Optimal Credit Allocation for Buy-and-Hold Investors

The trade-offs between risk and return are different for buy-and-hold investors and total return investors. For buy-and-hold investors, the portfolio return distribution is asymmetric; the maximum return is the yield, and the maximum loss is represented by default. The standard tools that total return investors use for top-down asset allocation (such as mean-variance optimization) and bottom-up security selection (such as multifactor risk models) are thus inappropriate. A more suitable approach for buy-and-hold investors, given current spreads, default rates and correlations, and loss tolerance, derives an optimal macro allocation across credit qualities. Application of this approach yields an optimized portfolio to minimize expected shortfall due to defaults, subject to a spread target and other portfolio constraints. The results suggest buy-and-hold investors should first determine their allocations to the A and Baa sectors, and then use an optimizer to select individual names.