DefinePK

Research Objective

To examine the risk management characteristics, diversification, and hedging benefits of investment portfolios by combining 5-year industrial corporate bonds and Credit Default Swaps (CDS) of the same industry, using various risk reduction techniques.

Methodology

The study employed three portfolio strategies: Risk minimization portfolio (P2), Variance minimization portfolio (P3), and Equally weighted portfolio (P4). Daily closing quotations of 9 US industry's bond return indices and their analogous 5-year industry's CDS spread indices were used. Industries included: Energy, Industrials, Utility, Health, Telecommunications, Utilities, Banks, Information and Technology (Infotech), and Leisure. Data was sourced from Thomson Reuters DataStream. Risk and downside risk measures, including Value-at-Risk (VaR) Reduction, Expected Shortfall (ES) Reduction, Semi-VaR Reduction, and Regret Reduction, were applied.

Methodology Flowchart

                        graph TD
    A["Data Collection: Daily bond and CDS indices for 9 industries"] --> B["Portfolio Strategy Selection"];
    B --> C["Risk Minimization P2"];
    B --> D["Variance Minimization P3"];
    B --> E["Equally Weighted P4"];
    C --> F["Risk and Downside Risk Measurement"];
    D --> F;
    E --> F;
    F --> G["Analysis of VaR Reduction, ES Reduction, Semi-VaR Reduction, Regret Reduction"];
    G --> H["Interpretation of Results"];
    H --> I["Conclusion on Diversification and Hedging Benefits"];                    

Discussion

The study highlights that while positive correlations between corporate bonds and CDS might indicate that shocks in one instrument affect the other, this relationship can make investment portfolios including both more risky. This suggests that for many industries, combining corporate bonds and their respective CDS is not a viable diversification strategy. The industry-specific nature of these relationships is emphasized, with some industries showing weak or negative correlations that could offer hedging and diversification benefits. The effectiveness of different risk reduction measures varied, with ES reduction showing promise for the risk minimization portfolio.

Key Findings

- For most industries, the correlation between 5-year corporate bonds and CDS returns is positive, with the Leisure industry being an exception (negative correlation).
- Risk reduction benefits were negative for both the Risk minimization portfolio (P2) and the Equally weighted portfolio (P4) across all industries when combining corporate bonds and CDS, making them less attractive for diversification and downside risk reduction.
- The Variance minimization portfolio (P3) showed positive but small numeric values for risk reduction, suggesting it's a better choice for safeguarding against downside risk compared to P2 and P4.
- Expected Shortfall (ES) reduction showed positive and significant values for the Risk minimization strategy portfolio (P2) across all industries, indicating it's a good option for mitigating downside and expected shortfall risk.
- It is generally not practical to diversify an investment portfolio and safeguard against downside credit risk by simultaneously adding both 5-year industry-wise corporate bonds and their respective CDS, with some exceptions noted in expected shortfall reduction.

Conclusion

The correlation between corporate bonds and CDS is industry-specific. For most industries, positive correlations between corporate bonds and their respective CDS make their simultaneous inclusion in investment portfolios risky and not ideal for diversification. Investors seeking to reduce portfolio risk through diversification should consider other options. The Variance minimization portfolio (P3) and Expected Shortfall reduction for the Risk minimization portfolio (P2) show some potential for downside risk management.

Fact Check

- The study analyzed 9 US industries: Energy, Industrials, Utility, Health, Telecommunications, Utilities, Banks, Information and Technology (Infotech), and Leisure. (Confirmed by text)
- The correlation for the Leisure industry between corporate bonds and CDS was negative with a value of -0.0361. (Confirmed by text)
- The Variance minimization portfolio (P3) showed positive risk reduction benefits, though with smaller numeric values. (Confirmed by text)

Mind Map