Investment funds have become increasingly visible players in global financial markets. For example, their share in world financial sector asset holdings reached 15% in 2022 (FSB 2023). At the same time, they operate under a relatively loose regulatory regime and face strategic complementarities in investor redemptions (Chen et al. 2010). This makes them particularly prone to runs, which can trigger fire sales and negative asset price spirals with spillovers to other funds and market segments (Falato et al. 2021, Ma et al. 2022, Claessens 2024). Against this background, a key question is how the presence of investment funds affects the transmission of shocks.

Sovereign debt markets are a case in point. Despite investment funds’ sizeable footprint (Fang et al. 2024), our understanding of their role in the volatility that afflicts these markets during stress episodes remains incomplete. Moreover, we lack evidence on how investment funds and other investor groups interact in these markets during stress episodes. Understanding the drivers of volatility is critical given persistently high debt levels in many advanced economies.

How do investment funds behave in sovereign bond markets?

In this column, we summarise our recent research (Anaya Longaric et al. 2025), in which we shed light on these issues by focusing on the effects of stress events in euro area sovereign debt markets over the period from 2007 to 2023. In particular, we study how investment funds adjust their holdings of euro area sovereign debt and how they interact with other investors during stress episodes. We term euro area political events that induce stress in sovereign debt markets ‘euro disaster risk shocks’.

Studying investment funds in euro area sovereign debt markets in the context of euro disaster risk events is important. Investment funds hold up to 25% of outstanding sovereign debt in some euro area countries. Moreover, anecdotal evidence suggests they exhibit distinct behaviour during stress episodes. A prominent example is the deadlock between Italy’s President and Prime Minister over a cabinet appointment in May 2018 and the following snap election that sparked fears of a strong mandate for euro-sceptic parties. In this episode, investment funds rebalanced from periphery to core debt (Figure 1, left panel). In contrast, other key investors such as banks picked up periphery debt (right panel). This rebalancing was accompanied by a sharp and persistent rise in yields and volatility in periphery relative to core sovereign debt markets.

Figure 1 Dynamics in holdings of euro area sovereign debt around May 2018

Notes: The figure shows the evolution of investor holdings of core and periphery sovereign debt around May 2018. The plots show percentage differences in holdings relative to the level one quarter before the event. The left-hand side panel shows fund holdings of periphery (red diamond lines) and core (blue triangle lines) sovereign debt. The right-hand side panel shows periphery debt holdings (red diamond lines) and banks (black triangle lines).

Euro disaster risk as a measure of sovereign bond market stress

In the spirit of Barro (2006) and Barro and Liao (2021), we conceive of euro disaster risk shocks as exogenous innovations to financial market beliefs about the probability of a euro-related, institutional rare disaster. Just as financial markets do in real time, we remain agnostic about the scenario that would play out if such a disaster were to materialise in terms of euro area dissolution or country exit(s) and sovereign debt redenomination or default.

As shocks to beliefs about the probability of such a rare disaster are not observable, we adopt a proxy-variable approach for identification. In particular, we use the change in the spread between the credit default swap (CDS) premia of euro area periphery and core sovereign debt issuers as a proxy variable.

Several pieces of evidence suggest that euro disaster risk, but no other macro-financial shock, is the key driver of the changes in the periphery-core CDS spread in our sample period – and hence that it is a valid proxy variable for euro disaster risk shocks. First, we carry out a narrative analysis of a comprehensive intra-day news reports archive on dates with large movements in the CDS spread. The analysis reveals that the largest spikes in the CDS spread coincide with unexpected political events related to election outcomes, leader resignations, or disagreements between national governments and international institutions. All these events have a clear intuitive interpretation of euro disaster risk shocks. Second, the patterns in the impulse responses of macro-financial variables to a change in the CDS spread cannot be rationalised by shocks other than euro disaster risk shocks.

Figure 2 Impulse responses to euro disaster risk shocks of investment funds’ holdings of euro area sovereign debt

Notes: The left-hand side panel shows the impulse response of fund holdings of euro area (black circle line), core (blue triangle line), and periphery (red diamond line) sovereign debt (nominal values) to a euro disaster risk shock that raises the periphery-core ten-year sovereign bond yield spread by one standard deviation. Dashed lines indicate 90% confidence bands. The right-hand side panel shows the decomposition of changes in holdings in market values into those driven by fund-manager and fund-investor decisions, respectively.

Investment funds sell periphery debt during sovereign stress episodes

In our empirical analysis, we first exploit a proprietary dataset on security-level holdings of global investment funds. Our key finding here is that in response to euro disaster risk shocks, investment funds persistently shed periphery debt but do not adjust holdings of core debt (Figure 2, left panel). The estimated effects on fund holdings of periphery debt are economically significant. For example, our estimates imply that for one of the largest euro disaster risk shocks in the sample – namely May 2018 – the average fund reduced its periphery sovereign debt holdings by up to 10%. Given that investment funds held about 13% of euro area sovereign debt outstanding at the time, this implies a shedding of 1.3% of the total outstanding amount. This is close to the actual sales of about 1.7% of total outstanding amounts observed during this event.

