Diversification, Original Sin, and International Bond Portfolios

Abstract

While there is a severe home bias in U.S. investors' foreign bond portfolios, we find that portfolio weights are greater for countries with more open capital accounts and whose bond returns are less correlated with U.S. returns. Positions in local-currency-denominated bonds are particularly sensitive to past and prospective returns volatility. An analysis of changes in portfolio weights over time indicates that U.S. investors have recently moved out of smaller markets and those with low and declining credit ratings. Our data also allow for an analysis of the size and currency composition of international bond markets. We find that countries with stronger institutions and better inflation performance have larger local currency bond markets. An implication for developing countries is that creditor friendly policies, such as vigilance on the inflation front and the development of strong institutions, can enable local bond market development and may in turn attract global investors.