Credit vs. Rate Risk Budgeting

Every fixed income portfolio carries two distinct risks that can either diversify or compound. Rate risk (duration exposure to Treasury yield changes) and credit risk (spread exposure to default and downgrade probabilities) behave differently across market regimes. A manager who blindly blends the two without explicit budgeting discovers too late that the 2022 drawdown hit both legs simultaneously: rates surged 400+ bps while investment-grade spreads widened 50 bps. The diversification you assumed wasn't there.

The point is: Risk budgeting forces explicit allocation decisions. You're not just asking "how much credit?" but "how much of my tracking error budget am I willing to spend on credit versus rate bets?"

The Risk Budget Framework (What It Actually Means)

A risk budget defines the total variance (or tracking error, or VaR) a portfolio can tolerate, then allocates that budget across risk factors. For bond managers, the two dominant factors are:

1. Interest rate risk: Measured by duration, key rate durations, or DV01 (dollar value of a basis point)
2. Credit spread risk: Measured by spread duration, credit DV01, or Index-Equivalent Spread Duration (IESD)

The CFA Institute's fixed income curriculum emphasizes that duration management is the primary tool for portfolio managers, but spread duration determines how much a portfolio moves when credit conditions deteriorate independently of rates (CFA Institute, 2024).

Setup → Calculation → Interpretation:

A core-plus strategy targets 150 bps tracking error against the Bloomberg Aggregate Index. The manager's research suggests rates will stay rangebound but credit spreads will compress. How should the risk budget split?

• Rate risk allocation: 50 bps of the tracking error budget (conservative, rangebound view)
• Credit risk allocation: 100 bps of the budget (aggressive, spread compression view)

If total tracking error is the square root of the sum of squared component risks (assuming low correlation):

• TE = sqrt(50^2 + 100^2) = sqrt(2500 + 10000) = ~112 bps

The 150 bps budget allows headroom for correlation and model error. The manager explicitly chose to make credit the dominant bet. If wrong about spreads, credit contributes the bulk of underperformance.

Rate Risk: Duration as the Primary Lever

Duration measures sensitivity to parallel yield curve shifts. A 6-year duration portfolio loses approximately 6% if rates rise 100 bps (ignoring convexity). Most benchmarks have defined duration ranges:

Active rate risk emerges when portfolio duration deviates from benchmark. A manager running 7.5-year duration against a 6.5-year benchmark has a +1 year duration bet: long rates. If the 10-year Treasury yield falls 50 bps, this adds ~50 bps of outperformance versus the benchmark.

The durable lesson: Rate bets are clean. Treasury yields move on macro factors (Fed policy, inflation prints, growth data). You can hedge rate risk with Treasury futures or swaps. But rate risk contributed massively to 2022's carnage: the Bloomberg Aggregate fell 13%, the worst calendar year since 1976.

The 2013 Taper Tantrum offers a faster case study. From April 30 to July 5, 2013, the 10-year Treasury yield rose 100+ bps in ten weeks after Bernanke signaled QE tapering (NY Fed, 2014). Managers overweight duration got crushed in weeks, not months.

Credit Risk: Spreads as the Independent Variable

Credit spread risk captures how much a portfolio moves when spreads widen or tighten, independent of Treasury rate changes. Spread duration measures this sensitivity. A corporate bond with 5-year spread duration loses approximately 5% if its option-adjusted spread (OAS) widens 100 bps.

But spread duration alone understates risk in high-yield or distressed credits. Fort Washington's research introduces Index-Equivalent Spread Duration (IESD), which adjusts for the empirical observation that lower-quality bonds exhibit higher spread volatility per unit of spread duration. The formula applies "spread beta" and "maturity beta" multipliers (Fort Washington, 2024):

IESD = Spread Duration x Spread Beta x Maturity Beta

A BB-rated bond might have a spread beta of 1.3 (30% more volatile than investment-grade) and a maturity beta of 1.1 for its 10-year tenor. Its 5-year spread duration becomes:

IESD = 5 x 1.3 x 1.1 = 7.15 index-equivalent spread duration

This adjusted figure better captures how much tracking error a high-yield tilt actually contributes.

Correlation: The Hidden Variable

Rate risk and credit risk aren't independent. Their correlation varies across regimes:

• Risk-off environments (2008, March 2020, 2022): Rates fall (Treasuries rally as safe havens) while spreads widen. Negative correlation can provide diversification.
• Stagflation or rate shock (2022, 1994): Rates rise aggressively while spreads also widen due to growth fears. Positive correlation compounds losses.
• Goldilocks periods (2017, 2019): Rates stable, spreads compress. Low correlation, both legs perform.

The test: How did your portfolio perform in March 2020? If both rate and credit bets went against you simultaneously, your risk budget assumptions about correlation were wrong. The 1994 Bond Massacre saw $1.5 trillion in global bond losses as rates rose (Fed hiked from 3% to 5.5%) and credit got no safe haven.

During the COVID Treasury market stress (March 9-24, 2020), even Treasuries lost liquidity. The 30-year bid-ask spread widened from 1/32 to 5/32 in days. Fixed income funds suffered 12% outflows within one month (NY Fed, 2020). The lesson: stress scenarios can break correlation assumptions entirely.

Practical Risk Budget Allocation

Step 1: Define Total Risk Budget

Start with tracking error tolerance based on strategy type:

Step 2: Decompose Current Exposures

Run factor attribution on your current portfolio. What's the duration deviation from benchmark? What's the spread duration deviation by sector (corporates, MBS, high-yield)?

A sample decomposition:

• Duration bet: +0.5 years vs. benchmark = ~40 bps rate risk contribution
• Credit overweight: +15% to BBB corporates = ~60 bps spread risk contribution
• Sector tilt: +5% to high-yield = ~50 bps additional spread risk

Correlation-adjusted total: sqrt(40^2 + (60+50)^2) + adjustment = ~120 bps

Step 3: Rebalance to Target Allocation

If your view favors credit over rates, you might target:

• Rate risk: 30% of budget (hedge duration to near-benchmark)
• Credit risk: 70% of budget (overweight spreads)

If your view favors rates falling while spreads stay flat:

• Rate risk: 70% of budget (extend duration beyond benchmark)
• Credit risk: 30% of budget (neutral to slight underweight spreads)

Why this matters: Insurance industry data from 2024 shows 42% of insurers increasing duration risk while 35% increase credit risk (Goldman Sachs Asset Management, 2024). The industry is voting with their risk budgets. Your allocation should reflect your specific views, not market consensus.

Checklist: Implementing Risk Budgeting

Essential (Do These First)

• Define total tracking error or VaR budget with investment committee approval
• Decompose current portfolio into rate and credit risk contributions
• Document correlation assumptions and stress test them against 2008, 2020, 2022
• Set rebalancing triggers when factor contributions drift 20%+ from targets

High-Impact Refinements

• Implement IESD adjustments for high-yield and emerging market holdings
• Run scenario analysis for +100 bps rates with simultaneous +50 bps spread widening
• Build early warning indicators for correlation regime changes (VIX levels, credit spread momentum)

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The bottom line: Risk budgeting transforms vague portfolio discussions into quantified trade-offs. Saying "we like credit" means nothing until you specify how much tracking error you're willing to allocate to that view. The manager who survived 2022 wasn't necessarily smarter about rates or spreads; they knew exactly how much they could lose and sized positions accordingly. The formula is simple: Total Risk = Rate Risk + Credit Risk + (the correlation you forgot to model).

Citation: Fort Washington Investment Advisors. (2024). Risk Budgeting Applied to Fixed Income.