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US REIT Preferred: A potential bright spot in challenging times

US REIT Preferred: A potential bright spot in challenging times

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Real estate investment trusts (REITS) have recovered from the coronavirus with the broader market, but real estate investors now face the prospect of persistently low rates, high volatility and slow economic growth.

One potential bright spot in this challenging environment is US REIT preferred securities. This lesser known part of the real estate capital structure has historically offered higher yields and lower volatility than REIT common stock as well as better downside protection and a preferred position in the capital stack. Since average dividend yields are currently above 8%, REIT preferred securities1 could also offer an attractive value opportunity that may generate equity-like total returns with fixed income-like risk.2

Understanding REIT preferreds. REIT preferred stock is a type of hybrid security that exhibits both equity- and bond-like characteristics. Like equities, preferred stocks are a permanent source of capital which does not count as debt on the balance sheet. Within the capital stack, REIT preferreds have a senior claim on assets, earnings and dividends relative to common stock, but are junior to corporate bonds. Like bonds, REIT preferreds typically make fixed payments on a quarterly basis, and the dividends are often considerably higher than those paid on common stock. In addition, most REIT preferreds offer cumulative dividends so that the issuer is obligated to make up any missed payments before issuing a dividend on any common stock. If a preferred security goes six quarters without a dividend payment, the preferred shareholders can elect two new board members who remain in place until all distributions have been paid.

Moreover, REIT preferred shares are generally issued at a par value (often $25) that can rise or fall but have historically remained in a tight range. REIT preferred shares have no voting rights, although the owners can benefit when shares are trading at a discount to par. REIT preferreds are often callable at par five years after issuance. This feature gives the REIT management team flexibility in its financing, while the five-year non-call period gives shareholders the potential for both income and capital appreciation.

Why issue REIT preferred stock? There are several reasons why REIT managers might elect to issue preferred stock instead of common stock or corporate debt.  For example, preferred stock does not fully appear as debt on the company’s balance sheet and there is no requirement of principal repayment. This is a permanent source of financing that, issued in place of debt, allows the company to operate with lower leverage on the balance sheet, an appealing factor for investors, analysts and rating agencies. A wide variety of REITs have issued preferred stock including residential, office, retail, industrial, self-storage, data center, infrastructure, healthcare and lodging sectors. While the investable universe of US REIT preferreds is relatively small by number of issuers and total capitalization, the potential benefits of these securities to both issuers and investors have historically been compelling.

Comparing REIT preferreds to REIT common stock. From the global financial crisis in October 2008 to April 30, 2020, US REIT preferred stock has outperformed US REIT common stock with slightly more than half the volatility (see Figure 1). However, selecting different time periods will generate different performance results, some of which will favor REIT common stock. But choosing any period that includes sharp downdrafts or volatility spikes in the market will generally favor REIT preferreds over REIT common stock. The reason why is that the higher level of income generated by the preferred shares, coupled with better downside risk mitigation and the potential for capital appreciation on discounted securities, has allowed this segment of the capital structure to generate excess returns.

Figure 1: US REIT Preferreds Performance
Competitive Risk-Adjusted Returns

Performance data quoted represents past performance; that past performance does not guarantee future results. An investment cannot be made directly into an index.
Source: Invesco Real Estate, Wells Fargo, and Zephyr StyleADVISOR. US REIT Preferreds represented by Wells Fargo Hybrid and Preferred REIT Index; US REIT Common represented by FTSE Nareit All Equity REITs Index. Data from October 1, 2008 – April 30, 2020.

We recognize that interest rates in the US are extremely low today and the Federal Reserve may not begin raising the Fed Funds rate for quite some time. But higher rates are always a risk for fixed income investors, so it is significant that from the global financial crisis through April 2020, US REIT preferred stock has tended to outperform2 US REIT common stock during periods of rising rates (see Figure 2). We believe that the higher yield spreads versus the 10-year Treasury note and other preferred sectors have insulated these securities and enabled them to outperform on a relative basis during periods of rising rates. At the same time, the subsequent one-year performance of the REIT preferred universe was slightly below REIT common stocks, although REIT preferreds outperformed broader equities and fixed income. As of March 31, the US REIT preferred market had an average yield of 8.82% compared to the 4.66% yield of the FTSE NAREIT All Equity REITs Index.4

Figure 2: US REIT Preferreds and Rising Rates
Real Estate Securities Performance During Rising Rates

Source: Invesco Real Estate, Bloomberg and Wells Fargo.  Average total returns where the cumulative rise in 10-Year US Treasury yields for each full month period is above 50 basis points (bps) and  the one-year subsequent periods from December 2008 through March 2020.  US REIT Preferred represented by Wells Fargo Hybrid and Preferred REIT Index.  US REIT Common represented by FTSE Nareit All Equity REITs Index.  General Equities represented by S&P 500.  US Fixed Income represented by Barclays US Aggregate Bond Index.  

