Capturing Credit Spread Premium

Kwok-Yuen Ng and Bruce D. Phelps

Financial Analysts Journal, 2011, vol. 67, issue 3, 63-75

Abstract: Despite high spread volatility, investment-grade credit portfolios have generated an average annual spread premium (returns net of U.S. Treasury returns and defaults) of 48 bps over the past 20 years. The authors show that relaxing a common portfolio constraint that requires selling downgraded bonds would have allowed investors to capture an average annual spread premium of 86 bps, with similar risk. Thus, adopting a downgrade-tolerant credit benchmark could generate a higher credit spread premium.At year-end 2009, despite a strong credit market rally, the average annual reported excess return on duration-matched U.S. Treasuries since 1990 for the Barclays Capital U.S. Corporate Investment Grade Index (IG Corporate Index) was only 27 bps, with an annual standard deviation of 741 bps. For investors looking to investment-grade credit bonds as a way to clip more coupons with modest additional risk, this performance was not particularly attractive. In response, investors began to ask whether they should abandon persistent allocations to credit and rely on that asset class solely as a market-timing tool.We showed that investment-grade credit bonds, as proxied by the IG Corporate Index, have generated a substantial average annual spread premium (i.e., returns net of duration-matched Treasuries and defaults) of 48 bps over the past 20 years despite a high level of spread volatility. Investors willing to tolerate the spread volatility may be able to harvest this spread premium over time. Credit investors, however, could do better.To try to capture as much spread premium as possible, investors need to ensure that their credit portfolios do not have self-imposed constraints that may inadvertently restrict the realization of any premium. We showed that many credit portfolios, which we modeled by using a common portfolio benchmark (the IG Corporate Index), have various constraints that have historically hampered their ability to capture a larger credit spread premium.We measured the cost of these constraints by constructing alternative credit benchmarks and examining their realized spread premium from 1990 to 2009. In particular, we found that a common portfolio constraint that requires investors to sell bonds downgraded below investment grade has significant implications for earning the spread premium. In fact, portfolios that are “downgrade tolerant” would have allowed investors with a persistent credit allocation to capture an annual spread premium of 86 bps, almost 80 percent larger than that offered by the IG Corporate Index (48 bps), with similar risk. Although these results are not guaranteed to recur over the next 20 years, adopting a downgrade-tolerant credit benchmark may allow investors to capture more credit spread premium in the future.

Date: 2011
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DOI: 10.2469/faj.v67.n3.4

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