Board of Governors of the Federal Reserve System

1. Asset Valuations

Prices of risky assets have risen further on the improved economic outlook, and valuations are generally high

Broad equity market indexes have reached record highs in recent months. Yields on corporate bonds and leveraged loans remain at low levels relative to their historical ranges. Meanwhile, yields on long‐term Treasury securities have risen over the past few months but remain low by historical standards. Reflecting, in part, increased prices, some measures of risk compensation, which account for the still‐low level of interest rates, have decreased to levels that are low relative to their historical norms.

On balance, indicators of commercial real estate (CRE) valuations remain high; however, low transaction volumes—especially for distressed properties—may mask declines in commercial property values. Farmland prices remain elevated relative to rents and incomes. Supported by relatively low mortgage rates, house prices have continued to increase amid strong home sales.

Looking ahead, asset prices may be vulnerable to significant declines should investor risk appetite fall, progress on containing the virus disappoint, or the recovery stall. Some segments of the economy—such as energy, travel, and hospitality—are particularly sensitive to pandemic‐related developments.

Table 1 shows the sizes of the asset markets discussed in this section. The largest asset markets are those for corporate public equities, residential real estate, Treasury securities, and CRE.

Table 1. Size of Selected Asset Markets

Treasury yields and term premiums have risen but remain low

Since the previous report, yields on longer‐dated Treasury securities have moved up to their pre‐COVID levels (figure 1‐1). Model estimates of Treasury term premiums have also risen but are still negative, and implied volatility on long‐term interest rates has edged up (figures 1‐2 and 1‐3).³ The increases in yields and term premiums are consistent with market perceptions of an improved economic outlook, higher inflation expectations, and diminished downside risks from the pandemic. Still, Treasury yields remain low relative to their historical range, and an increase in term premiums, if not accompanied by a strengthening of the economic outlook, could put downward pressure on valuations in a variety of markets.

Measures of Treasury market functioning have generally been stable since the stresses of spring 2020 receded. However, on February 25, market liquidity deteriorated following a disappointing seven‐year Treasury note auction and an accompanying sharp increase in Treasury yields. Some liquidity metrics, such as market depth, deteriorated significantly (figure 1‐4).⁴ Market depth overall rebounded in subsequent weeks; however, for short‐ and medium‐dated securities, the recovery was uneven and slower on net. This event highlighted the importance of continued focus on Treasury market resilience. The FSOC recently called for an interagency effort to understand key causes of last year's Treasury market disruptions and to enhance market resilience.

Corporate bond spreads declined to low levels, while issuance remained solid

Since the November report, amid the increase in Treasury yields, yields on higher‐rated corporate bonds increased modestly, while yields on lower‐rated corporate bonds declined significantly (figure 1‐5). These movements left the spreads of lower‐rated corporate bond yields over comparable‐maturity Treasury yields very narrow relative to their historical distributions (figure 1‐6).⁵ Corporate bond spreads in sectors heavily affected by the pandemic—such as energy, airline, and hospitality—also declined but remain wider than average spreads across all industries. The excess bond premium, which is a measure that captures the gap between corporate bond spreads and expected credit losses, is at the bottom quintile of its historical distribution, suggesting elevated appetite for risk among investors (figure 1‐7).⁶

Corporate bond markets appear to have functioned smoothly since the November Financial Stability Report, and bid‐ask spreads remained within historical norms. The Federal Reserve's corporate credit emergency lending facilities, as well as several other facilities, expired at the end of last year and are no longer authorized to purchase eligible assets. This event left no imprint on markets.

Corporate bond issuance by both investment‐ and speculative‐grade firms has remained solid, as companies boosted their cash buffers and refinanced their debt at lower interest rates and longer maturities. The share of investment‐grade issuance with the lowest ratings has increased. However, within speculative‐grade bonds, the share of new bonds with the lowest ratings remained subdued through the first quarter of 2021. While the composition of new issues of investment‐grade bonds has become riskier, overall credit quality of outstanding bonds has improved since November as actual and expected defaults have declined.

Spreads on leveraged loans, in both the primary and secondary markets, have narrowed further since the fall (figure 1‐8). These spreads are now in the bottom quintile of their post‐2008 distributions.

