Can an equity structure dominate the risk-return profile of corporate bonds?

Abstract

In a very low interest rate and tight credit spread environment, institutional investors look for alternatives to enhance their fixed income portfolios whilst maintaining their risk profile. Some have devised hedge funds as a solution to improve return at comparable risk levels. More recently, some authors show that appropriate optional strategies could offer better risk-return profiles than hedge funds. This paper proposes a synthetic equity derivative structure that mimics the cash flow behaviour of a corporate bond portfolio. Both alternatives are empirically compared, balancing their yield with their level of risk, and integrating the probability of default. In the case of the high-rating class, our results show that the derivative structure offers a better “spread-default” profile than that of corporate bonds. This may have interesting implications for insurers and pension funds that seek to invest a substantial fraction of their portfolio in high-grade fixed income assets and is consistent with the focus of liability-driven investors on yearly cash flow requirements.