So far we have described a rather intuitive way of combining individual views in a portfolio. Top-down and bottom-up analyses have determined the overall strategy for the portfolio, spread class and sector selection and finally issuer weightings. This qualitative methodology does not require estimates of returns, risks and correlations between the investments, and therefore is easy to implement. Yet, it is not able to capture the full benefits of diversification and to tailor the expected risk/return profile of the portfolio to the preferences of the investor. Since the seminal work of Markowitz (1952), diversification is a central tenet of modern investment theory. In the context of credit portfolios it plays a crucial role, because it helps to control downside risk arising from single issuer credit events. Since the mid-1990s debt-financed M&A activities, share buybacks, and the introduction of new technologies have fueled the new issue pipeline and broadened the corporate bond universe. Meanwhile, the European corporate bond market offers sufficient market breadth and depth for institutional investors to construct thoroughly diversified portfolios. If the portfolio manager is capable of quantifying the risk and return characteristics of his investment alternatives, portfolio optimization approaches present a formalized and thus objective way of deriving investment recommendations. This applies irrespective of the performance target of the investor. Portfolio optimization can be used with respect to portfolios that are managed in absolute risk/return terms as well as portfolios that are managed relative to a benchmark index. Various constraints can be included, for example a short sales restriction for real money investors, maximum concentration limits or esired duration ranges.

The addition of the individual contributions to expected excess return in Our study yields an expected 1-year excess return of 88.2 bp for A-rated corporate bonds with a maturity of 5-years. This is significantly below the initial spread of 100 bps. The difference reflects the fact that a downgrade is more probable for A-rated corporate bonds than an upgrade, and that the associated spread changes are not symmetric. The magnitude of spread widenings due to downgrades is usually much higher than the spread tightening after rating upgrades. It is interesting to note that among investment grade bonds the ratio of upgrades to downgrades is most favorable for Baa-rated bonds. However, in the case of a downgrade these bonds often suffer massive price declines, because they fall below investment grade levels.

A strong negative correlation between default rates and economic growth could always be expected, but during the economic crisis in the United States in the 1970s and 1980s a sharp increase of the default rates could not be observed. It was the economic slowdown in 1990, which was accompanied by extremely increasing default rates. The same acceleration of default rates occurred in 2001 due to a prolonged downturn of the economy, high political uncertainty after September 11, 2001, company accounting scandals, and aggregate weak credit fundamentals. Structural changes in the credit markets can explain the weaker than assumed relationship between the default rates and the economic cycle. This leads to the conclusion that the relationship between default rates and the spread level in the corporate bond market is a very complex one and that a good performance in the corporate bond market (tightening of credit spreads) can be consistent with increasing default rates at times where the market anticipates future decreasing default rates.

The following paragraph will deal with default rates because they are of central importance for high-yield investors. We compare the three major default peaks since 1920. Default rates have to be distinguished between “issuer-weighted” and “dollar-weighted”. The increasing amount of Fallen Angels in 2002 resulted in a sharp increase of the “dollar-weighted” default rate.

High-yield spreads tend to lead default rates, which means that a tightening will occur prior to a fall in the default rate because market participants will already anticipate the future development of the default rate. This relationship broke down in 2002 for a couple of months due to the large divergence of the “dollar-weighted” from the “issuer-weighted” default rate. As we can see cumulative default rates tend to increase progressively with a decreasing rating class.

Interestingly, the relationship between equity and bond markets differs in deflation-risk periods and inflation-risk periods. In inflation-risk periods, rising inflation rates push up long-term interest rates, reflecting the fear that aggressive monetary tightening will depress future earnings and hence stock prices. Thus, in periods of rising inflation risk, government bond prices and stock prices tend to fall. In deflation-risk periods government bond prices and stock prices usually go in opposite directions, because fixed income markets benefit from the expectation of falling interest rates, while equities suffer from the worsening profit outlook and increasing default risk. Credit spreads tend to benefit from rising inflation because it becomes easier for companies to pay down their debt.

Deflationary periods usually lead to a spread widening across the whole credit market, hitting consumer-related industries the hardest. However, long-term interest rates seem to have a minor influence on fluctuations of credit spreads in the short term. Companies that borrow at a fixed rate are immune to changes in yields and spreads over the life of the borrowing. Yet, there is a refinancing risk, when debt has to be rolled over. Conversely, when companies borrow at floating rates, they are directly affected by changes in money market rates, which are primarily driven by monetary policy.