Equity prices increased amid continued high volatility, and valuations continue to be supported in part by low interest rates

Equity prices have increased, on net, since November 2020. Forecasts of corporate earnings have risen roughly in line with equity prices, so the ratio of prices to forecasts of earnings remains near the top of its historical distribution (figure 1‐9). Meanwhile, the difference between the forward earnings‐to‐price ratio and the expected real yield on 10‐year Treasury securities—a rough measure of the compensation that investors require for holding risky stocks known as the equity premium—has declined since November (figure 1‐10). A lower equity premium generally indicates investors have a higher appetite for the risk of investing in equities. However, this measure of the equity premium remains above its historical median, suggesting that equity investor risk appetite, though higher since November by this measure, is still within historical norms. That said, this measure is close to its lowest level over the past 15 years. Option‐implied volatility, a proxy for perceived uncertainty, remains above pre‐pandemic levels (figure 1‐11).

In contrast to the mixed signals from price‐based measures, a number of nonprice measures suggest that investor appetite for equity risk is elevated relative to history. The pace of initial public offerings (IPOs) has increased to levels not seen since the 1990s. In addition, a rising share of IPOs is supported by special purpose acquisition companies (SPACs), which are nonoperating corporations created specifically to issue public equity and subsequently acquire an existing operating company. For a broader discussion of risk appetite, see the box "Vulnerabilities from Asset Valuations, Risk Appetite, and Low Interest Rates."

Commercial real estate valuation pressures appear to remain high

Disruptions caused by the pandemic continue to make it difficult to assess valuations in the CRE sector. Since the November report, CRE price indexes based on transactions recovered from their decline early last year, suggesting elevated pressures (figure 1‐12). Furthermore, capitalization rates, which measure annual income relative to prices of commercial properties, have continued to tick down (figure 1‐13). However, other measures suggest market participants perceive values as having fallen over the past year. For example, an index of the prices of CRE properties administered by real estate investment trusts (REITs), which supplements observed transactions with appraisal information, remains below pre‐pandemic levels.⁷ Similarly, stock prices of REITs that invest in harder‐hit commercial property sectors have increased since November but generally remain below their respective pre‐pandemic levels.

Other indicators continue to show strains in CRE markets. Vacancy rates continue to increase, and rent growth has declined further. Additionally, delinquency rates on commercial mortgage‐backed securities (CMBS), which usually contain riskier loans, remain elevated. Finally, the January Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) indicated that banks, on net, reported weaker demand for most CRE loans and tighter lending standards in the fourth quarter of 2020 (figure 1‐14).

Farmland prices remain high relative to rents

Farmland prices continued their slow decline at the national level—and at a slightly faster pace in several midwestern states—through the second quarter of 2020 (figure 1‐15). Recent estimates from Reserve Bank surveys suggest prices edged up in the second half of 2020 in the midwestern states where farmland values are more elevated. Overall, the ratio of farmland prices to rents remained elevated relative to historical norms (figure 1‐16).

House price growth continued to increase, and valuations appear high relative to history

The average growth rate of home prices increased significantly since the previous report (figure 1‐17). Nationwide, house price valuation measures moved up but remain well below the peak of the mid‐2000s (figure 1‐18). House price increases are widespread across regions and property types, and price‐to‐rent ratios also generally increased across regional markets (figure 1‐19).

Low levels of interest rates have likely supported robust housing demand. However, downside risks to the sector remain, given the unusually large number of mortgage loans in forbearance programs and the uncertainty around their ultimate repayment.

References

 3. Treasury term premiums capture the difference between the yield that investors require for holding longer‐term Treasury securities and the expected yield from rolling over shorter‐dated ones. Return to text

 4. Market depth indicates the quantity of an asset available to buy or sell at the best posted bid and ask prices. Return to text

 5. Spreads between yields on corporate bonds and comparable‐maturity Treasury securities reflect the extra compensation investors require to hold debt that is subject to corporate default or liquidity risks. Return to text

 6. For a description of the excess bond premium, see Simon Gilchrist and Egon Zakrajšek (2012), "Credit Spreads and Business Cycle Fluctuations," American Economic Review, vol. 102 (June), pp. 1692–720. Return to text

 7. The Green Street price index remained below its pre‐pandemic level in February. This index is appraisal based, using both sales and nonsales information to track prices of properties managed by REITs. Return to text