Interest rate swaps & credit default swaps in active bond funds

CFA Level II Fixed Income
#1

Hi there,

I am struggling to apply theory to practice when it comes to swaps in active bond management. I am wanting to invest in a active bond manager (I am someone who learns better ‘doing’ rather than just reading scenarios in textbooks!) & have been looking at what securities they employ & I just have a few questions as to how/why they use swaps.

1 - Interest rate swaps: how can they help a manager reduce their credit risk? I understand the benefits for interest duration ie a manager can increase the portfolio’s duration by entering into a interest rate swap (receiving floating & paying fixed). but could someone give me an example of how they would reduce credit duration.

2 - And if a manager does want to reduce credit risk, when do they choose between an interest rate swap and a credit default swap? I feel like it would have someone thing to do with duration ie credit default swaps allow a manager to alter credit duration whilst using little interest duration? Is that the reason?

Many thanks

#2

When a PM chooses to reduce overall credit risk without selling any cash bonds he typically buys protection on Index CDS like Itraxx or CDX. If he wishes to reduce credit risk on a particular credit, he buys protection on a single name CDS of that particular credit (if available)

#3

I don’t see how interest rate swaps can reduce credit risk; if anything, they add credit (i.e., counterparty) risk.

1 Like
#4

Actually they convert market risks into credit (i.e. counterparty) risk.