• Fixed Income
  • Pensions
  • Insurance

Boxing clever

Portfolio construction in investment-grade credit

Mark Miller and James Vokins explain how our portfolio construction process for investment-grade credit could benefit investors in the new market regime.

Read this article to understand:

  • Why beta-driven approaches to investment-grade credit may come unstuck in a market defined by higher volatility
  • How our sector customisation methodology allows us to control risk
  • How our portfolio construction approach has held up in tougher market environments

Inflation has been knocked down but not out. US and European data released in February and March suggest declarations of victory in the inflation fight were premature. As such, further large rate rises in the US are back on the table, according to Federal Reserve chair Jay Powell.

We are not surprised inflation is proving difficult to tame or that rates do not look like coming down any time soon. In our recent article Higher for longer: A new era for fixed income, we outlined exactly these concerns. In our view, we have entered a new, more challenging fixed-income market regime, defined by higher-for-longer inflation and interest rates and greater volatility in credit spreads.1

Higher rates have contributed to stresses in the financial system. These stresses have been exposed by recent issues in the banking sector, which started with the collapse of Silicon Valley Bank, before quickly spreading to Europe with the shotgun wedding of Credit Suisse and UBS and volatile trading in Deutsche Bank.

In the near term at least, we believe investors should exercise caution and favour higher-quality credits. At the same time, a greater dispersion of returns in this new era should create opportunities to outperform through fundamental analysis, security selection and robust portfolio construction.

In this article, we focus on the latter. We will explain how portfolio construction techniques are employed across our global investment-grade strategies and how our approach prioritises downside protection. This is critical, given the asymmetric nature of the asset class. Gains from credit exposure typically build gradually over time, but drawdowns can be aggressive and spread blowouts relatively sudden.

Figure 1: Drawdowns for Bloomberg Fixed Income Index

Source: Aviva Investors, Bloomberg. Data as of December 31, 2022

We believe disciplined portfolio construction can also provide an independent source of alpha, uncorrelated to market returns, leading to more consistent outperformance through the cycle as well as better downside protection.

In this new, more volatile environment, downside protection is more essential than ever. Like a good boxer, it is important to keep your guard up and be selective with your punches.

Beta biases, benchmarks and our sector approach

Three core investment beliefs influence how we construct portfolios: avoiding a beta bias, portfolio optimisation and an alternative approach to allocating risk.

Avoiding a beta bias

Positioning across many investment-grade strategies is too often reliant on beta, the direction of the overall market, rather than alpha, the excess return achieved over the relevant benchmark.

During the post-global financial crisis years, low rates and low dispersion of returns encouraged a hunt for yield, with investors able to rely on the central bank backstop when markets stuttered and take a buy-the-dips approach. However, such approaches leave portfolios vulnerable to periods of market stress when BB and BBB-rated issuers generally underperform higher-quality names.

Behavioural biases may explain why investors chase beta. Our research has revealed it is unusual for credit analysts to recommend an investment idea where the issuer trades at a narrower spread than other issuers in the wider sector.2 Instead, recommendations are invariably driven by an analyst’s expectation the issuer’s spread will compress relative to the sector.

This can lead analysts to favour lower-quality BBB-rated issuers or even off-benchmark BB-rated issuers (which probably accounts for the high BB exposure among many purportedly investment-grade funds within our fund’s universe — see Figure 2). Beta-led approaches may struggle in more volatile conditions when individual returns are more dispersed and aggressive movements in spreads are more common.

Our global investment-grade strategies do not typically look to generate outperformance from beta or duration positioning — we maintain a stable beta in line with the benchmark while typically managing duration at +/- 0.5 years versus the benchmark.

Furthermore, we have a limited allocation to high yield (up to five per cent of the global investment-grade portfolio), in contrast to others in our peer group. It is important for clients to have transparency on what a strategy invests in. Just as a flyweight boxer would never be matched to fight against a heavyweight, an investment-grade strategy should be exactly that and behave accordingly. 

Figure 2: BB exposure in GIG peer group (per cent)

Source: Aviva Investors, March 2023

We see this as a building-block approach. There may be complementary characteristics of a high-beta strategy that, when combined with our investment-grade strategy, can potentially provide positive and uncorrelated outcomes for clients.

