Cost of sovereign debt and foreign bias in bond allocations

Finance theory suggests that markets where foreign bond portfolio investors overweight their portfolio relative to the prescribed theoretical benchmark should experience higher international risk sharing. Correspondingly, the cost of debt in such markets should be lower compared to markets facing a lower degree of international risk sharing. We empirically examine this prediction using a panel data set of sovereign bond yield spreads and a measure of suboptimal foreign bond portfolio allocations for 50 emerging and ten developed markets. Consistent with theory, our results show higher levels of foreign bond allocations – relative to the theoretical benchmark – are negatively related to the cost of debt. These results have important policy implications as a country's cost of debt could potentially be lowered by encouraging foreign portfolio investors to hold their optimal allocation.