Given the historically elevated yields of US REIT preferred stocks, investors could properly question the sustainability of these distributions. In this regard, financial preferreds have experienced certain periods of double-digit payment defaults. In contrast, the average annual default rate for US REIT preferred stock has been below 0.50% over the last 20 years, reflecting the potentially stable and predictable cashflows generated by real estate-related companies over that period.5

Potentially attractive valuations. Both common and preferred shares of US REITs traded sharply lower during the height of the pandemic-related market turmoil, and both have partially recovered from the market bottom in late March. Regarding the common stock, US REITs over the last 30 years have traded close to net asset value (NAV) on average versus private real estate valuations. As of March 31, 2020, US REITs traded at a discount of -21.9% to NAV.6 Discounts of this magnitude have only historically been observed during the 1990 Gulf War recession and the global financial crisis in 2008/09. These periods have historically provided investors with a window for deeper value opportunities as there was a fragmentation between underlying real estate fundamentals and asymmetrically steep declines in valuation. We may see something similar in this current environment.

US REIT preferred shares also sold off sharply during the recent market turmoil. Investors frequently analyze preferred securities based on their yield spreads to risk-free securities, including the benchmark 10-year US Treasury note. Over the past five years, US REIT preferred securities have traded between 400 to 500 basis points (bps) above 10-year Treasury yields, with occasional and limited excursions outside of that range (see Figure 3).

Figure 3: US REIT Preferred Spreads
As of March 31, 2020

Source: Invesco Real Estate and Wells Fargo as of 31 March 2020. Performance data quoted represents past performance; that past performance does not guarantee future results.  An investment cannot be directly made into an index. US REIT Preferreds represented by Wells Fargo Hybrid & Preferred REIT Index.  Data shown from 1 January 2015 – 31 March 2020.    

However, as news of the coronavirus pandemic started to roil markets, US REIT preferred spreads widened to levels not seen since the global financial crisis. In particular, spreads widened to 900 bps above Treasuries before falling slightly to end the first quarter just below 800 bps. As of March 31, US REIT preferred shares, represented by Wells Fargo Hybrid & Preferred REITs, had an average yield of 8.82% versus 0.67% for the 10-year Treasury note, 1.59% for US Bonds, and 1.22% for Global Bonds.7 By the end of Q1 2020, REIT preferreds were trading over 300 bps wider to 10-year Treasuries than their five-year averages.8 Accordingly, we believe, on both an absolute and relative basis, that yields and spreads for US REIT preferred securities could represent a potentially attractive value opportunity.     

To be clear, there are many uncertainties with respect to the current global health and capital markets environment, and REIT preferreds have their own potential risks as well. For example, many REIT preferred securities are less liquid than REIT common stock. Since a significant portion of the total return for REIT preferreds typically comes from dividends, these securities are subject to interest rate risk. During steep market downturns, they are also subject to potential dividend deferrals. However, we believe that in any forthcoming market recovery, REITs with higher quality assets operating in relatively supply constrained markets, healthier balance sheets and the prospect for above average earnings growth may present a potentially attractive investment opportunity. 

Key takeaways. Looking beyond the current turmoil to a period when the capital markets have stabilized, investors can likely expect structurally lower interest rates, higher levels of volatility and slower economic growth. A low rate and slow growth environment has historically been favorable for commercial real estate and may prove to be so again. In addition, US REIT preferred securities, with their historically higher yields and lower volatility than REIT common stock, may help investors generate attractive levels of income with less downside risk in a low-to-zero-rate world. In the event of another steep downdraft in the market, REIT preferreds reside higher up the capital stack, and they offer the potential for attractive total returns in light of their overall yields and historically attractive spreads. In summary, the Invesco Real Estate team believes that the utilization of US REIT preferred stock (in portfolios allowing these securities) may enhance returns, reduce volatility and generate income over time compared to a pure REIT common stock portfolio.

