Fixed-Income Active Management: Credit Strategies

Credit managers earn their keep by deciding how much credit risk to hold, where in the cycle to hold it and which issuers deserve it. This module compares spread measures and estimates excess returns, contrasts bottom-up and top-down strategies, manages liquidity and tail risk, uses CDS and index products to express views, and looks beyond domestic corporates to international credit and structured products.

Start this lesson free Practice questions

What you will learn

1. Compare credit spread measures (G-spread, I-spread, asset swap spread, Z-spread and option-adjusted spread), explain why OAS is usually preferred, and estimate excess returns using spread duration.

G-spread uses a government yield, I-spread a swap rate, ASW the floating spread after an asset swap.
Z-spread is the constant spread over the spot curve; OAS = Z-spread - option cost.
OAS is preferred for comparing bonds with and without embedded options, but depends on the volatility model.
Spread duration measures price sensitivity to spread changes; floaters have spread duration far above rate duration.
Expected excess return is approximately spread x time - spread duration x change in spread - POD x LGD.

2. Contrast bottom-up and top-down credit strategies, and measure top-down risk with spread duration and duration times spread (DTS).

Bottom-up: relative value within sectors, comparing spreads with leverage and coverage, plus covenants and event risk.
Top-down: credit-cycle view drives overall exposure, quality, sector and regional allocation.
Lower-rated bonds suffer most as recessions approach; spreads move in proportion to their level.
Contribution to spread duration = weight x spread duration; DTS = spread duration x spread.
Price change is approximately -DTS x percentage change in spreads, so DTS captures risk that spread duration misses.

3. Manage liquidity risk and tail risk in credit portfolios using liquidity measures, liquid proxies, VaR, conditional VaR, stress tests and hedges.

Liquidity measures: bid-ask spread, volume, issue size and age, dealer participation.
Round-trip trading cost in price terms is approximately bid-ask (in bp of spread) x spread duration.
Liquid proxies (index CDS, credit ETFs, TRS) adjust exposure quickly; illiquid bonds need a liquidity premium.
Credit returns are negatively skewed: prefer CVaR and stress tests to VaR alone.
Tail hedges: buy index CDS protection, payer options on CDS indexes or puts on credit ETFs.

4. Use credit default swaps and other positioning tools, including CDS curve and basis trades and index CDS, to express a credit spread view.

Protection buyer = short credit; protection seller = long credit without funding a bond.
Upfront (% of notional) is approximately (CDS spread - fixed coupon) x CDS spread duration; negative means the buyer receives it.
Value change for the buyer is approximately change in spread x spread duration x notional.
Negative basis (bond spread > CDS spread): buy the bond and buy protection.
Index CDS give fast, liquid market exposure; large positions can become impossible to exit.

5. Discuss international credit portfolios and structured products (ABS, MBS, CLOs, covered bonds) as complements or alternatives to corporate bonds, including tranche losses.

International credit adds cycle diversification but also currency, sovereign, legal and liquidity risks.
Loss-absorption order can depend on local law and on the decisions of national authorities.
CLO tranches: losses hit equity first; a tranche loses between its attachment and detachment points.
Covered bonds offer dual recourse to the issuing bank and a ring-fenced cover pool.
Structured products add yield and diversification but bring complexity, model risk and crisis correlation.

Module at a glance

Use OAS to compare bonds with and without embedded options; Z-spread includes the option cost.
Expected excess return is approximately spread x time - SD x change in spread - POD x LGD.
Bottom-up: relative value against fundamentals; top-down: credit cycle, quality, sector and region.
DTS = spread duration x spread; proportional widening hits high-spread bonds hardest.
Round-trip liquidity cost is approximately bid-ask (bp) x spread duration; use CVaR and stress tests for skewed credit returns.
CDS upfront is approximately (spread - fixed coupon) x SD x notional; negative basis: buy the bond and buy protection.
CLO tranche loss = (pool loss - attachment) / thickness, capped at 100%; covered bonds give dual recourse.

This free module has 5 lessons, 18 practice questions with full explanations and 1 essay case with a model answer.

Start the lesson