Diversification, original sin, and international bond portfolios

This paper has two main goals: to analyze country allocations in international bond portfolios and to describe the development of bond markets around the world. In the primary analysis, we find that country weights in U.S. investors' foreign bond portfolios are determined by the openness of capital accounts and potential diversification benefits. Positions in local-currency-denominated bonds are particularly sensitive to past and prospective volatility of returns. Analysis of reallocations in bond portfolios from 1997 to 2001 reveals a flight to quality from countries with low and declining credit ratings; reallocations in U.S. investors' equity portfolios also reveal a discriminating flight from higher credit risks. In the secondary analysis, we present measures of the size and currency composition of bond markets and analyze the development of local currency bond markets. We find that while country size and the level of economic development influence the level of bond market development, past policies---as evidenced in the level and volatility of historical inflation---play an important role. An implication for developing countries is that creditor friendly policies, such as vigilance on the inflation front, can enable local bond market development and in turn attract global investors, in part by promoting the development of derivative instruments that allow the decoupling of bond and currency investments.