While the industry has traditionally focused on real estate strategies that invest exclusively in REIT common stock, we believe that by leveraging different parts of the capital structure, investors may be able to generate higher risk-adjusted returns over the long term. By pairing REIT common stock positions with REIT preferred stock (and considering REIT corporate debt and collateralized mortgage-backed securities in select portfolios), investors can pursue the capital appreciation and income they seek in a potentially more risk-controlled fashion. The overall goal is to generate real estate equity-like returns but with lower volatility, higher Sharpe ratios, shallower drawdowns, higher income and lower correlation to the broader equity market. US REIT preferreds can be an important part of achieving that goal.

Investors seeking information about Invesco Global Real Estate Income Fund can find additional information here.

Footnotes

1. Source: Invesco Real Estate and Wells Fargo as of 3/31/20.  US REIT Preferreds represented by Wells Fargo Hybrid & Preferred REIT Index.

2.  Source: Bloomberg L.P. as of 5/13/2020

3. Sources: Wells Fargo and Zephyr Style Advisors as of 4/30/2020

4. Sources: Bloomberg L.P. and Morningstar Direct, 5/8/20; Invesco Real Estate and Wells Fargo, 3/31/20. US REIT Preferreds are represented by the Wells Fargo Hybrid and Preferred REIT Index.

5. Sources: Invesco Real Estate, Bloomberg L.P. and Wells Fargo. Data as of 12/31/19 and updated annually. US REIT Preferred represented by Wells Fargo Hybrid & Preferred Securities REIT Index. US Financial Preferred represented by Wells Fargo Hybrid & Preferred Securities Financial Index.

6. Source: Invesco Real Estate estimates based on consensus data, 4/1/20. Past performance does not guarantee future results. US Real Estate Securities represented by FTSE Nareit All Equity REITs Index.

7. Sources: Bloomberg L.P. and Morningstar Direct, 5/12/20. US Bonds represented by Bloomberg Barclays US Aggregate Bond Index and Global Bonds represented by Bloomberg Barclays Global Aggregate Bond Index. An investment cannot be made directly into an index.

8. Sources: Invesco Real Estate and Wells Fargo as of 3/31/20.  US REIT Preferreds represented by Wells Fargo Hybrid & Preferred REIT Index.

Important Information

Blog Header Image: Hannes Egler / Unsplash

NAREIT is The National Association of Real Estate Investment Trusts

The Sharpe Ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk

The capital stack refers to the organization of all capital contributed to finance a real estate transaction or a company.

The standard deviation is a statistic that measures the dispersion of a dataset relative to its mean.

Standard deviation is a statistical measurement in finance that, when applied to the annual rate of return of an investment, sheds light on the historical volatility of that investment. 

A yield spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, issuer, or risk level, calculated by deducting the yield of one instrument from the other. 

The S&P 500® Index is an unmanaged index considered representative of the US stock market.

The Barclays US Aggregate Bond Index is an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.

The Wells Fargo Hyrbid & Preferred REIT Index is designed to track the performance of preferred securities issued in the US market by Real Estate Investment Trusts. The index is composed of preferred stock and securities that, in Wells Fargos judgment, are functionally equivalent to preferred stock including, but not limited to, depositary preferred securities, perpetual subordinated debt and certain capital securities.

The Wells Fargo Hybrid and Preferred Securities Financial Index is a market capitalization-weighted index that tracks the performance of preferred stocks and securities that are functionally equivalent to preferred stock including, but not limited to, depositary preferred securities, perpetual subordinated debt and certain capital securities issued in the US market by financial institutions.

The Wells Fargo Hybrid and Preferred Securities Index is a market capitalization-weighted index that tracks the performance of preferred stocks, as well as certain types of “hybrid securities” that are functionally equivalent to preferred stocks, that are issued by US-based or foreign issuers and that pay a floating or variable rate dividend or coupon.

Global REITS are represented by FTSE EPRA/NAREIT Global Index is designed to track the performance of listed real estate companies and REITs in both developed and emerging markets

US REITS are represented by FTSE NAREIT All Equity REITs Index is an unmanaged index considered representative of U.S. REITs Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions, there can be no assurance that actual results will not differ materially from expectations. An investment cannot be made into an index.

