Fixed-Income Active Management: Credit Strategies
2024 Curriculum CFA Program Level III Portfolio Management and Wealth Planning
Two ways to enjoy this Refresher Reading
Available to members only. Login required.Access the Full Reading in the Learning Ecosystem Download the full reading (PDF)
Most fixed-income instruments trade at a nominal yield to maturity (YTM) that lies above that for an equivalent government or benchmark bond of similar maturity. This yield spread or difference compensates investors for the risk that they might not receive interest and principal cash flows as expected, whether as a result of a financially distressed corporate borrower, a sovereign issuer unable (or unwilling) to meet scheduled payments, or a deterioration in credit quality in an underlying pool of assets of a structured instrument such as an asset-backed security. A portion of the yield spread reflects the bid–offer cost of buying or selling a particular bond versus a government security, a liquidity premium that varies based on market conditions. Active managers of spread-based fixed-income portfolios take positions in credit and other risk factors that vary from those of an index to generate excess return versus passive index replication. Financial analysts who build on their foundational knowledge by mastering these more advanced fixed-income concepts and tools will broaden their career opportunities in the investment industry.
We begin by reviewing expected fixed-income portfolio return components with a particular focus on credit spreads. These spreads are not directly observable but rather derived from market information. Similar to benchmark yield curves, credit-spread curves are often defined by spread level and slope, and usually grouped by credit rating to gauge relative risk as well as to anticipate and act on expected changes in these relationships over the business cycle. We outline credit spread measures for fixed- and floating-rate bonds and quantify the effect of spread changes on portfolio value. Building blocks for active credit management beyond individual bonds include exchange-traded funds (ETFs), structured financial instruments, and derivative products such as credit default swaps (CDS). These tools are used to describe bottom-up and top-down active credit management approaches as well as how managers position spread-based fixed-income portfolios to capitalize on a market view.
The member should be able to:
- describe risk considerations for spread-based fixed-income portfolios;
- discuss the advantages and disadvantages of credit spread measures for spread-based fixed-income portfolios, and explain why option-adjusted spread is considered the most appropriate measure;
- discuss bottom-up approaches to credit strategies;
- discuss top-down approaches to credit strategies;
- discuss liquidity risk in credit markets and how liquidity risk can be managed in a credit portfolio;
- describe how to assess and manage tail risk in credit portfolios;
- discuss the use of credit default swap strategies in active fixed-income portfolio management;
- discuss various portfolio positioning strategies that managers can use to implement a specific credit spread view;
- discuss considerations in constructing and managing portfolios across international credit markets;
- describe the use of structured financial instruments as an alternative to corporate bonds in credit portfolios;
- describe key inputs, outputs, and considerations in using analytical tools to manage fixed-income portfolios.
Active spread-based, fixed-income portfolio management involves taking positions in credit and other risk factors that differ from those of an index to generate excess return. The main points of the reading are as follows:
- Yield spreads compensate investors for the risk that they will not receive expected interest and principal cash flows and for the bid–offer cost of buying or selling a bond under current market conditions.
- Two key components of a bond’s credit risk are the POD and the LGD.
- Credit spread changes are driven by the credit cycle, or the expansion and contraction of credit over the business cycle, which causes asset prices to change based on default and recovery expectations.
- High-yield issuers experience greater changes in the POD over the credit cycle than investment-grade issuers, with bond prices approaching the recovery rate for distressed debt.
- While fixed-rate bond yield spread measures use actual, interpolated, or zero curve–based benchmark rates to capture relative credit risk, OAS allow comparison between risky option-free bonds and bonds with embedded options.
- FRNs pay periodic interest based on an MRR plus a yield spread.
- Spread duration measures the change in a bond’s price for a given change in yield spread, while spread changes for lower-rated bonds tend to be proportional on a percentage rather than an absolute basis.
- Bottom-up credit strategies include the use of financial ratio analysis, reduced form credit models (such as the Z-score model), and structural credit models, including Bloomberg’s DRSK model.
- Top-down credit strategies are often based on macro factors and group investment choices by credit rating and industry sector categories.
- Fixed-income factor investing incorporates such factors as size, value, and momentum to target active returns and also increasingly include ESG factors.
- Liquidity risk in credit markets is higher than in equities because of market structure differences and is often addressed using liquid bonds for short-term tactical positioning, less liquid positions for buy-and-hold strategies, and liquid alternatives where active management adds little value.
- Credit market tail risk is usually quantified using VaR or expected shortfall measures and is frequently managed using position limits, risk budgeting, or derivative strategies.
- Credit derivative strategies offer a synthetic liquid alternative to active portfolio managers as a means of over- or underweighting issuers, sectors, and/or maturities across the credit spectrum.
- Credit spread levels and curve slopes change over the credit cycle, with credit curve steepening usually indicating low near-term default expectations and higher growth expectations, while curve flattening, or inversion, suggests rising default expectations and lower future growth.
- Active credit managers can benefit under a stable credit curve scenario by adding spread duration for existing exposures and/or increasing average portfolio credit risk and can capitalize on divergent market views using cash- or derivative-based strategies related to specific issuers, sectors, or the overall credit market.
- Investors in international credit markets distinguish between developed and emerging markets. Developed markets face common macro factors, with market and credit cycle differences affecting relative interest rates, foreign exchange rates, and credit spreads. Emerging markets usually exhibit higher growth combined with greater sovereign and geopolitical risk, currency restrictions, and capital controls.
- Structured financial instruments offer active credit managers access to liquid bond portfolios, fixed-income cash flows derived from real estate and consumer loans, and enhanced returns by adding volatility and/or debt exposure via tranching across the credit spectrum.
- Key considerations for fixed-income analytical tools include the accuracy of model inputs and assumptions as well as alignment between model outputs and fixed-income manager objectives.