress conditions versus USD 12 billion during turmoil, and a similar deterioration in substitutability between Bunds and other euro area government bonds is noted during the sovereign debt crisis.

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