The European Central Bank has published a working paper examining how investment funds rebalance euro area sovereign bond portfolios when financial markets raise the perceived probability of a rare, euro-related institutional “disaster” such as euro exit. Using data from 2007 to 2023, the authors find investment funds behave distinctly procyclically by shedding periphery sovereign debt in these episodes, without materially increasing core sovereign debt holdings, while other investor sectors absorb the sales. The paper notes that investment funds can hold more than 20% of outstanding sovereign debt in some euro area countries and up to 25% overall, while operating under a looser regulatory regime than banks. It identifies euro disaster risk shocks using changes in the periphery-core sovereign credit default swap spread linked to unexpected political events. Fund-level evidence indicates the response is driven both by investor redemptions and by managers’ decisions to reduce periphery portfolio weights, with stronger sensitivity among funds that are not euro area domiciled or euro area focused, have a low initial share of euro area sovereign debt, or are not bond-only funds. Sector-level evidence shows the periphery debt sold by investment funds is predominantly picked up by domestic investors in the issuing country, with banks absorbing in the short term and households and insurance corporations in the medium term, increasing investor home bias. The authors argue these dynamics imply closer monitoring of the investment-fund sector for early signs of sovereign market fragmentation that could hinder monetary policy transmission, including scenarios in which the ECB might need to deploy non-standard measures such as Outright Monetary Transactions or the Transmission Protection Instrument. The paper states the views expressed are those of the authors and do not necessarily reflect those of the ECB.
European Central Bank 2025-02-16
European Central Bank working paper finds investment funds sell euro area periphery sovereign debt when euro disaster risk spikes
The European Central Bank's working paper analyzes how investment funds adjust euro area sovereign bond portfolios during perceived euro-related institutional crises. The study finds funds act procyclically by selling periphery sovereign debt without significantly increasing core holdings, with domestic investors absorbing these sales. The authors suggest closer monitoring of investment funds to detect early signs of market fragmentation affecting monetary policy transmission.