How to Invest Optimally in Corporate Bonds: A Reduced-Form Approach

34 Pages Posted: 17 May 2005

See all articles by Holger Kraft

Holger Kraft

Goethe University Frankfurt

Mogens Steffensen

University of Copenhagen

Date Written: November 11, 2005


In this paper, we analyze the impact of default risk on the portfolio decision of an investor wishing to invest in corporate bonds. Default risk is modeled via a reduced form approach and we allow for random recovery as well as joint default events. Depending on the structure of the model, we are able to derive almost explicit results for the optimal portfolio strategies. It is demonstrated how these strategies change if common default factors can trigger defaults of more than one bond or different recovery assumptions are imposed. In particular, we analyze the effect of beta distributed loss rates.

Keywords: portfolio optimization, stochastic interest rates, default risk, recovery risk, beta distribution, joint default factor

JEL Classification: G11, G33

Suggested Citation

Kraft, Holger and Steffensen, Mogens, How to Invest Optimally in Corporate Bonds: A Reduced-Form Approach (November 11, 2005). Available at SSRN: or

Holger Kraft (Contact Author)

Goethe University Frankfurt ( email )

Faculty of Economics and Business
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323

Mogens Steffensen

University of Copenhagen ( email )

Universitetsparken 5
DK-2100 Copenhagen

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