Differential treatment in the bond market: Sovereign risk and mutual fund portfolios

How do international investors adjust their portfolios in response to sovereign risk? We answer this question by combining data on default probabilities for 31 developed and emerging markets with monthly data on the portfolios of individual bond mutual funds. We show that bond funds reduce their exposure to a country when sovereign default risk increases, indicating that changes in yields do not fully compensate investors for additional sovereign risk. We find that the magnitude of the response is heterogeneous. Portfolio weights of high-risk countries are more sensitive to sovereign risk, while core developed markets appear to enjoy preferential treatment, with their portfolio weights little affected by sovereign risk. Fund characteristics, such as past performance, also affect sensitivity to sovereign risk. Finally, we document what determines the destination of reallocation flows. Funds shift their assets to countries outside the immediate geographic region while avoiding markets to which they are heavily exposed.