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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.

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