While both strategies yield portfolios that have the same sensitivity to parallel shifts of the credit curve, they usually yield very different returns in real world scenarios. Not only will capital gains differ when the credit curve moves in a nonparallel way, but returns from carry differ also when the yield pickup from extending duration is not equal to the yield pickup from increasing the allocation to the sector. Of course, these presumptions are rarely met in reality. Increasing the allocation to a high beta sector like automotive usually generates more carry than extending duration. Therefore, over the long run, this strategy has proven more successful. The allocation strategy is also more intuitive with respect to the allocation of capital to different risk or spread classes.
Archive for the ‘credit score’ Category
A bond swap on an issuer’s credit curve November 7th, 2009
In most cases portfolio managers do not expect the spread change to occur that is priced in forward spreads. If this view is strong enough, and if the portfolio manager has proven his skill in predicting corporate bond spread changes, he may decide to bet against the market, in other words to take an active position with respect to the credit curve. Several different ways to implement such trades will be discussed subsequently.
The first trade is simply a bond swap on an issuer’s credit curve. If an investor expects the credit curve to flatten more than implied by forward spreads over the holding period, he may switch out of short-term bonds into longer maturities. In order to keep the duration exposure constant, a part of the proceeds of the sale of the short-term bonds would have to be kept in cash. Although this trade can be constructed to be duration-neutral, the performance over the holding period relative to the benchmark depends on changes of the shape of the yield curve. A yield curve steepening can lead to the underperformance of the long bonds even if the credit curve flattens.
