Original sin redux: role of duration risk

(revised January 2024)

Summary

Focus

Emerging market economies (EMEs) have been able to tap global capital markets by issuing government bonds in domestic currency. The "low-for-long" period of monetary policy globally has encouraged the issuance of longer-maturity bonds. The paper shows the mutually reinforcing nature of currency risk and duration risk. The disruptive impact of tightening global financial conditions is much larger when the EME government bonds have long maturities.

Contribution

The study makes use of a detailed and comprehensive data set of US investors' holdings of EME sovereign bonds. It examines the sensitivity of each investor sector's holdings to shifting financial conditions as proxied by the fluctuations in the broad dollar index. The "low-for-long" period of accommodative monetary policy has been accompanied by the lengthening of the maturity of bond issuance and outstanding stocks. While longer-maturity borrowing provides resilience against rollover risk, it increases duration risk for the investor, leading to portfolio outflows and associated tightening of financial conditions in the borrowing country.

Findings

The mutual fund sector has the largest holdings, and accounts for the bulk of the aggregate fluctuations in portfolio flows into EME government bonds. The key finding is that mutual funds holding relatively longer-maturity bonds account for the lion's share of the fluctuations in portfolio flows. There is also a strong mutually reinforcing effect between currency risk and duration risk. Portfolio outflows tend to coincide with an appreciation of the broad dollar index, and the effect is much greater for longer-maturity bonds. 

Abstract

We highlight the role of duration and exchange rate risks on portfolio flows by using a unique and comprehensive database of US investor flows into emerging market government bonds denominated in local currency. Borrowing long-term mitigates roll-over risk but amplifies valuation changes that further interact with currency movements. Our analysis highlights the double-edged nature of long-term borrowing and draws attention to market stress dynamics from the nonbank financial sector.

JEL classification:  F65, G23, H63

Keywords: portfolio flows, local currency bonds, non-bank financial intermediaries