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 ‘money management’ Category
Credit curves of two issuers will converge November 15th, 2009
If an investor only has a view that the credit curves of two issuers will converge, but is not sure whether this will happen at wider or tighter spread levels, he would like to construct the box trade in a way that makes it insensitive to parallel shifts of the credit curves. In order to achieve this goal the trade has to be proceeds neutral. It is worth noting that the spread-neutral box trade is almost independent of the spreads, except for the minor impact of spreads on duration.
Remember that this trade is designed to protect investors from spread changes that might adversely impact their credit curve trade. Yet, often portfolio managers not only have a view on the relative changes of the credit curve of the two issuers but also on the direction of spreads. In this case the spread-neutral box trade is not optimal. The investor would rather choose a longer or shorter duration, depending on his view on the direction of spreads.
When a steepening of the credit curve is expected November 9th, 2009
When a steepening of the credit curve is expected that is not fully reflected in forward spreads a portfolio manager would have to sell the long bonds and buy short-term bonds. However, in order to keep duration constant, he would have to put more cash to work in the short-term bonds than he receives from selling the long bonds. Since real money managers such as mutual funds and insurance companies are not allowed to borrow and to leverage their positions, setting up a credit curve steepener involves taking a duration view, because the investor implicitly ends up being short duration.
