Miikka Taurén and Thomas Philips
Fixed income portfolio managers and risk managers constantly grapple with the question of how to size their corporate credit trades. Their task is made more difficult by the fact that corporate credit events are rare, particularly among Investment Grade bonds, and that tail risk is not well captured by most multifactor risk models. In this article, we propose a simple, but effective, method for sizing credit trades based on their spread. In particular, we model the cross-sectional behavior of corporate spreads, estimate the expected shortfall of monthly spread returns, and use our results, along with some observations on the duration of corporate bonds, to derive a simple upper bound on the permissible exposure to any single issuer in a credit portfolio.
The method has been applied successfully to Investment Grade and High Yield fixed income portfolios in both developed and emerging markets, and has proven its worth in daily use by protecting portfolios against disproportionate idiosyncratic losses, while allowing portfolio managers sufficient flexibility to express their investment views with clarity. Its use is not confined to limits on issuers—our method is easily extended to create limits on a portfolio’s exposures to individual industries, sectors, countries, and regions.