Periphery debt is sold both to meet fund-investor redemptions and to reduce its portfolio weight (Figure 2, right panel). On the one hand, funds experience large outflows, so that they need to shed some of their holdings – including periphery sovereign debt. On the other hand, funds also persistently reduce the portfolio weight of periphery sovereign debt, rebalancing their portfolio towards other assets.

Moreover, we document that funds with features that correlate with weaker fund-investor or fund-manager expertise about euro area sovereign debt markets are more sensitive: funds exhibit a greater response of debt holdings and outflows when they are not domiciled in and do not have a geographical focus on the euro area, have a low portfolio share of euro area sovereign debt at the outset, and are not specialising only in bond markets.

Investment funds are the only sector selling periphery debt

We then zoom out from the investment-fund sector and compare its responses to those of other key holder-sectors of euro sovereign debt. To this end we analyse an administrative security-level dataset on the universe of holdings of all euro area domiciled investors. The key finding here is that only investment funds shed periphery debt in response to euro disaster risk shocks (Figure 3). Banks pick it up in the short term, and households and insurance corporations in the medium term. Moreover, the absorption is concentrated among investors in periphery countries and in the debt of their own sovereign, implying an increase in investor home bias in response to euro disaster risk shocks (Rojas and Thaler 2024). Overall, our analysis reveals a distinctly procyclical behaviour of investment funds in euro area sovereign debt markets during disaster risk episodes. Our findings expand existing evidence which has focused on the behaviour of banks during such episodes (Acharya and Steffen 2015, Altavilla et al. 2017, Ongena et al. 2019) but does not explore which investors, and for what reasons, drive the sell-off.

Figure 3 Impulse responses to euro disaster risk shocks of holdings of periphery sovereign debt, by investor type and holder area

Notes: The figure shows the effects across investors of a euro disaster risk shock of one standard deviation on holdings of periphery sovereign debt, on impact (Panel a) and for the average effect over the first four quarters (Panel b). Blue (yellow) bars indicate point estimates for all (only domestic) holders. The striped bars indicate that effects are not statistically significant at the 10% level. Euro area holder sectors: B stands for banks; HH stands for households; IC stands for insurance corporations; IF stands for investment funds; PF stands for pension funds; ROW stands rest of the world (non-euro area).

Implications for both fiscal and monetary policy

Our results speak to important policy questions. As investment funds are key investors in euro area debt markets, our findings imply that fiscal policy and governments more generally must internalise that investor appetite may be more sensitive in their presence. As the procyclical behaviour of investment funds tends to be destabilising, they can exert a strong disciplining force on fiscal policy. We can, thus, locate the ‘bond vigilantes’ among investment funds. However, investment-fund behaviour can also trigger excessive volatility that could require policy intervention. Therefore, especially the investment-fund sector needs to be monitored carefully to detect unwarranted sovereign debt market fragmentation early on (Lane 2020). In case such fragmentation impairs the smooth transmission of monetary policy, the ECB has multiple instruments in its toolkit, including the Transmission Protection Instrument.  

References

Acharya, V V and S Steffen (2015), “The “Greatest” Carry Trade Ever? Understanding Eurozone Bank Risks”, Journal of Financial Economics 115(2): 215–236.

Altavilla, C, M Pagano and S Simonelli (2017), “Bank Exposures and Sovereign Stress Transmission”, Review of Finance21(6): 2103–2139.

Anaya Longaric, P, K Cera, G Georgiadis and C Kaufmann (2025), “Investment funds and euro disaster risk”, ECB Working Paper No. 3029.

Barro, R (2006), “Rare Disasters and Asset Markets in the Twentieth Century”, Quarterly Journal of Economics 121(3): 823–866.

Barro, R and G Liao (2021), “Rare Disaster Probability and Options Pricing”, Journal of Financial Economics 139(3): 750–769.

Chen, Q, I Goldstein and W Jiang (2010), “Payoff Complementarities and Financial Fragility: Evidence from Mutual Fund Outflows”, Journal of Financial Economics 97(2): 239–262.

Claessens, S (2024), “Non-bank financial intermediation: Research, policy, and data challenges”, VoxEU.org, 9 May.

Falato, A, A Hortacsu, D Li and C Shin (2021), “Fire-Sale Spillovers in Debt Markets”, Journal of Finance 76(6): 3055–3102.

Fang, X, B Hardy and K Lewis (2024), “Who holds sovereign debt and why it matters”, VoxEU.org, 11 October.

FSB (2023), Global Monitoring Report on Non-Bank Financial Intermediation 2023.

Lane, P (2020), “The Market Stabilisation Role of the Pandemic Emergency Purchase Programme”, The ECB Blog, 22 June.

Ma, Y, K Xiao and Y Zeng (2022), “Mutual Fund Liquidity Transformation and Reverse Flight to Liquidity”, Review of Financial Studies 35(10): 4674–4711.

Ongena, S, A Popov and N Van Horen (2019), “The Invisible Hand of the Government: Moral Suasion during the European Sovereign Debt Crisis”, American Economic Journal: Macroeconomics 11(4): 346–79.

Rojas, L and D Thaler (2024), “The ‘doom loop’ and default incentives”, VoxEU.org, 23 December.