Diversifying Credit Risk with International Corporate Bonds

This paper explores the potential for US investors to diversify credit risk exposure with international corporate bonds. Using a newly compiled dataset of firm-level monthly corporate bond quotes for foreign and domestic issues, I show that by adding foreign corporate bonds to a benchmark of US equity and bond portfolios, the investor achieves an economically significant reduction in portfolio risk particularly during periods of high volatility in the US markets such as the recent credit crisis. Further, in contrast to the observed US holdings in foreign bonds of 6%, the model implied portfolio holding in foreign corporate bonds should be 25% or more, which implies a potential bond home bias puzzle. Finally, I find that the potential diversification gains cannot be replicated by holding bond issues of foreign firm that trade in the US, known as Yankee bonds, and must be achieved through direct investment in the respective foreign corporate bond markets.