Portfolio optimisation

The aim of our portfolio optimisation process is to maximise the expected excess return of our portfolios while maintaining the same level of volatility as the investment-grade benchmark.

Step one is to define the universe. The investment-grade universe is made up of around 15,000 securities and 2,000 issuers. No-one can have a view on every bond: you must bucket sectors to help risk allocation. The typical approach is to bucket the index using broad industry sectors, credit ratings and maturity buckets. This makes no allowance for the different risk and volatility characteristics of the securities over time and how they behave in different scenarios.

We go one step further. Using over 20 years of historic data, we have re-defined sectors of the credit universe to more effectively isolate securities into categories with similar risk and volatility characteristics, as depicted in Figure 3.

Figure 3: Our custom sector approach

Our custom sector approach

For illustrative purposes only.
Source: Aviva Investors, March 2023

Step two is to calculate the return expectation of each customised sector using yields as a broad measure of the annual return expectation. We overlay this with our own forecast for spreads, tilting the portfolio to sectors we like from a fundamental perspective.

Carry is an underappreciated driver of returns, but it matters where you own it

The carry element of the return – the regular income provided by the coupon – is crucial. It is difficult for portfolio managers to have a consistently strong view on the direction of bond markets. If you base your excess return on trying to predict the direction of spreads, you can fall into the beta traps mentioned above.

Carry is an underappreciated driver of returns, but it matters where you own it. Typically, it is more efficient to own riskier carry at the front end of the curve and higher-quality carry at the long end. History has shown this is the most efficient way to reduce volatility in the portfolio without giving up expected returns.

Now you have the expected return profiles and volatility characteristics of the universe, you can run an optimisation to maximise the expected return for a volatility equal to the benchmark. With the custom sectors as a guide, the output suggests where the most efficient areas are to allocate risk to outperform, as Figure 4 demonstrates.

Figure 4: Looking for optimal carry on the yield curve (basis points)

Note: The names shown are for informational purposes only as an example to show the research process for Aviva Investors. This is not an offer to sell, nor a solicitation to buy, securities.
Source: Bloomberg. Data as of December 31, 2022

Experience suggests isolating this strategy as an alpha source can deliver 30 basis points of excess returns through the cycle. It also provides an excellent tool for discussion with our global credit analysts and helps alleviate behavioural biases. In practice, it means the riskiest ideas compete with one another and higher-quality ideas compete for inclusion in the portfolio. It also means portfolio managers and portfolio construction specialists adhere to a structural allocation of risk that does not allow us just to be long beta.

Portfolio construction should drive about one third of a strategy’s alpha

We complement our portfolio construction process with high-conviction stock selection, underpinned by fundamental credit research.  Our team of global analysts are aligned to our customised sector framework and tasked with populating these sectors with their best ideas. This leads to fewer holdings, less turnover and lower correlation with our peers.

In our view, portfolio construction should drive about one third of a strategy’s alpha and security selection. Our portfolio construction process gives portfolio managers a more thoughtful way to harness the ideas from our credit analysts.

The investment-grade benchmark is not the most efficient allocation of risk

Our benchmark, the widely used Bloomberg Global Aggregate Corporates Index, does not capture risk efficiently. In our view, it should be possible to deliver higher returns for the same level of volatility or the same return for a lower level of volatility.

This can be achieved by exploiting carry and roll. These are the main drivers of credit returns, but their importance is often overlooked by beta-driven investors more focused on the direction of spreads. As an aside, we would rather leave spread forecasting to others; we do not profess to have any additional insight and believe it is difficult, if not impossible, to predict the next economic downturn or recession and therefore when spreads may widen.

Roll is the capital gain generated by the natural fall in a bond’s yield as it approaches maturity

Many experienced investors will be familiar with the term carry. Fewer are familiar with roll. This is the capital gain generated by the natural fall in a bond’s yield as it approaches maturity — the bond “rolls” down the yield curve. For example, roll accrues when, as time passes, a three-year bond becomes a two-year bond, leading to a lower yield (and higher price) that reflects the reduced term risk.