Common stocks do not assure dividend payments and the amount of a dividend if any, may vary over time. There can be no guarantee or assurance that companies will declare dividends in the future of that if declared, they will remain at current levels or increase over time.

Preferred securities may include provisions that permit the issuer to defer or omit distributions for a certain period of time, and reporting the distribution for tax purposes may be required, even though the income may not have been received. Further, preferred securities may lose substantial value due to the omission or deferment of dividend payments.

Mortgage- and asset-backed securities are subject to prepayment or call risk, which is the risk that the borrower’s payments may be received earlier or later than expected due to changes in prepayment rates on underlying loans. Securities may be prepaid at a price less than the original purchase value.

Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.

Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.

The opinions expressed are those of the author, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds, and is an indirect, wholly owned subsidiary of Invesco Ltd.

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Coronavirus dashboard for October 5: an autumn lull as COVID-19 evolves towards seasonal endemicity

  – by New Deal democratBack in August I highlighted some epidemiological work by Trevor Bedford about what endemic COVID is likely to look like, based…

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 - by New Deal democrat

Back in August I highlighted some epidemiological work by Trevor Bedford about what endemic COVID is likely to look like, based on the rate of mutations and the period of time that previous infection makes a recovered person resistant to re-infection. Here’s his graph:




He indicated that it “illustrate[s] a scenario where we end up in a regime of year-round variant-driven circulation with more circulation in the winter than summer, but not flu-like winter seasons and summer troughs.”

In other words, we could expect higher caseloads during regular seasonal waves, but unlike influenza, the virus would never entirely recede into the background during the “off” seasons.

That is what we are seeing so far this autumn.

Confirmed cases have continued to decline, presently just under 45,000/day, a little under 1/3rd of their recent summer peak in mid-June. Deaths have been hovering between 400 and 450/day, about in the middle of their 350-550 range since the beginning of this past spring:



The longer-term graph of each since the beginning of the pandemic shows that, at their present level cases are at their lowest point since summer 2020, with the exception of a brief period during September 2020, the May-July lull in 2021, and the springtime lull this year. Deaths since spring remain lower than at any point except the May-July lull of 2021:



Because so many cases are asymptomatic, or people confirm their cases via home testing but do not get confirmation by “official” tests, we know that the confirmed cases indicated above are lower than the “real” number. For that, here is the long-term look from Biobot, which measures COVID concentrations in wastewater:



The likelihood is that there are about 200,000 “actual” new cases each day at present. But even so, this level is below any time since Delta first hit in summer 2021, with the exception of last autumn and this spring’s lulls.

Hospitalizations show a similar pattern. They are currently down 50% since their summer peak, at about 25,000/day:



This is also below any point in the pandemic except for briefly during September 2020, the May-July 2021 low, and this past spring’s lull.

The CDC’s most recent update of variants shows that BA.5 is still dominant, causing about 81% of cases, while more recent offshoots of BA.2, BA.4, and BA.5 are causing the rest. BA’s share is down from 89% in late August:



But this does not mean that the other variants are surging, because cases have declined from roughly 90,000 to 45,000 during that time. Here’s how the math works out:

89% of 90k=80k (remaining variants cause 10k cases)
81% of 45k=36k (remaining variants cause 9k cases)

The batch of new variants have been dubbed the “Pentagon” by epidmiologist JP Weiland, and have caused a sharp increase in cases in several countries in Europe and elsewhere. Here’s what she thinks that means for the US:


But even she is not sure that any wave generated by the new variants will exceed summer’s BA.5 peak, let alone approach last winter’s horrible wave:



In summary, we have having an autumn lull as predicted by the seasonal model. There will probably be a winter wave, but the size of that wave is completely unknown, primarily due to the fact that probably 90%+ of the population has been vaccinated and/or previously infected, giving rise to at least some level of resistance - a disease on its way to seasonal endemicity.

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Gonorrhea became more drug resistant while attention was on COVID-19 – a molecular biologist explains the sexually transmitted superbug

The US currently has only one antibiotic available to treat gonorrhea – and it’s becoming less effective.

