Managing the Risks of Corporate Bond Portfolios: New Evidence in the Light of the Sub‐Prime Crisis
54 Pages Posted: 11 Feb 2012
Date Written: February 1, 2012
Abstract
We consider modeling errors in the hedging of a portfolio composed from BBB‐rated bonds. By doing this, we open a new perspective to the debate on the relationship between corporate bonds and CDS spreads. We find that in ordinary times the added value of indexlinked credit derivatives is very limited: hedging portfolios including only T‐bond futures can reduce the variance by 80‐85%. This compares well to the maximum variance reduction of 50% reported by previous studies. On the contrary, in times of extraordinary volatility – such as the years 2008 and 2009 ‐ T‐bond futures would have been insufficient to successfully hedge the bond portfolio. However, including the 5‐year CDX contract would have only slightly improved the quality of hedging. This is consistent with the literature identifying an important non‐default component within corporate bond spreads. Our results encourage the offering of collateralized credit spread forwards as more effective hedging instruments than non‐collateralized CDS contracts.
Keywords: hedging, corporate bonds, model errors
JEL Classification: C51, G13, G32
Suggested Citation: Suggested Citation