However, successful credit investing is not as simple as just picking up carry and roll indiscriminately. Where on the yield curve a manager obtains that carry and roll is crucial. For instance, when yield curves are flat, as they are today, an investor can buy a two-year bond yielding five per cent and a 30-year bond yielding the same. Clearly, the latter exposes the bondholder to materially more duration risk without additional compensation. Yield curve positioning matters.

In essence, we seek to earn excess carry from riskier lower-quality issuers (e.g., BBB-rated) at the short end of the curve while allocating to more defensive sectors and higher-quality issuers at the long end. We believe the asset class’s historic performance has shown this represents the most efficient method of reducing volatility without sacrificing returns.

This approach, with its limited spread duration, provides downside protection during periods of widening credit spreads and market stress, while the excess carry we collect at the front end of the curve ensures we typically at least keep pace with the index if not outperform it.

Allocating risk based on traditional sectors is inefficient

When allocating risk, we believe it is more relevant to focus on a bond’s beta and volatility than on which sector it sits in. However, index providers group issuers based on their business activity rather than the investment characteristics of their bonds.

This leads investors to compare bonds and issuers with very different qualities just because they are in the same sector. Consequently, simply choosing a preferred credit within that sector may not lead to the most desirable risk-adjusted investment outcome, as shown in Figure 5.

Figure 5: Structural allocation of risk (basis points)

Note: The names shown are for informational purposes only as an example to show the research process for Aviva Investors. This is not an offer to sell, nor a solicitation to buy, securities.
Source: Aviva Investors, Bloomberg. Data as of December 31, 2022

For that reason, we have developed customised sectors to compare credits based on their fundamentals, not their industry category. Our approach to sector classification, employed since we launched the strategy two decades ago, enables us to slice and dice the index in a far more efficient and meaningful way.

A dedicated credit analyst is assigned to each customised sector and identifies the best opportunities for consideration. Having dedicated sector specialists located in the same regions as the credits they cover facilitates better one-on-one company access and engagement. Furthermore, collaboration with our equity, environmental, social and governance, liability-driven investment, high-yield and buy-and-maintain credit teams provides more enriched, longer-term company and sector outlooks.

Summary and key takeaways

Rather than being afraid of changing market regimes, we seek to build a portfolio with the efficiency and resilience to cope with varying outcomes. Portfolio construction is an invaluable tool in preparing for such uncertainty.

For investors unaccustomed to high interest rates and inflation, the potential to receive a knockout blow has risen sharply. However, by placing downside protection at the heart of our portfolio construction process, we believe our strategy is well-placed to go the distance.

  • The asymmetric nature of credit as an asset class means spread-widening events can undermine long-term portfolio performance
  • In more challenging market regimes, credit investors should be wary of beta-led approaches and focus on strategies designed for all weathers
  • Our robust portfolio construction process has historically delivered downside protection in tougher market conditions

Key risks

Past performance is not a guide to future performance. 

Investment risk

The value of an investment and any income from it can go down as well as up. Investors may not get back the original amount invested.

Credit risk

Bond values are affected by changes in interest rates and the bond issuer's creditworthiness. Bonds that offer the potential for a higher income typically have a greater risk of default.


  1. “Higher for longer: A new era for fixed income” Aviva Investors, January 26, 2023
  2. We conducted a study to evaluate every investment grade corporate bond recommendation from five publishing sell-side research departments. In the investment grade credit universe, there are roughly 700 BBB rated issuers and 400 issuers rated A and above. In our study, we captured the “outperform”, “market perform” and “underperform” recommendations across each rating category published: AAA and AA; A; and BBB. This data suggests the number of outperform recommendations for BBB bonds is six times higher than the number of outperform recommendations for A bonds.

Related views

Important information


Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

Where relevant, information on our approach to the sustainability aspects of the strategy and the Sustainable Finance disclosure regulation (SFDR) including policies and procedures can be found on the following link: https://www.avivainvestors.com/en-gb/capabilities/sustainable-finance-disclosure-regulation/

In Europe this document is issued by Aviva Investors Luxembourg S.A. Registered Office: 2 rue du Fort Bourbon, 1st Floor, 1249 Luxembourg. Supervised by Commission de Surveillance du Secteur Financier. An Aviva company. In the UK this is issued by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: 80 Fenchurch Street, London, EC3M 4AE. Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.