Did you know that the credit rating agencies provide the same rating for a given issuer, irrespective of the maturity of its bond? In other words, an issuers two year bond is given the same credit rating as its ten year bond, despite the fact that projecting corporate ability to pay increases in uncertainty over longer time horizons. With that in mind, this graph combines credit and interest rate risk. Each vertical bar shows the percentage of the fixed income portfolio invested in a given credit rating. The horizontal line shows the average portfolio duration, while the other lines connect the points corresponding to the duration (interest rate risk) within a given credit rating.
Combining credit and interest rate risk simultaneously can be problematical. Ideally, the duration for any given credit rating will not vary much from the portfolio’s overall duration. However, if duration increases as credit risk increases (an upward sloping line) the portfolio is indeed combining credit and interest rate risk simultaneously.
What should you ask your investment manager?
Are you combining credit and interest rate risk within a given credit rating? Why is this the case (if so)? Have you considered the risks inherent with that strategy and are we being compensated for taking that risk? How?