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The _Neisseria gonorrhoeae_ bacterium causes gonorrhea by infecting mucous membranes. Design Cells/iStock Getty Images Plus via Getty Images

COVID-19 has rightfully dominated infectious disease news since 2020. However, that doesn’t mean other infectious diseases took a break. In fact, U.S. rates of infection by gonorrhea have risen during the pandemic.

Unlike COVID-19, which is a new virus, gonorrhea is an ancient disease. The first known reports of gonorrhea date from China in 2600 BC, and the disease has plagued humans ever since. Gonorrhea has long been one of the most commonly reported bacterial infections in the U.S.. It is caused by the bacterium Neisseria gonorrhoeae, which can infect mucous membranes in the genitals, rectum, throat and eyes.

Gonorrhea is typically transmitted by sexual contact. It is sometimes referred to as “the clap.”

Prior to the pandemic, there were around 1.6 million new gonorrhea infections each year. Over 50% of those cases involved strains of gonorrhea that had become unresponsive to treatment with at least one antibiotic.

In 2020, gonorrhea infections initially went down 30%, most likely due to pandemic lockdowns and social distancing. However, by the end of 2020 – the last year for which data from the Centers for Disease Control and Prevention is available – reported infections were up 10% from 2019.

It is unclear why infections went up even though some social distancing measures were still in place. But the CDC notes that reduced access to health care may have led to longer infections and more opportunity to spread the disease, and sexual activity may have increased when initial shelter-in-place orders were lifted.

As a molecular biologist, I have been studying bacteria and working to develop new antibiotics to treat drug-resistant infections for 20 years. Over that time, I’ve seen the problem of antibiotic resistance take on new urgency.

Gonorrhea, in particular, is a major public health concern, but there are concrete steps that people can take to prevent it from getting worse, and new antibiotics and vaccines may improve care in the future.

How to recognize gonorrhea

Around half of gonorrhea infections are asymptomatic and can only be detected through screening. Infected people without symptoms can unknowingly spread gonorrhea to others.

Typical early signs of symptomatic gonorrhea include a painful or burning sensation when peeing, vaginal or penal discharge, or anal itching, bleeding or discharge. Left untreated, gonorrhea can cause blindness and infertility. Antibiotic treatment can cure most cases of gonorrhea as long as the infection is susceptible to at least one antibiotic.

There is currently only one recommended treatment for gonorrhea in the U.S. – an antibiotic called ceftriaxone – because the bacteria have become resistant to other antibiotics that were formerly effective against it. Seven different families of antibiotics have been used to treat gonorrhea in the past, but many strains are now resistant to one or more of these drugs.

The CDC tracks the emergence and spread of drug-resistant gonorrhea strains.

Why gonorrhea is on the rise

A few factors have contributed to the increase in infections during the COVID-19 pandemic.

Early in the pandemic, most U.S. labs capable of testing for gonorrhea switched to testing for COVID-19. These labs have also been contending with the same shortages of staff and supplies that affect medical facilities across the country.

Many people have avoided clinics and hospitals during the pandemic, which has decreased opportunities to identify and treat gonorrhea infections before they spread. In fact, because of decreased screening over the past two and a half years, health care experts don’t know exactly how much antibiotic-resistant gonorrhea has spread.

Also, early in the pandemic, many doctors prescribed antibiotics to COVID-19 patients even though antibiotics do not work on viruses like SARS-CoV-2, the virus that causes COVID-19. Improper use of antibiotics can contribute to greater drug resistance, so it is reasonable to suspect that this has happened with gonorrhea.

Overuse of antibiotics

Even prior to the pandemic, resistance to antibiotic treatment for bacterial infections was a growing problem. In the U.S., antibiotic-resistant gonorrhea infections increased by over 70% from 2017-2019.

Neisseria gonorrhoeae is a specialist at picking up new genes from other pathogens and from “commensal,” or helpful, bacteria. These helpful bacteria can also become antibiotic-resistant, providing more opportunities for the gonorrhea bacterium to acquire resistant genes.

Strains resistant to ceftriaxone have been observed in other countries, including Japan, Thailand, Australia and the U.K., raising the possibility that some gonorrhea infections may soon be completely untreatable.

Steps toward prevention

Currently, changes in behavior are among the best ways to limit overall gonorrhea infections – particularly safer sexual behavior and condom use.

However, additional efforts are needed to delay or prevent an era of untreatable gonorrhea.

