Foreign institutional investors, monetary policy, and reaching for yield

Ahmed Ahmed, Boris Hofmann and Martin Schmitz

No 1153, BIS Working Papers from Bank for International Settlements

Abstract: This paper uses security-level data of euro area investment funds' bond holdings to analyze their reaching for yield in the US dollar bond market. We find that they rebalance their US dollar bond portfolios toward higher yielding, riskier bonds when US monetary policy tightens, reflecting the effects of foreign exchange hedging. The effect is driven by the practice of hedging currency risk through rolling short-term hedging contracts. This gives rise to an erosion of the hedged yield earned on US dollar bonds when US monetary policy tightens and hedging costs increase, inducing reaching for yield in order to bolster portfolio returns. The hedging channel of monetary transmission is diametrically opposed to the classical risk-taking channel operating through US dollar-based investors, where a monetary tightening is associated with less reaching for yield. We further find that the US dollar bond purchases by euro area investment funds induced by their reaching for yield have meaningful effects on bond prices, implying that they affect conditions in the US dollar bond market.

Keywords: monetary policy; foreign institutional investors; FX hedging; US dollar bond market (search for similar items in EconPapers)
JEL-codes: E43 E52 G11 G12 G15 G23 (search for similar items in EconPapers)
Date: 2023-12
New Economics Papers: this item is included in nep-ban, nep-cba, nep-fdg, nep-ifn and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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