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Managing sovereign credit risk in bond portfolios

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  • Bruder, Benjamin
  • Hereil, Pierre
  • Roncalli, Thierry

Abstract

With the recent development of the European debt crisis, traditional index bond management has been severely called into question. We focus here on the risk issues raised by the classical market-capitalization weighting scheme. We propose an approach to properly measure sovereign credit risk in a fixed-income portfolio. For that, we assume that CDS spreads follow a SABR process and we derive a sovereign credit risk measure based on CDS spreads and duration of portfolio bonds. We then consider two alternative weighting methods which are fundamental indexation and risk-based indexation. Fundamental indexation is based on GDP indexation whereas risk-based indexation uses a risk budgeting approach based on our sovereign credit risk measure. We then compare all these methods in terms of risk, diversification and performance. We show that the risk budgeting approach is the most appropriate scheme to manage sovereign credit risk in bond portfolios and gives very appealing results with respect to active management of bond portfolios.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 36673.

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Date of creation: 15 Oct 2011
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Handle: RePEc:pra:mprapa:36673

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Related research

Keywords: sovereign credit risk; credit spread; convex risk measure; sabr model; CDS; bond indices; fundamental indexation; risk-based indexation; risk budgeting;

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References

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  1. Antonio Cesare, 2006. "Do Market-based Indicators Anticipate Rating Agencies? Evidence for International Banks," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 35(1), pages 121-150, 02.
  2. Blake, Christopher R & Elton, Edwin J & Gruber, Martin J, 1993. "The Performance of Bond Mutual Funds," The Journal of Business, University of Chicago Press, vol. 66(3), pages 370-403, July.
  3. Victor DeMiguel & Lorenzo Garlappi & Raman Uppal, 2009. "Optimal Versus Naive Diversification: How Inefficient is the 1-N Portfolio Strategy?," Review of Financial Studies, Society for Financial Studies, vol. 22(5), pages 1915-1953, May.
  4. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
  5. Francis A. Longstaff & Jun Pan & Lasse H. Pedersen & Kenneth J. Singleton, 2011. "How Sovereign Is Sovereign Credit Risk?," American Economic Journal: Macroeconomics, American Economic Association, vol. 3(2), pages 75-103, April.
  6. Jens Hilscher & Yves Nosbusch, 2010. "Determinants of Sovereign Risk: Macroeconomic Fundamentals and the Pricing of Sovereign Debt," Review of Finance, European Finance Association, vol. 14(2), pages 235-262.
  7. Roncalli, Thierry, 2010. "Understanding the Impact of Weights Constraints in Portfolio Theory," MPRA Paper 36753, University Library of Munich, Germany.
  8. Teiletche, Jérôme & Roncalli, Thierry & Maillard, Sébastien, 2010. "The properties of equally-weighted risk contributions portfolios," Open Access publications from Université Paris-Dauphine urn:hdl:123456789/4688, Université Paris-Dauphine.
  9. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, volume 1, number 8973.
  10. Ejsing, Jacob & Lemke, Wolfgang, 2011. "The Janus-headed salvation: Sovereign and bank credit risk premia during 2008-2009," Economics Letters, Elsevier, vol. 110(1), pages 28-31, January.
  11. Richard Cantor & Frank Packer, 1996. "Determinants and impacts of sovereign credit ratings," Research Paper 9608, Federal Reserve Bank of New York.
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Cited by:
  1. Bruder, Benjamin & Roncalli, Thierry, 2012. "Managing risk exposures using the risk budgeting approach," MPRA Paper 37246, University Library of Munich, Germany.

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