John D. Burger and Francis E. Warnock *

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Abstract:

We analyze the development of, and foreign participation in, 49 local bond markets. Countries with stable inflation rates and strong creditor rights have more developed local bond markets and rely less on foreign-currency-denominated bonds. Less developed bond markets have returns characterized by high variance and negative skewness, factors eschewed by U.S. investors. Results based on a three-moment CAPM indicate, however, that it is diversifiable idiosyncratic risk that U.S. investors appear to shun. Taken as a whole our results hint at a virtuous cycle of bond market development: Creditor friendly policies and laws can spark local bond market development that enables the development of derivatives markets and, in turn, attracts foreign participation.

Keywords: bond market development, home bias, emerging market debt, original sin

JEL Classification: F30, G11, G15, O16

* Burger is Assistant Professor at the Sellinger School of Business and Management at Loyola College of Maryland. Warnock is Economist in the International Finance Division of the Board of Governors of the Federal Reserve System and Adjunct Assistant Professor at the Walsh School of Foreign Service at Georgetown University. An earlier version of this paper was distributed as IFDP#755, «Diversification, Original Sin, and International Bond Portfolios.» The authors thank William Griever, Thomas Jans, and Denis Petre for invaluable assistance with data; JP Morgan for providing data on bond returns; and Jillian Faucette, Tamara Hayford, and Sara Holland for research assistance. We thank for helpful comments Morris Goldstein, Bill Helkie, Olivier Jeanne, Steve Kamin, Ross Levine, Ugo Panizza, Vincent Reinhart, Charles Thomas, Joachim Voth, Jon Wongswan, and seminar participants at CEPR/Gerzensee Conference on International Capital Flows, IF Monday Workshop, IMF Research Seminar, Loyola College, and University of North Carolina. All errors are our own. John Burger acknowledges support from the Sellinger School Junior Sabbatical Program. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System, or of any other person associated with the Federal Reserve System. Email addresses for the authors are jburger@loyola.edu and frank.warnock@frb.gov . Return to text

1 Introduction

A well-functioning domestic bond market provides an important means for firms and governments to borrow funds. Historically, the ability of a country to borrow internationally by selling bonds to foreign investors has enabled expansion (e.g. the funding of the Lousiana Purchase), economic development (railroads), and war (too numerous to cite). 1 In a world of asymmetric information, firms needing to raise cash look first to bonds [Myers (1984)], which, unlike equities, enable borrowing without relinquishing control rights. From an investor’s perspective, foreign bonds offer potential diversification benefits that have been documented by Levy and Lerman (1988), Jorion (1991), and Levich and Thomas (1993), among others. Indeed, according to U.S. capital flows data, cross-border flows in bonds greatly exceed those in equities; U.S. gross cross-border trading of bonds averaged $8.6 trillion annually in the 1990s, more than three times the trading in equities.

Despite the importance of bond markets, data limitations have hampered research. Unlike equities, information on bonds is not readily available across a wide range of countries, in part because bonds do not typically trade on standardized exchanges. Perhaps because of the relative paucity of bond market data, the literatures on financial development and international portfolio analysis have largely focused on equities with little analysis of the diversification opportunities offered by international bonds. A limited discussion of international bond returns and the home bias is provided by Bekaert and Harvey (2003), Karolyi and Stulz (2002), and Tesar and Werner (1995). 2

In this paper we aim to enhance our understanding of global bond markets, focusing on local-currency bonds throughout. We present data on the characteristics of the world bond market portfolio and analyze factors associated with local bond market development. We describe the returns characteristics of hedged and unhedged bonds and note important differences related to bond market development. We then investigate the ability of countries to attract foreign investment by analyzing the determinants of U.S. investors’ portfolios.

