Diversifying Market and Default Risk in High Grade Sovereign Bond Portfolios

Abstract

We discuss the potential benefits of international diversification for high grade sovereign bond portfolios. First, we apply a CAPM-based model to the G-7 sovereign bonds and find that on average 75% to 80% of the bond returns are determined by global factors, whereas about 20-25% remains determined by local factors. Thus, while the sovereign bond market is integrated to a relatively high degree, still there is some room for diversification. The volatility reduction obtained by diversifying across the G-7 issuers in general has been shrinking over the past decade, but local factors gained more importance over the past two years for European issuers. Second, in light of recent turbulence within the Eurozone, we discuss diversification with a special focus on default risk. If an investor aims at enhancing expected return by going down on the credit rating spectrum, diversification may mitigate the impacts of default risk to some degree.