Cost of sovereign debt and foreign bias in bond allocations

Abstract

Finance theory suggests that markets where foreign bond portfolio investors overweight their portfolio relative to the prescribed theoretical benchmark should experience higher international risk sharing. Correspondingly, the cost of debt in such markets should be lower compared to markets facing a lower degree of international risk sharing. We empirically examine this prediction using a panel data set of sovereign bond yield spreads and a measure of suboptimal foreign bond portfolio allocations for 50 emerging and ten developed markets.Consistent with theory, our results show higher levels of foreign bond allocations -relative to the theoretical benchmark -are negatively related to the cost of debt. These results have important policy implications as a country's cost of debt could potentially be lowered by encouraging foreign portfolio investors to hold their optimal allocation. JEL Classification: E43, G12, G15

The impact of central bank transparency on debt home and foreign bias

“…Second, we contribute to the growing literature on the implications of central bank transparency (Borio and Lowe, 2002;Ma and Lin, 2016;Spiegel, 1998;Bodea and Hicks, 2015). Our study is closely related to Bhatta et al (2017) who examined the cost of sovereign debt and foreign bias in bond allocations.…”

“…Following the existing literature (see Bhatta et al 2017), we employ two variables to proxy for suboptimal international debt allocation; these are debt home bias (DHB) and debt foreign bias (DFB).…”

“…Following the existing literature (Dahlquist and Robertsson, 2001;Chan et al 2005;Lau et al 2010;Bhatta et al 2017) and using CPIS and BIS data we computed debt foreign bias (DFB) using Equation (4). Debt foreign bias captures the extent to which domestic investors underweight or overweight foreign bond markets in their bond holdings.…”

“…In the spirit of existing literature (Dahlquist and Robertsson, 2001;Chan et al 2005;Lau et al 2010;Bhatta et al 2017), this study defines debt home bias (DHB) as the deviation between the proportion of the total debt portfolio weight invested in the domestic bond market and the relative weight of the domestic bond market in the global bond market portfolio. Debt home bias for a certain origin country𝑙 (𝐷𝐻𝐵 ) for the period of 𝑡 is the extent to which country𝑙 's bond holdings in the domestic market deviate from country 𝑙's holdings in respect to the world market portfolio as the ICAPM benchmark.…”

The Structure and Degree of Dependence in Government Bond Markets

“…Correct estimation of dependence is particularly essential for a proper understanding of the functioning and performance of government bond markets, which are often assumed to be risk-free in nominal terms for local investors. International investors, however, are facing the risk of a sovereign (selectively) defaulting on its debt or exchange rate risk involved with holding foreign assets (Arellano and Ramanarayanan, 2012;Bhatta et al, 2017;Lustig and Verdelhan, 2019). Understanding better how these financial market risks vary in periods with and without stress is of crucial importance to investors constructing a diversified government bond portfolio.…”