When Investors Care About Currencies: A New Twist on Exchange Rates and Sovereign Bonds

When the euro gets stronger, European investors tend to sell government bonds from emerging countries if those bonds are in the local currencies of those countries. They do this because a stronger euro means those investments are now worth less to them, even if countries themselves aren’t riskier.

💡 Key Idea

Currency mismatches on the investor's balance sheet, not just the borrower's, explain bond flows. Exchange rate movements—especially the broad dollar index and the broad euro index—impact portfolio reallocation even when credit risk remains unchanged.

📚 Economic Rationale

The paper builds on the financial channel of exchange rates: currency fluctuations affect risk appetite and constraints. But it shifts focus from borrowers' debt burden to investors' mark-to-market exposure, especially when bonds are held unhedged.

🛠️ Practical Applications

Monitor reference currency exposure (e.g., euro for euro-based investors).
Build currency-aware bond strategies: underweight local currency EM bonds when your reference currency strengthens.
Factor in global financial conditions (BDI) when allocating to EM bonds.

⚙️ How to Do It

Data

Euro area investors’ holdings from SHS-S (ECB).
Bond characteristics from CSDB.
Exchange rates: BIS, ECB, Federal Reserve.
Control variables: VIX, credit ratings, macro fundamentals.

Model/Methodology

Multi-level panel regressions (aggregate, country, security).
Tracks holdings of local vs foreign currency bonds.
Value-at-Risk (VaR) portfolio model with reference currency and exchange rate shocks.

Strategy (Implied)

Avoid local currency EM bonds if your home currency (e.g., EUR) appreciates.
Watch the dollar index (BDI) as a global tightening signal—reduce EM bond exposure broadly.
For long-only portfolios, rotate into foreign currency bonds of same issuers during local currency depreciation.

📊 Table or Figure

[Figure 2] – Financial channel of exchange rates
Illustrates how different exchange rates affect investor behavior depending on bond currency and reference currency. Confirms that investors shed local currency bonds when their own currency strengthens.

📝 Paper Details

Title: Which Exchange Rate Matters to Global Investors?
Authors: Kristy A.E. Jansen, Hyun Song Shin, Goetz von Peter
Date: March 2024
Source: BIS, De Nederlandsche Bank, Marshall School of Business
Link: SSRN 4771424

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