Using credit to enhance a traditional bond/equity portfolio
CDS was created as a tool for market participants to hedge credit risk, but over time has developed into the default instrument for short and long credit exposure without the interest rate risk inherent in cash bonds. CDS are widely used by specialist fixed income managers. However, as they become more accessible, including via ETFs, they could play a useful role in multi-asset portfolios too.
There is an intuitive link between equity and corporate credit and, when you strip out the interest rate component, corporate credit displays equity-like characteristics. If an investor uses credit to completely or partially substitute the equity component of a traditional equity/bond portfolio, returns are enhanced, and for partial substitution volatility and drawdowns are reduced.
We constructed three portfolios using major European equity and bond benchmarks and the iTraxx European Performance Credit Index, a levered European credit index with primarily investment grade exposure. The portfolios were rebalanced monthly.
Substituting 20% of the equity allocation with credit enhanced performance during the financial crisis and in more recent periods of market turmoil. Underperformance has tended to be in strong equity market rallies.
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