Fixed Income 101: Hedging credit risk

Credit risk is one of the building blocks of a diversified fixed income portfolio.

Credit risk reflects the likelihood of a bond issuer failing to make payments on its debt. The market’s perception of that risk helps to determine the size of a bond’s credit spread – the yield premium investors demand for holding credit assets over government bonds, which are generally perceived as lower risk.

For a diversified portfolio holding some combination of government bonds and credit assets, the level of credit risk taken is therefore one of the main drivers of yield and expected return. An active manager typically seeks to maximise risk-adjusted returns by adapting the portfolio’s credit exposure as market conditions evolve.

In a long-only strategy, credit risk is primarily managed through careful bond selection rather than deploying short-selling or complex derivatives. A long-only manager will usually be comfortable holding every bond in their portfolio to maturity, allowing for an expected level of volatility, because their research has determined that the yield on each bond is adequately compensating for the credit risk.

However, in particularly volatile periods for markets where macro uncertainty is high, or around binary events such as elections, long-only managers can also deploy simple hedging tools to help them manage credit risk.

The two components of credit risk

For fixed income portfolios, it is important to distinguish between two different components of credit risk.

Default risk describes the risk that an issuer fails to meet its interest payments or return principal at maturity, putting investors’ capital at risk. 

Spread risk describes the risk that the market demands greater compensation for holding a bond – through wider credit spreads – even where an issuer continues to meet its obligations. This can occur in response to specific events such as an economic shock, or simply a broader deterioration in market sentiment, and can hit portfolio performance as bond prices fall. 

Spread risk is a potentially unwanted source of volatility for a fund’s end investors, even if the portfolio manager remains confident that each issuer in their portfolio will continue to make coupon payments and return their capital at maturity.

For the most part, a long-only manager will look to manage spread risk organically by rotating gradually in and out of different credit assets. However, there are times when hedging can be a valuable extra tool.

How does credit hedging work?

Portfolio managers can hedge credit risk with a credit default swap, or CDS. A CDS contract is effectively a form of insurance against credit risk, which can be taken out against a single issuer or the broader market via an index.

In both cases, the investor pays a regular premium to the seller of the CDS in return for protection against either a “credit event” or a sharp deterioration in the issuer's creditworthiness, though the mechanics are slightly different.

Single-name hedging

With a single-name CDS, the seller agrees to compensate the investor if the bond issuer experiences a “credit event” such as bankruptcy, a debt restructuring, or a failure to pay obligations.

Importantly, though, CDS positions themselves are tradeable and can rise and fall in value. This means the underlying issuer doesn’t need to experience a recognised “credit event” for the CDS protection to benefit the CDS holder. If the perceived likelihood of default rises, the value of the CDS protection also rises as more investors look to take similar positions.

Hedge funds, for example, often use single-name CDS to make sizeable bets against individual issuers, but it can be a high-risk strategy given that the position can become a significant drag on portfolio performance if the issuer’s outlook improves.

Again, the job of a long-only fixed income portfolio manager is generally to avoid or exit positions in individual issuers where they perceive credit risk to be too high, rather than taking “short” positions seeking to benefit from a negative credit event.

Index-level hedging

CDS protection can also be taken out on an index, offering more general protection against a downturn in market sentiment.

As an example, one way of gaining protection against a sharp spread widening in European high yield (HY) bonds would be to use a CDS on the iTraxx Crossover Index, which covers 75 European HY issuers with high liquidity.

An index-level CDS provides protection against both spread widening and any default from an index constituent on a pro-rata basis. However, for most long-only managers, the primary use case is hedging broad spread moves rather than specific default risk. Since the investor purchases the CDS at a specific execution level, if the spread on the iTraxx Crossover Index widens beyond that level the value of the position increases, and vice versa.

Just as with single-name CDS, the holder doesn’t need any of the 75 index constituents to default for the position to represent a mark-to-market gain, helping to offset any negative performance from the portfolio’s credit holdings. As Exhibit 1 shows, the spread on the iTraxx Crossover Index can react quickly to exogenous shocks, widening sharply when market sentiment deteriorates and then recovering when investors have digested the impact.

It is worth noting that even the most acute risk events of recent years, such as the onset of Covid-19 or Russia’s invasion of Ukraine, did not result in a wave of defaults across the European HY market. However, the moves highlight the potential benefit for portfolio managers of being able to hedge credit risk more generally even when their view on underlying credit fundamentals hasn’t changed.

Generally, index-level CDS trades are more cost efficient and more liquid than single-name CDS, making them more suitable for long-only or broadly diversified portfolios. The greater liquidity of index-level contracts means a manager can exit the position quickly as spreads begin to normalise, enabling them to lock in potential mark-to-market gains. For long-only managers, exiting and then re-entering a position in less liquid HY bonds would be much more difficult, particularly in a stressed environment when bid-ask spreads tend to widen. 

The potential benefits of hedging

A portfolio manager can opt to hedge if they believe they are not being adequately compensated for the risk they are holding. In certain scenarios, this assessment may include bonds held in the portfolio.

However, there are three main benefits to using hedging as opposed to selling credit assets when a portfolio manager anticipates a potential downturn in market sentiment.

First, an index-level hedge may help to reduce overall market exposure without selling preferred bonds. This can be particularly important in less liquid markets or at times when technical demand is high, where a portfolio manager must consider their ability to source those same bonds again.

Second, hedging allows investors to still receive coupon payments, an income stream which would be lost if a bond were sold. Hedging allows a manager to maintain a portfolio’s overall yield, offset by the CDS premium payments.

Third, hedging can potentially be more cost-efficient than the transaction costs associated with executing several trades in and out of credit assets in response to what a portfolio manager views as a transitory shock. Like individual bond trades, CDS trades also incur bid-ask spreads in addition to their premiums, so it is up to the manager to assess the cost of the hedge in the context of the portfolio’s target returns. 

An optimal hedge would generate gains that exactly offset portfolio losses from credit spread widening, though in practice this is extremely difficult to achieve – a concept known as “basis risk.” Because the portfolio's holdings will never move in perfect lockstep with the index, a CDS hedge will always be an approximation rather than an exact offset, so the sizing and execution of the trade should be done in close collaboration with the firm's Risk department.

A complement to credit research

Hedging can be a valuable occasional tool for long-only portfolio managers, allowing them to maintain high-conviction credit positions during periods of anticipated market stress without necessarily forfeiting the income streams those positions generate. 

Deployed at the right time and removed strategically as conditions normalise, a credit hedge can complement rather than replace the underlying credit research that drives investment decisions.