We begin, in Section 2, with a description and analysis of the world bond market. Compiling data from a number of sources, we present information on the size and currency composition of bond markets in 49 countries. We investigate the determinants of local-currency bond market development (the ratio of the size of the local bond market to GDP) and the local-currency share (the percentage of outstanding bonds issued in local currency). Our analysis reveals roles for both creditor-friendly policies and creditor-friendly laws. Countries with better historical inflation performance (an outcome of creditor-friendly policies) have more developed local bond markets and rely less on foreign-currency-denominated bonds. Creditor-friendly laws matter, too; strong rule of law is associated with deeper local bond markets, while countries with better creditor rights are able to issue a higher share of bonds in their local currency.

The analysis of local-currency bond market development is important for investors and policy makers alike. A country that relies heavily on foreign-currency bonds may suffer from a currency mismatch that could lead it on a downward spiral of self-fulfilling crises [Krugman (1999), Schneider and Tornell (2001), Aghion, Bacchetta and Banerjee (2001)]. Deeper local bond markets can also provide a redundancy of funding sources, something that may well ameliorate financial crises [Greenspan (1999)]. From the investor’s perspective, increased breadth of local bond markets provides enhanced opportunities for investors to diversify their bond portfolios. Further, after the recent string of currency crises, investors are likely to keep a close eye on the share of a nation’s debt that is denominated in the local currency.

While the bond market analysis in Section 2 provides insights into a country’s ability to issue local-currency-denominated debt, it does not address whether these local-currency bonds will be attractive to international investors. We do not have data on all foreigners’ investment in local bond markets, but rely instead on high quality data on the international bond positions of one of the largest groups of international bond investors, U.S. investors. We first illustrate in Section 3, from the perspective of a U.S.-based investor, the historical risk and return characteristics of hedged and unhedged local-currency bonds. Returns on unhedged developed country bonds are very volatile because exchange rates are volatile, but they also provide an attractive skewness profile because bad outcomes in these bond markets tend to coincide with capital inflows and currency appreciation. In contrast, returns on emerging market bonds exhibit sizeable volatility and—because periods of poor emerging bond market performance coincide with capital outflows and not with currency appreciations—the most negative skewness. Classifying by the degree of bond market development yields a similar conclusion: Countries with less developed bond markets have returns that are more volatile and left-skewed.

We then, in Section 4, follow work by Kraus and Litzenberger (1976), Athayde and Flores (forthcoming) and Harvey, Liechty, Liechty, and Muller (2003) and sketch a model in which investors care about the mean, variance, and skewness of returns. The model predicts that if these characteristics are priced with respect to the U.S. investor, country weights in U.S. investors’ international bond portfolios should be a function of bond market capitalizations and direct barriers to international investment. To the contrary, we find evidence that U.S. investors avoid local-currency bonds that have returns with historically high variance and negative skewness. Decomposing these risks, we find that U.S. investors are avoiding diversifiable idiosyncratic risk, yet another indication of the home bias in portfolios.

We conclude by discussing the possibility of a virtuous cycle in local bond market development. Countries that pursue responsible policies (low, stable inflation and strong institutions) are better able to develop local-currency bond markets. Countries with these policies also have lower variance and more right-skewed bond returns, factors that should attract international investors. In addition, development of local bond markets will allow the creation of derivative markets, thus enabling international investors to hedge currency risk. The ability to hedge currency risk should increase foreign participation and, supporting this, we find some evidence that countries with more active derivatives markets attract a larger U.S. investor presence. If emerging economies are able to borrow internationally in their local currency, they can better avoid the pitfalls of a currency mismatch and thus further stabilize their macroeconomic performance.

2 The World Bond Market Portfolio

In this section we first present salient features of the world bond market portfolio and then analyze determinants of countries’ local-currency bond market development.

