Portfolio Positioning Strategies

Understanding the economic cycle significantly influences the evolution of spread curves. Managers and candidates must grasp how spread curves behave throughout the credit cycle regarding their levels and expected changes. This knowledge is crucial for making informed decisions about positioning a fixed-income portfolio.

\(HY\) = High yield (lower credit quality).

\(IG\) = Investment grade (higher credit quality).

Static Spread Curve Strategies

Strategies involving static spread curves become profitable when the manager’s belief that spread curves won’t change aligns with reality. Here are methods for static spread curve approaches:

• Lowering the average credit rating of the portfolio.
• Increasing credit spread duration by investing in longer-maturity bonds with a similar rating.

These methods align with investing principles: longer durations and lower credit quality typically lead to higher yields.

Derivative-based credit strategies, such as selling CDS for longer maturities or lower credit quality, aim to add credit spread duration and exposure.

Dynamic Credit Spread Curve Strategies

Dynamic credit spread curve strategies are more intricate. They involve managers forming a detailed perspective on how the following factors might unfold within specific:

• Borrowing entities.
• Industry sectors.
• Overall credit market cycles.
• Expected changes in ratings and/or maturities on the curve.

Managers will typically short positions they anticipate will decrease in value and buy positions they expect to appreciate. A combination of these methods can yield positive returns. For each viewpoint the manager holds, they must identify bonds, perhaps on an individual bond level within the extensive fixed-income market, and execute buy and sell actions based on their outlook.

Question

Which of the following credit cycle phases does not indicate an anticipated future narrowing of spreads between High Yield (HY) and Investment Grade (IG) bonds?

1. Early Expansion.
2. Contraction.
3. Peak.

Solution

The correct answer is C.

Both early expansion and contraction imply that spreads will decrease between HY and IG bonds over time. The peak phase signifies low spreads that are rising simultaneously.

A and B are incorrect. The “Early Expansion” and “Contraction” phases suggest an anticipated narrowing of spreads between HY and IG bonds as economic conditions improve. 

Reading 22: Fixed Income Active Management: Credit Strategies

Los 22 (h) Discuss various portfolio positioning strategies that managers can use to implement a specific credit spread view