By Matt Grossman

Elevated asset valuations and the role of leverage in the financial sector are among the financial-stability risks the Federal Reserve is tracking most closely, according to the central bank's latest financial-stability report.

Staffers at the Fed's board in Washington, D.C. note that equity prices are hovering near the high end of historical valuation levels, with equity risk premiums hovering near lows. That is a sign investors may not be receiving solid compensation for holding risky investments.

Another risk on the Fed's radar: financial-sector leverage, including at hedge funds that are key buyers of U.S. government debt. In recent years, concerns have mounted that because many hedge funds finance their holdings with debt of their own, any downturn in the U.S. Treasury market may quickly spiral into a worsening crisis if funds are forced to sell their holdings in order to cover what they owe.

Over the past few years, the financial sector has faced down a handful of vulnerabilities to its stability while dodging serious crises.

A string of regional-bank failures in 2023 posed one of the most direct threats to trust in the banking system since the financial crisis that began 15 years earlier. Last fall, volatility in overnight lending markets--critical plumbing at the heart of the financial system--spurred concerns that funding pressures might spread broadly through the bond and stock markets.

Neither of those episodes, however, grew into the type of self-feeding crisis that can impact investors across the board.

More recently, many investors' concerns have centered around private credit, a fast-growing corner of the lending world that has increasingly displaced traditional banking. In its report, the Fed acknowledged that "since the middle of last year, investor sentiment turned increasingly negative following some high-profile corporate defaults."

In particular, investors have been wary that private-credit funds are facing a mini-wave of redemption requests that could mark the start of a sectoral downturn. The Fed's researchers noted that because more private-credit investment vehicles are designed to meter redemption requests, "risks to financial stability ... appear limited and manageable."

The report noted that "continued redemptions and negative sentiment could lead to a reduction in credit availability for some borrowers."

Write to Matt Grossman at matt.grossman@wsj.com

(END) Dow Jones Newswires

05-08-26 1639ET