2.1 The Size and Geography of the World Bond Market

Unlike equity markets, about which information is readily available, comprehensive information on the size of the global bond market is not available from any one source. La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997, henceforth LLSV) present data on debt finance, but their measure is of private bank debt and nonfinancial bonds. In this section we present information on the size and currency composition of bond markets in 49 countries. 3

Our estimates of the size of each country’s bond market are derived primarily from unpublished data from the Bank for International Settlements (BIS). For international bonds (i.e. those in foreign currencies or placed abroad), we use the security-level data underlying BIS Quarterly Review Table 14B. To form the security-level international bonds database, the BIS combines information from Capital DATA (Bondware), Thomson Financial Securities Data (Platinum), and Euroclear; identifies and removes duplicates; corrects mistakes; ensures a consistent classification of issuers across the different sources; and performs general quality control. The BIS data on international bonds are likely the most comprehensive available, but they do not include information on Brady bonds, which we obtain from Merrill Lynch (2002). For domestic bonds. we rely again on unpublished data from the BIS. BIS Quarterly Review Table 16A publishes data on outstanding domestic debt securities, but combines both short- and long-term securities. In our study we focus on long-term debt securities—those with an original maturity of more than one year—and so utilize instead the unpublished long-term component of the domestic debt data.

The global bond market totaled $31.1 trillion in 2001 (Table 1). The bulk of outstanding bonds were issued by developed countries (93%), in particular the United States (46%), euro area (22%), and Japan (16%). Emerging market issuance comprised the other 7% of the global bond market, with issuance much greater in emerging Asia (3.8% of the global market) than in Latin America (1.7%). Developed country bond markets not only comprised a large portion of the global bond market, but they were also large relative to the size of their economies: Most developed countries have outstanding bonds that are about equal in magnitude to the size of annual GDP (third column). For example, the bonds-to-GDP ratio is 105% for Germany, 116% in Japan, and 141% in the United States. Emerging bond markets are much smaller, averaging just 39% of annual GDP.

In this paper we focus on local-currency bonds issued by residents of a particular country (for example, Chile) in that country’s currency (Chilean pesos), regardless of whether it was placed in the domestic market or offshore. Local-currency bond markets make up the bulk of the global bond market (right panel of Table 1), totaling $28.7 trillion, or 92% of all bonds; the other 8% of outstanding bonds were issued in foreign currencies, primarily the dollar, euro, and sterling.

2.2 The Determinants of Local Bond Market Development

Table 1 reveals quite a bit of variation in the size of local-currency bond markets. Variation is evident among developed countries; Denmark’s local bond market is 151% of its GDP, whereas Finland’s is only 48%. Variation is evident within regions; Chile’s local bond market is 52% of GDP, whereas Mexico’s is only 9%. And variation is not just a developing versus emerging market split; were Malaysia considered a developed country, its bond market would be at the median.

In this section we examine the determinants of two measures of local bond market development: the ratio of the size of the local bond market to GDP (Local Development) and the share of a country’s outstanding bonds that are denominated in the local currency (Local Share). Understanding the factors associated with the observed variation in local bond market development should be important to both policy makers and investors. Investors, whether they hold local-currency or foreign-currency bonds, should be wary of a country that relies heavily on foreign-currency bonds, as the resulting currency mismatch could lead it on a downward spiral of self-fulfilling crises. From a policy maker’s perspective, the determinants of local bond market development may provide a prescription for avoiding the financial fragility inherent in a currency mismatch. 4

In our regressions (Table 2), we follow LLSV (1997) and examine the influence of Rule of Law, Creditor Rights, country size (as measured by the log of GDP), and growth rates (annual GDP growth over the preceding ten years). 5 As argued in LLSV (1997), country size and growth might influence the breadth of markets. Creditor Rights measures whether the laws of a country are creditor friendly; we also include another variable, Inflation Variance (the variance of the inflation rate over the past ten years), as a measure of whether policies have been creditor friendly. Columns (1) and (2) present results from parsimonious regressions of all 49 countries in our study. Columns (2) and (3) include other variables that have less coverage and reduce the sample to 41 countries. 6

