Impact of Domestic Investor Protection on Foreign Investment Decisions: Evidence from Bond Markets

• DOI: http://doi.org/10.1002/ijfe.1554
• Published date: 01 October 2016
• Date: 01 October 2016
• Author: Elina Pradkhan

IMPACT OF DOMESTIC INVESTOR PROTECTION ON FOREIGN

INVESTMENT DECISIONS: EVIDENCE FROM BOND MARKETS

ELINA PRADKHAN*

,†

Institute of Finance, Humboldt University of Berlin, Berlin, Germany

ABSTRACT

This study explores the relationship between domestic creditor protection and foreign investment decisions in bond markets. It

also investigates how the difference between domestic and foreign creditor protections affects the foreign investment. The

impact of domestic creditor protection on cross-border investment in bonds is twofold. A high level of domestic creditor

protection increases international diversification. At the same time, an efficient protection of creditor rights at home reduces

the sensitivity of foreign investment to foreign creditor protection. These results hold most strongly for investing countries with

high levels of domestic creditor protection. In addition, this study shows that the difference between domestic and foreign

creditor protections matters for investment decisions: if domestic creditor protection is more efficient than foreign creditor

protection, the sensitivity of foreign investment to foreign (domestic) creditor protection decreases (increases). Copyright ©

2016 John Wiley & Sons, Ltd.

Received 02 February 2015; Revised 21 March 2016; Accepted 12 April 2016

JEL CODE: G02; G11; G15; G30

KEY WORDS: bonds; creditor protection; home bias; international diversification

1. INTRODUCTION

Under the assumption of perfectly efficient capital markets, all investors should hold the same value-weighted

portfolio where the weight of each asset corresponds to its weight in the world market portfolio, independently

of the nationality and relative risk aversion of individual investors (Sercu, 1980). However, if diversification costs

exceed diversification benefits, home bias arises: investors assign disproportionately high shares of their portfolios

to domestic assets and underweight foreign assets (Lewis, 1999). Existing literature distinguishes two aspects of the

home bias phenomenon: the domestic bias (overinvestment in domestic bonds) and the foreign bias (bilateral

overinvestment or underinvestment in bonds issued in different destination countries). Inefficient protection of

investor rights may become an important barrier to foreign investment if the level of investor protection is not fully

incorporated in asset prices.

1

Whereas the existing studies on foreign bond bias explore the importance of investor protection in destination

countries (Fidora et al., 2007; Ferreira and Miguel, 2011; Giofré, 2013), the focus of this study is the way in which

domestic creditor protection impacts foreign investment decisions in debt markets. This paper is closely linked to

the evidence of Giofré (2014a) who shows that domestic corporate governance exerts a twofold effect on cross-

border investment in equity markets. A high level of domestic investor protection does not only directly increase

the bilateral equity investment but also indirectly impacts the foreign equity bias in the sense that a high

shareholder protection at home reduces the investors’responsiveness to the shareholder protection in destination

countries (Giofré, 2014a).

*Correspondence to: Elina Pradkhan, Institute of Finance, Humboldt University of Berlin, Berlin, Germany.

†

E-mail: elina.pradkhan@hu-berlin.de

Copyright © 2016 John Wiley & Sons, Ltd.

International Journal of Finance & Economics

Int. J. Fin. Econ. 21: 417–446 (2016)

Published online 26 May 2016 in Wiley Online Library

(wileyonlinelibrary.com). DOI: 10.1002/ijfe.1554

The interaction effects between domestic and foreign investor protections have received comparatively little

attention in the existing research. The ‘good country bias’theory of Giannetti and Koskinen (2010) implies that

portfolio investors from countries with weak shareholder protection invest more in foreign stocks than portfolio

investors from countries with a more efficient protection of their rights. The ‘comparative corporate governance’

theory of Giofré (2014b) is based on the assumption that the driver of cross-border investment decisions in equity

markets is the foreign relative to the domestic investor protection.

The results for equity markets cannot trivially be extended to bond markets. Information costs faced by foreign

investors are closely related to investor protection and legal environment (Gehrig, 1993; Leuz et al., 2009). Given

that information asymmetries are less relevant for the payoff of a fixed claim compared with a residual claim,

2

domestic investor protection may not impact the cross-border investment in bonds in the same way as the cross-

border investment in equities.

3

This study makes two contributions to the existing literature. First, it examines whether the twofold effect of

domestic investor protection, as documented by Giofré (2014a) for equity markets, is an asset-invariant

phenomenon, that is, whether it also holds in bond markets. Second, this study investigates how the difference

between domestic and foreign creditor protections affects the foreign investment’s sensitivity to domestic and

foreign creditor protection levels. In this respect, it is an extension of the ‘good corporate governance theory’of

Giannetti and Koskinen (2010) and the ‘comparative corporate governance theory’of Giofré (2014b) that focus

only on the direct effect of the difference between domestic and foreign investor protections on foreign investment.

An analysis of cross-border debt holdings of 36 countries over the 2004–2012 period reveals that the twofold

effect of domestic investor protection that has been documented for equity markets seems to hold in bond markets

as well. A high level of domestic creditor protection increases foreign investment, but decreases the foreign

investment’s sensitivity to the creditor protection in destination countries. These results are valid not only for

traditional measures for the protection of the secured creditors’rights by collateral and bankruptcy laws, but also

with regard to the quality of legal environment, in particular the efficiency and impartiality of the judicial system.

However, this study also documents important differences between investing countries with creditor protections

above and below the world average. The twofold effect of domestic creditor protection on international

diversification manifests itself for the total sample and for investors from countries with relatively high levels of

creditor protection. By contrast, the results are different for investors from countries with creditor protection below

the world average. In this case, a high level of domestic creditor protection is associated with a lower level of the

foreign bond bias, that is, investors from countries where their rights are well protected are less likely to diversify

their portfolios abroad, and the investors’sensitivity to the foreign creditor protection is not significantly affected

by the level of creditor protection at home.

With respect to the ‘good country bias’and ‘comparative corporate governance’theories, the empirical evidence

finds little support for these concepts in the context of the cross-border investment decisions in bond markets.

However, this study shows that the difference between domestic and foreign creditor protections affects the foreign

investment indirectly via the sensitivity of foreign investment to creditor protections in home and host countries. A

higher domestic creditor protection relative to the creditor protection in the destination country reduces (increases)

the sensitivity of foreign investment to foreign (domestic) creditor protection. This evidence strengthens the

importance of domestic creditor protection in the foreign debt portfolio choices. It appears to be more than a simple

benchmark against which the protection of creditor rights abroad is evaluated.

This paper is structured as follows. Section 2 briefly summarizes the existing literature on home bias and creditor pro-

tection. In Section 3, data and methodology are outlined. Section 4 presents the empirical results. Section 5 concludes.

2. RELATED LITERATURE

The importance of investor protection for portfolio allocation decisions has attracted considerable attention in the

empirical and theoretical research. Several studies confirm both empirically and theoretically the importance of

corporate governance of the home (host) country as an explanation of domestic (foreign) bias in equity markets

(e.g. Dahlquist et al., 2003; Giannetti and Simonov, 2006;). In equity markets, two types of investors are distinguished:

portfolio investors whose returns from the share ownership consist solely of dividends and capital gains/losses and

ELINA PRADKHAN418

Copyright © 2016 John Wiley & Sons, Ltd. Int. J. Fin. Econ. 21: 417–446 (2016)

DOI: 10.1002/ijfe