12 August 2025
Investors who sell off sovereign bonds in times of stress are commonly referred to as “vigilantes” as they punish governments for what they consider to be bad policy choices. This post finds that investment funds account for most net sales of sovereign bonds in such times.
Financial markets are sensitive to macroeconomic and political news, especially given the high debt levels in several euro area countries. On sovereign bond markets, investment funds – which invest the money of households, companies and others – have become key players. In some euro area countries, they hold as much as a quarter of outstanding government debt. So, when investment funds adjust their portfolios, they can have an impact on bond markets and, in turn, on the ability of governments to finance their budgets. That is why they are often referred to as “vigilantes” who discipline governments for what they consider to be unsustainable policy and enforce change.
Despite their large footprint in sovereign debt markets, it is not always clear what role investment funds play in generating market volatility and how they interact with other groups of investors in times of stress.
In this blog post, we summarise our recent research (Anaya Longaric et al., 2025), in which we dig deeper into the idea that investment funds are “vigilantes” and examine how they respond to stress in euro area sovereign bond markets. Specifically, we examine how investment funds adjust their holdings of euro area sovereign debt in comparison with other domestic and international investor groups, including banks, insurance companies and households. We find that investment funds do act as “vigilantes” as they account for most net sales of sovereign bonds in times of stress, while domestic households and insurance companies buy the bonds they sell.
Euro area sovereign stress episodes
We identify episodes of stress in euro area sovereign bond markets using credit default swaps (CDSs) – financial instruments that are like a kind of insurance for an investor. For a fee, the seller of the CDS commits to covering the investor’s loss if their investment defaults. The price the investor pays to insure against the default of a debtor in this way is called the CDS premium.
As a first step, we use these CDS premia to identify episodes of euro area sovereign stress. We look at spikes in CDS premia of euro area governments that are particularly vulnerable and thus under pressure from financial markets. The largest spikes happen after unexpected political events, such as elections, resignations or disagreements between national governments and international institutions. Following such events, macro-financial conditions deteriorate, market volatility and policy uncertainty increase, and the euro depreciates.
Investment funds sell debt during sovereign stress
We then look at how different market participants adjust their portfolios after euro sovereign stress episodes.[1] And it is investment funds that stand out. While they don’t adjust their holdings of sovereign debt of less risky countries with low and stable risk premia, they do act as “vigilantes” and persistently sell off the debt of countries that are under market pressure.[2] When we examine the drivers of this behaviour more closely, we find that investment funds sell the debt of countries under market pressure for two reasons. First, sovereign stress triggers large investor outflows from investment funds. If these outflows exceed the funds’ cash buffers, fund managers need to sell bonds to pay out their investors. Second, fund managers want to reduce the weight of these countries in their portfolios to reduce the risk of their investments. This means funds sell bonds whose default risk has increased and keep those they consider to be safer. So, in fact, both fund managers and their investors act as “vigilantes” on sovereign bond markets. Fund investors withdrawing their money triggers bond sales, but fund managers decide how portfolios are reshuffled – including how much of each country’s debt is sold.
Who sells the most debt?
Investment funds are not all the same. They differ in terms of size, investors and location. And we find that some funds are more sensitive to sovereign stress than others. For example, funds whose managers or investors are less familiar with euro sovereign debt markets are more sensitive. Funds located outside the euro area face larger withdrawals and sell more debt, potentially because they have a higher share of international investors. As international investors may not be as well informed about euro sovereign debt markets and may see the euro as a risky foreign currency, they react more strongly to bad news and rising uncertainty.
Investment funds are the only sector selling debt
How do investment funds differ from other market players? We find that only investment funds sell (in net terms) the debt of countries that are being closely watched by markets (Chart 1). Banks tend to buy the debt in the short term, and households and insurance companies buy it in the medium term. Domestic investors drive this behaviour, as they buy the sovereign debt of the country where they are based. So, while banks, households and insurance companies move against the cycle, investment funds play a distinctly procyclical role in sovereign debt markets in times of stress.
Implications for fiscal and monetary policy
Our analysis is relevant for important policy issues. As investment funds are key players on euro area sovereign debt markets, governments need to be aware that investor appetite can quickly decline on the back of adverse fiscal news. Investment funds can therefore impose market discipline by selling – or threatening to sell – large amounts of debt and, in doing so, act as “bond vigilantes”. However, their behaviour can also trigger excessive market volatility that could require policy intervention. The investment fund sector therefore needs to be monitored particularly carefully to detect any unwarranted fragmentation in sovereign debt markets at an early stage (Lane, 2020). In the event that such fragmentation severely impairs the smooth transmission of monetary policy, the ECB has multiple instruments in its toolkit, including the Transmission Protection Instrument.
Chart 1
When stress events occur, investment funds withdraw from euro sovereign debt markets, while domestic investors step in
Impulse responses to sovereign stress shocks of holdings of sovereign debt from countries closely watched by markets, by investor type and holder area
a) Immediate response within the first quarter | b) Average response within the first year |
(EUR billions)
| (EUR billions)
|
Sources: ECB Securities Holdings Statistics and authors’ calculations.
Notes: The chart shows the effects across investors of a euro sovereign stress shock of 1 standard deviation on holdings of sovereign debt from countries vulnerable to being closely watched by financial markets, 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. The estimates are obtained from security-level panel local-projection regressions run separately for each holder sector. 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 for rest of the world (non-euro area), consisting predominantly of internationally domiciled investment funds.
The views expressed in each blog entry are those of the author(s) and do not necessarily represent the views of the European Central Bank and the Eurosystem.
Check out The ECB Blog and subscribe for future posts.
For topics relating to banking supervision, why not have a look at The Supervision Blog?
For our analysis we use two datasets with detailed information on which investors hold which sovereign bonds: We use investment fund data from LSEG and the administrative Eurosystem Securities Holdings Statistics by Sector.
The vulnerability of some countries to sovereign stress has changed significantly over time. Given the long-term perspective that we take in our analysis, we categorise the following countries as vulnerable to being closely watched by markets: Ireland, Greece, Spain, Italy, Cyprus, Portugal, Slovenia and Slovakia.