A credit PM and a duration PM can both buy the same 10-year corporate bond and run opposite risk books. The exam tests whether you can isolate the spread bet, price it correctly, and manage what happens when liquidity evaporates.
A spread-based portfolio earns excess return by accepting credit, liquidity, and structure risks the benchmark Treasury does not carry. Five risk factors dominate.
Credit migration risk. A downgrade widens spreads even without default. An IG-to-HY migration (fallen angel) often forces selling by IG-only mandates, compounding the move.
Default and recovery risk. Loss given default depends on seniority, collateral, and the recovery cycle. Senior unsecured recoveries average roughly 40 cents on the dollar; subordinated paper sees 20-30 cents.
Spread volatility. Even absent migration, spreads widen and tighten with risk appetite. A 100bp widening on a 7-year spread-duration position costs 7% of price.
Liquidity risk. Bid-ask widens and depth disappears in stress. The cost of forced selling can exceed the credit loss itself.
Common mistakes
- Comparing nominal spreads across callable and bullet bonds. A 215bp Z-spread callable is not "wider" than a 180bp Z-spread bullet; both have 180bp OAS. Trap: chasing nominal spread and overpaying for the option cost.
- Treating yield-to-worst as expected return. YTW ignores migration cost and default loss. Trap: a 6% YTW BBB cyclical with 30bp expected annual migration drag returns closer to 5.7% in expectation.
- Hedging individual bond positions with the wrong CDX. Buying CDX IG protection to hedge a BB position is a beta mismatch. Trap: use CDX HY for HY positions; basis can move against the hedge in stress.
Bottom line
- Spread duration measures price sensitivity to a 1bp spread change; total return = carry + roll-down + spread change × (−spread duration) + default loss
- OAS strips embedded option value out of nominal spread, enabling apples-to-apples comparison across callable, putable, and bullet bonds (a 215bp Z-spread callable can be 180bp OAS)
- Spread-based portfolios carry credit migration, default, spread volatility, liquidity, and curve risks beyond Treasury duration
- Bottom-up = security-by-security credit selection; top-down = sector, quality, and region tilts based on macro and credit cycle stage
Exam shortcut
For any callable / bullet comparison, compute OAS = Z-spread − option cost for both bonds and compare OAS only. Nominal-spread and Z-spread comparisons are traps. For international credit, compare OAS minus FX hedge cost, not headline OAS. The hedge cost is the short-rate differential between base and foreign currency.
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