Efficiently Replicating Corporate Bond Returns with CDS Indices

CDS indices, such as CDX and iTraxx, can be an efficient alternative to physical corporate bond portfolios. These indices enable portfolio managers to replicate corporate bond market exposure, benefiting from enhanced liquidity, lower transaction costs, and operational flexibility. By combining CDS indices with government bonds, managers can achieve similar risk-return profiles to traditional corporate bond indices while mitigating the challenges of investing in physical bonds, particularly in illiquid or distressed market conditions. This chapter details the mechanics of CDS index replication, highlighting how CDS indices allow portfolio managers to gain credit risk exposure while government bonds provide interest rate exposure. Compared to physical bonds, CDS indices offer higher liquidity and lower trading costs, making them an efficient tool for managing large portfolios. Additionally, the historical performance of CDS index-based portfolios shows lower volatility and default rates than traditional corporate bond portfolios, particularly during crises such as the 2007–2008 Global Financial Crisis and the COVID-19 market turmoil. CDS indices exhibit large relative risk (tracking error) for portfolio managers who benchmark against physical bond indices. However, patient managers focusing on long-term results may benefit from comparable returns with reduced volatility and fewer defaults. Moreover, the case demonstrates that dynamic beta allocation strategies using CDS indices can enhance portfolio returns. By employing a trend-following strategy based on past performance, managers can adjust credit exposure to capitalize on favorable market conditions while reducing risk during downturns.