Many factors can explain return attribution differences in credit portfolio returns —duration, interest rate positioning and, most importantly, sector allocation and security selection. Solid bottom-up fundamental credit research is certainly a cornerstone of any successful corporate bond management strategy, as most managers generate a majority of their excess returns through sector allocation and security selection. But what if we told you that effective portfolio construction is an inexpensive alpha source that can allow a credit manager the opportunity to build portfolios around their best ideas while also producing consistent and uncorrelated excess returns in both bull and bear credit markets?

We believe most corporate credit investment managers don’t place enough weight on the importance of portfolio construction. Moreover, many investors in the corporate credit market do not fully understand why portfolio construction is so important or what implications effective or ineffective portfolio construction can bring to their overall returns.

In this paper, we explain why investors should look more closely at the portfolio construction process when considering and evaluating corporate credit managers. We will focus this discussion on three primary themes to our thesis.

  •  Credit investors may be exposed to downside risk when behavioral biases lead credit managers to overweight portfolios to more risky corporate issues and produce higher portfolio betas than benchmarks.
  • We feel tracking error is a useful but misunderstood risk metric; credit managers should be aware of portfolio tracking error but also beware of its limitations.
  • Outperformance in up and down bond markets is achievable when effective portfolio construction can uncover sources of alpha.