All regressions in Table 2 provide strong evidence that large countries and those with better inflation performance (the result, perhaps, of more stable monetary and fiscal policies) have larger local-currency bond markets and rely less on foreign currency bonds. 7 Countries with stronger institutions (high score on Rule of Law) have broader local-currency bond markets, and those with stronger Creditor Rights rely less on foreign currency bonds. Overall, our results are similar to LLSV (1997), who analyzed the extent of debt financing (bank debt and nonfinancial bonds), but we also highlight the importance of creditor friendly policies (i.e. stable inflation environment) and perhaps offer a more nuanced explanation of the roles of Rule of Law (which enable local bond market development) and Creditor Rights (which enables borrowing in the local currency and less reliance on foreign currency bonds). 8

Our results suggest that countries such as Australia (with a low score on creditor rights), Indonesia (poor inflation performance), or Peru (poor rule of law) might increase the breadth of their local-currency bond market and rely less on foreign currency borrowing if they address their deficient creditor laws and policies. They are also consistent with the model of Jeanne (2002), which shows an important role for monetary policy credibility in explaining the currency composition of a country’s debt. To gauge the importance of various factors, our results imply that (ceteris paribus) if Brazil had Denmark’s rule of law, its bond market as a share of GDP would be 40 percentage points higher. If Brazil had Denmark’s inflation history, its bond market would be 32 percentage points (of GDP) larger. These amounts are both economically significant—Brazil’s local-currency bond market is currently only 20 percent of GDP—and suggest an important role for creditor friendly policies in emerging markets. Finally, there may also be virtuous interactions between the development of the bond market and future inflation performance; for example, Eichengreen and Hausmann (1999) suggest that a well-developed domestic bond market may generate a political constituency opposed to inflationary policies.

3 Risk and Return Characteristics of International Bond Portfolios

Having described and analyzed the breadth of bond markets in a wide range of countries, we now analyze factors that attract foreign participation. We do not have data on all foreigners’ investment in bond markets, so we rely instead on data on the largest group of international investors in the world, U.S. investors. Before turning to the analysis of international portfolio allocations, in this section we present the (ex post) risk and return characteristics of international bond markets from the perspective of a U.S.-based investor.

Not knowing the extent to which international bond positions are hedged, we form two sets of returns. The first, Unhedged, is comprised of unhedged local-currency bonds for developed countries. For emerging markets, where local-currency bond indices are generally not available, Unhedged is the sum of currency returns and bond returns from the EMBI (which is composed of dollar-denominated bonds). Our second set of returns, Hedged, are comprised of hedged bonds for developed countries and returns on dollar-denominated bonds for emerging markets. 9

Table 3 presents statistics on the mean, variance, and skewness of hedged and unhedged historical returns. Three features of returns stand out. First, for developed country bonds, a comparison of hedged and unhedged returns indicates that hedged returns were much higher (7% per year vs. 0.7%) and much less volatile (0.017 vs. 0.140). The mean-variance dominance of hedged bonds is also illustrated in Figure 1, which depicts the risk-return profiles of hedged (dashed line) and unhedged (solid line) bond portfolios for the period from January 1994 to December 2001. 10 The higher return that hedged foreign bonds provided U.S. investors is clearly sample dependent; December 2001 coincided with the apex of the dollar’s six-year appreciation. But the fact that unhedged returns are much more volatile than hedged returns, on average by a factor of eight, is not sample dependent. From the perspective of a U.S.-based investor, unhedged returns are comprised of returns on the underlying bond and on the foreign currency; the latter component, foreign currency returns, is notoriously volatile. As pointed out in Levich (2001), a negative covariance between currency and bond returns—caused perhaps by tight monetary policy that results in bond losses but capital inflows that appreciate the currency—would reduce the variance of unhedged foreign currency positions somewhat, but the reduction is likely orders of magnitude smaller than the variance of currency returns.

