Credit Risk Management Strategies in Bond Portfolios

Very Hard Risk Management Applications Credit Risk Management

A portfolio manager is assessing the credit risk associated with a corporate bond. Unexpectedly, the credit rating of the bond issuer has been downgraded from 'A' to 'BB', indicating significant deterioration in creditworthiness. The portfolio manager must decide how to manage this increased risk within the portfolio.

The portfolio consists of various assets including corporate bonds, government securities, and equities. The credit spread has widened after the downgrade, signaling increased market perceptions of default risk. Using the modified duration of the bond along with current market data and the manager's investment horizon, the manager considers potential actions to mitigate the credit risk.

Which of the following strategies should the portfolio manager consider to effectively manage the credit risk associated with this downgraded bond?

Increase the weighting of high-yield bonds in the portfolio to capture higher returns.

Implement a credit default swap (CDS) on the downgraded bond to hedge against potential default risk.

Sell the downgraded bond and reinvest in government securities to eliminate credit exposure.

Hint

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