Managing Credit Risk in a Corporate Bond Portfolio

Abstract

The author proposes a portfolio selection method to manage market risk and credit risk in a corporate bond portfolio relative to its benchmark. He formulates an optimization problem that minimizes the variance of the loss distribution arising from credit risk with the constraints that the expected return of the portfolio not be below the benchmark and the market risk be identical to the benchmark. Such a problem formulation produces a portfolio that exhibits improved risk–adjusted return characteristics ex ante compared to the benchmark. A practical example illustrates the method.