Economy & Credit – Everyday Something New

With the decline of default rates and credit blowups in 2003 and 2004, more and more portfolio managers have realized that the concentration on idiosyncratic risk yields unsatisfactory results in a more favorable environment for credit. Increasing allocation and spread duration may sometimes not be enough to outperform the market during a rally. The use of betas can help to correct this error. The concept originally stems from the equity markets where it is used to describe the portion of the variation in asset returns that is due to market fluctuations. In credit markets beta analysis should only be applied to credit returns, that is the part of a bond’s return that is solely due to changes of the spread versus the swap curve. For a well-diversified portfolio systematic risk, which is captured by the beta, is the major part of credit risk. On a single issuer basis, however, idiosyncratic risk prevails, especially for lower rated credits. Since market data for individual bonds contain a lot of noise, regressions to obtain betas versus the market index should also be done on the sector level. If the portfolio manager is bullish on the credit market, he will tend to overweight higher beta sectors and issuers. This methodology adds a third dimension to the process of tactical positioning, supplementing the decisions on the sector allocation and spread duration.