How Much Credit?

Abstract

Corporate bonds are an important asset class for fixed-income investors. For asset allocation, the crucial question is how to account for the fact that (particularly non-investment-grade) corporate bond returns show fat tails and significantly non-normal distributions. Some fixed-income asset classes also lack liquidity. Illiquidity induces positive serial correlation into asset returns. This in turn results in sample variances that underestimate the true level of risk. The effect is that optimal portfolios are heavily exposed to non-normality and illiquid asset classes. Adjusting for non-normality and autocorrelation patterns results in different allocations of high-yield and investment-grade bonds.