Differential Treatment in the Bond Market: Sovereign Risk and Mutual Fund Portfolios

47 Pages Posted: 22 Oct 2019 Last revised: 29 Apr 2020

See all articles by Nathan Converse

Nathan Converse

Board of Governors of the Federal Reserve System

Enrico Mallucci

Board of Governors of the Federal Reserve System

Date Written: 2019-10-18

Abstract

How does sovereign risk affect investors' behavior? We answer this question using a novel database that combines sovereign default probabilities for 27 developed and emerging markets with monthly data on the portfolios of individual bond mutual funds. We first show that changes in yields do not fully compensate investors for additional sovereign risk, so that bond funds reduce their exposure to a country's assets when its sovereign default risk increases. However, the magnitude of the response varies widely across countries. Fund managers aggressively reduce their exposure to high-debt countries and high-risk countries. By contrast, they are more lenient toward core developed markets. In this sense, these economies appear to receive preferential treatment. Second, we document what determines the destination of reallocation ows. When fund managers reduce their exposure to a country in response to its sovereign risk, they shift their assets to countries outside the immediate geographic region while at the same time avoiding countries with high debt-to-GDP ratios and markets to which they are already heavily exposed. These results are supportive of models of sovereign default that assign a nontrivial role to the preferences of international creditors.

Keywords: Sovereign risk, Mutual funds, International capital flows, Spillovers

JEL Classification: F3, F32, F36, G1, G11, G15, G2, G23

Suggested Citation

Converse, Nathan and Mallucci, Enrico, Differential Treatment in the Bond Market: Sovereign Risk and Mutual Fund Portfolios (2019-10-18). FRB International Finance Discussion Paper No. 1261, Available at SSRN: https://ssrn.com/abstract=3473071 or http://dx.doi.org/10.17016/IFDP.2019.1261

Nathan Converse (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Enrico Mallucci

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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