Sovereign bond markets and financial stability: examining the risk to absorption capacity (2024)

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
(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
(Q2 2014-Q4 2022, € billions)	(Q2 2014-Q4 2022, € billions)

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
(Q1 2016-Q4 2022, percentages)	(left-hand scale: percentages, right-hand scale: percentage points)

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.