Second, although hedged bonds dominated unhedged bonds in a mean-variance sense during this period, unhedged bonds provided a more attractive skewness profile. The unhedged returns of every developed country bond market (except for Sweden’s) exhibited positive skewness, while for most countries hedged returns were negatively skewed. A plausible explanation of this relationship is that in months when developed country bonds experience a large negative return, the currency appreciates and eliminates the infrequent bad outcome for a U.S.-based investor. The case of Japan, with the largest negative skewness among hedged returns for developed countries, is instructive. In December 1998, long-term interest rates in Japan surged following the announcement of various fiscal stimulus measures. U.S. investors holding a hedged portfolio of Japanese bonds experienced a substantial 5% loss during the month; hence, the negative skewness. But a simultaneous appreciation of the yen generated by capital inflows enabled U.S. investors holding unhedged Japanese bonds to earn a positive return in dollar terms. More generally, this relationship is evidence that we do not see `flight-from-quality’ in developed country capital markets. Bond returns might at times be negative, and sometimes severely so, but this does not tend to coincide with broad-based capital outflows and, hence, is not associated with currency depreciations.

The third regularity is that returns on emerging market bonds—indeed, less developed bond markets in general, regardless of the level of economic development—were much more volatile and exhibited significantly more negative skewness than developed country bonds. The average variance for emerging market bond returns was 0.8, nearly six times greater than the unhedged developed country bond returns, and the average skewness was negative (-0.95). Returns on dollar-denominated emerging market bonds (bottom right) were also very volatile and negatively skewed. Figure 2 shows that less developed bond markets are characterized by higher variance and more negative skewness, whether returns are assumed to be hedged or not. This highlights a distinct difference between emerging market and developed country bonds (or less developed and more developed bond markets): Periods of negative bond returns for emerging markets do not coincide with currency appreciations. To the contrary, periods of rising interest rates often occur during an episode of financial flight and currency depreciation—the makings of a currency crisis.

4 Foreign Participation in Local Bond Markets

In this section we analyze the extent and determinants of foreign participation in local bond markets. We first present the country allocation of U.S. investors’ international bond portfolios, and compare that allocation with the composition of the world bond market portfolio. This shows that U.S. investors severely underweight foreign bonds overall, and the bonds of some countries more than others. We then present a simplified mean-variance-skewness model that informs our regressions on deviations from world portfolio weights.

4.1 Comparison of U.S. Investors’ Foreign Bond Portfolio and the World Market Portfolio

Table 4 presents data on U.S. investors’ foreign bond portfolios. 11 The first column shows two facts that are not terribly surprising. Compared to their weight in the world bond market portfolio ( = 46.95%), local-currency bonds have only a very small weight in U.S. investors’ bond portfolios ( = 1.22%). And the vast majority ($150 billion) of U.S. holdings of local-currency foreign bonds was issued by developed countries, compared to only $3 billion of emerging market bonds.

The underweighting is best illustrated in the final column, which shows the ratio of weights in U.S. portfolios to weights in the world market portfolio. If allocations in U.S. investors’ bond portfolios were in line with the world bond market portfolio, this ratio would equal one, but it is much less than one for every country. The underweighting is severe in developed country’s bonds ( / = 0.029) and even more so in emerging markets ( / = 0.004). But there are exceptions. For example, the relative weight on South African bonds ( / = 0.029) is greater than the weight on many developed country bonds. In the next subsection, we analyze the variation in relative portfolio weights.

4.2 Historical Returns Characteristics, Capital Account Restrictions, and U.S. Participation

Table 4 establishes that U.S. investors’ foreign bond portfolios deviate substantially from the world market portfolio. In this section we sketch a simple model of portfolio allocation that encompasses two features of international bond markets—barriers to international investment and returns that exhibit higher moments—and use the model to inform cross-sectional regressions of the extent to which U.S. investors’ portfolio weights deviate from benchmark (market) weights.

We follow the work of Kraus and Litzenberger (1976), Athayde and Flores (forthcoming), and Harvey, Liechty, Liechty, and Muller (2003) and allow for the fact that asset returns exhibit higher moments and that investors with non-increasing absolute risk aversion should care about skewness, in particular, in addition to mean and variance. 12 Specifically, we assume that investors choose a vector of portfolio weights, . to maximize utility that is a function of (expected) returns . variance . and skewness :