Using credit to enhance a traditional bond/equity portfolio
Replacing equity with credit in a simulated European bond/equity portfolio improved long-term performance, reduced drawdowns and enhanced risk-adjusted returns over 1, 3, 5 and 10 years. This strategy and variations on this theme can be readily implemented with ETFs.
Credit spreads as a substitute for equity
There is a clear intuitive link between equity and corporate credit. However, because corporate bonds also have interest rate risk, they have differing performance characteristics. When you strip out the interest rate component, the pure credit exposure behaves more like equity.
Credit default swaps (CDS) allow investors to take long or short credit exposure without the interest rate risk inherent in corporate bonds. Initially developed as hedging tools, CDS are now the default instruments for credit exposure and are widely used by specialist fixed income managers. As they become more accessible, including via ETFs, they could play a useful role in multi-asset portfolios too. Here, we look at whether substituting credit for equity in a simulated portfolio could improve returns, on an absolute and risk-adjusted basis.
Three sample portfolios
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 and minimal interest rate risk. 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, for example in early 2015.
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