Scientists can create new antibiotics that are effective against resistant strains; however, decreased investment in this research and development over the past 30 years has slowed the introduction of new antibiotics to a trickle. No new drugs to treat gonorrhea have been introduced since 2019, although two are in the final stage of clinical trials.

Vaccination against gonorrhea isn’t possible presently, but it could be in the future. Vaccines effective against the meningitis bacterium, a close relative of gonorrhea, can sometimes also provide protection against gonorrhea. This suggests that a gonorrhea vaccine should be achievable.

The World Health Organization has begun an initiative to reduce gonorrhea worldwide by 90% before 2030. This initiative aims to promote safe sexual practices, increase access to high-quality health care for sexually transmitted diseases and expand testing so that asymptomatic infections can be treated before they spread. The initiative is also advocating for increased research into vaccines and new antibiotics to treat gonorrhea.

Setbacks in fighting drug-resistant gonorrhea during the COVID-19 pandemic make these actions even more urgent.

Kenneth Keiler receives funding from NIH.

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Measuring the Ampleness of Reserves

Over the past fifteen years, reserves in the banking system have grown from tens of billions of dollars to several trillion dollars. This extraordinary…

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Over the past fifteen years, reserves in the banking system have grown from tens of billions of dollars to several trillion dollars. This extraordinary rise poses a natural question: Are the rates paid in the market for reserves still sensitive to changes in the quantity of reserves when aggregate reserve holdings are so large? In today’s post, we answer this question by estimating the slope of the reserve demand curve from 2010 to 2022, when reserves ranged from $1 trillion to $4 trillion.

What Are Reserves? And Why Do They Matter?

Banks hold accounts at the Federal Reserve where they keep cash balances called “reserves.” Reserves meet banks’ various needs, including making payments to other financial institutions and meeting regulatory requirements. Over the past fifteen years, reserves have grown enormously, from tens of billions of dollars in 2007 to $3 trillion today. The chart below shows the evolution of reserves in the U.S. banking system as a share of banks’ total assets from January 2010 through September 2022. The supply of reserves depends importantly on the actions of the Federal Reserve, which can increase or decrease the quantity of reserves by changing its securities holdings, as it did in response to the global financial crisis and the COVID-19 crisis.

Reserves Have Ranged from 8 to 19 Percent of Bank Assets from 2010 to 2022

Sources: Federal Reserve Bank of New York; Federal Reserve Economic Data, FRED (“TLAACBW027SBOG”); authors’ calculations.

Why does the quantity of reserves matter? Because the “price” at which banks trade their reserve balances, which in turn depends importantly on the total amount of reserves in the system, is the federal funds rate, which is the interest rate targeted by the Federal Open Market Committee (FOMC) in the implementation of monetary policy. In 2022, the FOMC stated that “over time, the Committee intends to maintain securities holdings in amounts needed to implement monetary policy efficiently and effectively in its ample reserves regime.” In this ample reserves regime, the Federal Reserve controls short-term interest rates mainly through the setting of administered rates, rather than by adjusting the supply of reserves each day as it did prior to 2008 (as discussed in this post). In today’s post, we describe a method to measure the sensitivity of interest rates to changes in the quantity of reserves that can serve as a useful indicator of whether the level of reserves is ample.

The Demand for Reserves Informs Us about Rate Sensitivity to Reserve Shocks

To assess whether the level of reserves is ample, one needs to first understand the demand for reserves. Banks borrow and lend in the market for reserves, typically overnight. The reserve demand curve describes the price at which these institutions are willing to trade their balances as a function of aggregate reserves. Its slope measures the price sensitivity to changes in the level of reserves. Importantly, banks earn interest on their reserve balances (IORB), set by the Federal Reserve. Because the IORB rate directly affects the willingness of banks to lend reserves, it is useful to describe the reserve demand curve in terms of the spread between the federal funds rate and the IORB rate. In addition, we control for the overall growth of the U.S. banking sector by specifying reserve demand in terms of the level of reserves relative to commercial banks’ assets.

