Credit Strategies: The Top-Down Approach

The top-down approach to credit strategy is similar to the top-down approach to security selection: start with the macroeconomy.

Based on expectations of economic growth, default rates, volatility, interest rates, exchange rates, and other macro things, make portfolio weighting decisions. What sounds like a logical next step?

No, it's too late for that. You're a bond manager now. Stick to bonds.

Exactly! If you expect some credit tightening, then maybe cash will become more scarce, and defaults will increase. Then it might be good to look at investment-grade bonds and stay away from high-yield bonds. Using just a few broad divisions makes a lot of sense here, where a bottom-up approach uses a lot more divisions to separate out sub-industry groups.

No. There is really no need for those.

One of the biggest issues for a top-down strategy is choosing a level of credit quality, just like the investment-grade vs. high-yield decision just mentioned. Of course it's not really a simple, binary choice. Credit quality exists on a spectrum, and where you end up with a target credit quality level will make a big difference on how your portfolio performs in the next year. For example, suppose you're expecting credit spreads to narrow. What level of credit quality would be best for you ahead of this change?

No. Actually low credit quality would be a better choice.

Yes!

Choosing low credit quality bonds is basically saying "okay, market, I know you don't trust these issues... but I'm taking a chance on them." If spreads narrow, that's good for the market, and these low credit quality bonds will outperform. Just the opposite happens if spreads widen, of course. That means those high-yield bond prices are going down. Fast.

Related to credit spread expectations is the __credit cycle__, which is essentially how the default rate changes over time. This is clearly determined by macro factors. How would you expect default rates to be correlated with economic growth?

Absolutely. And how about the correlation between default rates and option-adjusted spreads?

No, negatively. Economic growth is a good thing and allows debts to be repaid more easily. More growth, fewer defaults. Lower (or negative) growth, higher defaults. So there's a negative correlation there. And how about the correlation between default rates and option-adjusted spreads?

Right again! You're on a roll.

No, this time it's positive.

There you go.

No. This one is also the other choice. It's positive.

Spreads are a measure of risk, and so higher spreads will certainly correlate with default rates. Macroeconomic analysis can be quite useful if it can give you some indication that higher risks are on their way. Once you see spreads widen, defaults may be not too far away. In fact, you may already be too late.

To summarize: [[summary]]

Choose the best asset class

Decide how bond types will respond to expectations

Make the same sub-industry divisions as in a bottom-up strategy

Low credit quality

High credit quality

Positively

Negatively

Positive

Negative

Positive

Negative

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