15-08-1999 · Research

Value of security selection versus asset allocation in credit markets

Should credit investors apply a top-down or a bottom-up approach? Here, we present a quantitative study of the relative merits of various forms of fixed-income research, as applied to portfolio management relative to a benchmark.


  • Erik van Leeuwen

    Chief Operations Investments

In this article,1 we quantify the relative merits of different styles of credit investing in a limiting ideal case. For portfolios of credit spread securities managed relative to fixed-income benchmarks, we investigate the value added by security selection and various asset allocation strategies based on “perfect foresight.”

In conducting this historical study, we rely on the simulation of such strategies using data for the Lehman Brothers US High Grade Corporate Index. Simulations of a given strategy are matched to the index in every dimension but one. The success of each strategy is evaluated on the basis of the “information ratio” a ratio of the strategy's outperformance of the index to the standard deviation of such outperformance.

Our findings suggest that security selection with “perfect foresight” in a corporate bond portfolio is the single most effective way to generate steady outperformance of the index. This applies to both the “select winners” and the “avoid losers” cases. Yield curve timing, sector rotations, and credit rating selections may deliver more outperformance, but with higher variance.

Results obtained in this study may be used to justify selection of bottom-up versus top-down portfolio management styles and allocation of research efforts and risk budgets.

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1Dynkin, L., Ferket, P., Hyman, J., Van Leeuwen, E. and Wu W., 1999, ‘Value of security selection versus asset allocation in credit markets’, The Journal of Portfolio Management.

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