Using Derivatives for Risk Management in High-Yield Bond Portfolios

Johnathon is a portfolio manager for a large institutional investor. He has been tasked with managing a portfolio that includes a significant allocation to high-yield bonds. Recently, the volatility in the credit markets has increased due to rising interest rates and economic uncertainty, raising concerns about potential defaults in his bond holdings.

In response to this risk, Johnathon considers using derivatives as a method for hedging his portfolio against potential credit and interest rate risks. Specifically, he is looking at credit default swaps (CDS) to manage credit risk and interest rate swaps to fix the cost of borrowing.

In an essay, discuss how Johnathon can effectively use derivatives to manage the risks associated with his high-yield bond portfolio, highlighting the roles of credit default swaps and interest rate swaps. Include the advantages and potential pitfalls of using these derivatives as a risk management tool.