There is a clear nonlinear downward-sloping relationship between prices and quantities of reserves, consistent with economic theory. The chart below plots the spread between the federal funds rate and the IORB against total reserves as a share of commercial banks’ total assets.  When reserves are very low, the demand curve has a steep negative slope, reflecting the willingness of borrowers to pay high rates because reserves are scarce. At the other extreme, when reserves are very high, the curve becomes flat because banks are awash with reserves and the supply is abundant. Between these two regions, an intermediate regime–that we refer to as “ample”–emerges, where the demand curve exhibits a modest downward slope. The color coding of the chart reflects the shifts in the reserve demand curve over time. In particular, the curve appears to have moved to the right and upward around 2015 and then moved upward after March 2020, at the onset of the COVID pandemic.

Reserve Demand Has Shifted over Time

Sources: Federal Reserve Bank of New York; Federal Reserve Economic Data, FRED (“TLAACBW027SBOG,” “IOER,” and “IORB”); authors’ calculations.

This chart highlights two of the main challenges in estimating the slope of the reserve demand curve. First, the curve is highly nonlinear, which means that a standard linear estimation approach is not appropriate. Second, various long-lasting changes in the regulation and supervision of banks, in their internal risk-management frameworks, and in the structure of the reserve market itself have resulted in shifts in the reserve demand curve. A third challenge is that the quantity of reserves may be endogenous to banks’ demand for them. Therefore, to properly measure the reserve demand curve, one must disentangle shocks to supply from those to demand. As we explain in detail in a recent paper, our estimation strategy addresses all three of these challenges.

Estimating the Slope of the Reserve Demand Curve

Our approach provides time-varying estimates of the price sensitivity of the demand for reserves that can be used to distinguish between periods in which reserves are relatively scarce, ample, or abundant. The chart below presents our daily estimates of the slope of the demand curve, as measured by the rate sensitivity to changes in reserves. Although we do not have a precise criterion for when reserves are scarce versus ample, during two episodes in our sample, the estimated rate sensitivity is well away from zero. The first episode occurs early in our sample, in 2010, and the second emerges almost ten years later, in mid-2019. In two other periods—during 2013-2017 and from mid-2020 through early September 2022—the estimated slope is very close to zero, indicating an abundance of reserves. The remaining periods are characterized by a modest negative slope of the reserve demand curve, consistent with ample (but short of abundant) reserves. The overall pattern of these estimates is robust to changes in the model specification, such as including spillovers from the repo and Treasury markets or measuring reserves as a share of gross domestic product or bank deposits (instead of as a share of banks’ assets).

Rate Sensitivity Changed over Time, Following the Path of Reserves

Sources: Federal Reserve Bank of New York; Federal Reserve Economic Data, FRED (“TLAACBW027SBOG,” “IOER,” and “IORB”); authors’ calculations.

Interest Rate Spreads Alone Are Not Reliable Indicators of Reserve Scarcity

As we discuss in our paper, the time variation in the estimated price sensitivity in the demand for reserves is based on observations of small movements along the demand curve due to exogenous supply shocks. The location of the curve itself, however, also changes over time. That is, there is not a constant relationship between the level of reserves and the slope of the reserve demand curve.  

In our paper, we find evidence of both horizontal and vertical shifts in the reserve demand curve, with vertical upward shifts being particularly important since 2015. This finding implies that the level of the federal funds-IORB spread may not be a reliable summary statistic for the sensitivity of interest rates to reserve shocks, and that estimates of the price sensitivity in the demand for reserves provide additional useful information.

In summary, we have developed a method to estimate the time-varying interest rate sensitivity of the demand for reserves that accounts for the nonlinear nature of reserve demand and allows for structural shifts over time. A key advantage of our methodology is that it provides a flexible and readily implementable approach that can be used to monitor the market for reserves in real time, allowing one to assess the “ampleness” of the reserve supply as market conditions evolve.

Gara Afonso is the head of Banking Studies in the Federal Reserve Bank of New York’s Research and Statistics Group.

Gabriele La Spada is a financial research economist in Money and Payments Studies in the Federal Reserve Bank of New York’s Research and Statistics Group.   

John C. Williams is the president and chief executive officer of the Federal Reserve Bank of New York.  

How to cite this post:
Gara Afonso, Gabriele La Spada, and John C. Williams, “Measuring the Ampleness of Reserves,” Federal Reserve Bank of New York Liberty Street Economics, October 5, 2022, https://libertystreeteconomics.newyorkfed.org/2022/10/measuring-the-ampleness-of-reserves/.


Disclaimer
The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).

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