Use Bloomberg Credit Futures in Credit Portfolio Risk Management

Bloomberg Credit futures can be used to manage the two primary risks that holders of corporate bonds face: interest rate risk and credit risk. Interest rate risk refers to the change in price a bond experiences when its yield rises or falls because of changing risk-free interest rates. Credit risk refers to the risk that a bond issuer defaults on its agreement to repay its bond holders.

U.S. Treasury securities are considered to be free of credit risk and are therefore a proxy for risk-free interest rate exposure. All other forms of debt – including corporate bonds – are priced based on credit risk as well as interest rate risk. The difference between the yield of a corporate bond and the yield of an on-the-run Treasury of similar maturity is one popular measure of credit spread, and this metric is used to gauge credit risk above the risk-free Treasury rate. 

Modified Duration and Spread Duration measure a bond’s sensitivity to interest rate changes and credit spread changes, respectively. While these two duration measures provide a good measure of sensitivity, it is helpful to express them in dollar terms. The dollar value of one basis point change in risk-free rates (DV01) measures the change in bond price given one basis point change in interest rates. Its formula is:

Cash Bond Position DV01 = Modified Duration × Price × 0.0001

The dollar value of one basis point change in credit spread (CR01) measures the change in bond price given one basis point change in credit spread:

Cash Bond Position CR01 = Spread Duration × Price × 0.0001

Bloomberg U.S. Corporate Investment Grade Index futures (Globex/Bloomberg Terminal Code: IQB) and Bloomberg U.S. Corporate Investment Grade Duration-Hedged Index (Globex/Bloomberg Terminal Code: DHB) futures help bond holders manage these risks. The two futures reference the same corporate bond index – the Bloomberg U.S. Corporate Investment Grade Index – which is a large and well-established index that measures U.S. dollar-denominated investment grade, fixed-rate and taxable corporate bond issues. While IQB directly references this index, DHB references a duration-hedged variant of this index. 

In addition to the corporate bond component, the underlying index for the DHB futures (Bloomberg U.S. Corporate Investment Grade Duration Hedged Index) also includes an index of notional short U.S. Treasury futures positions across the curve (2-Year, 5-Year, 10-Year, 30-Year and Ultra Bond futures are used). These short positions remove the interest rate risk from the broader corporate bond index. The resulting index effectively isolates only the credit risk component of the corporate bond index.

After adjusting for optionality (a significant portion of the bonds in the index are callable under a certain set of criteria laid out by the issuer), Bloomberg Index Services calculates the following risk statistics for the Bloomberg U.S. Corporate Investment Grade Index that are relevant to this article:

• Index Options-Adjusted Duration (OAD)

  • This is found via Bloomberg Terminal code BX215. It measures index’s sensitivity to interest rates.  

• Index Options-Adjusted Spread (OAS)

  • This is found via Bloomberg Terminal code BX213. It expresses the index’s credit spread over the Treasury curve. 

• Index Options-Adjusted Spread Duration (OASD)

  • This is found via Bloomberg Terminal code DU355. It measures the index’s sensitivity to changes in the OAS. 

Note that these metrics are all calculated for the Bloomberg U.S. Corporate Investment Grade Index that IQB futures are based on. Since the Bloomberg U.S. Corporate Investment Grade Duration Hedged Index (the underlying index for DHB futures) is constructed by removing Treasury duration from the corporate bond index, it is designed to have an OAD of zero. 

Figure 3 below shows the relationship between the Investment Grade Index value and its OAD. These two data metrics move relatively in line with one another; this is expected as both bond prices and bond duration increase as interest rates (or interest rate expectations) fall.

Figure 4 below shows the relationship between the Duration Hedged Index value and the Investment Grade Index’s OAS. As the OAS tightens – that is, as the credit spread becomes smaller – the Duration Hedged Index value increases. This behavior is expected as a tighter credit spread typically represents a more expensive corporate bond market, which in turn is reflected by a more expensive Duration Hedged Index value.

Let’s assume that a credit portfolio manager has a hypothetical investment grade corporate credit position valued at $18 million with an OAD of 6.50. As mentioned previously, there are two primary risks to this position: interest rate risk and credit risk. 

Interest rate risk can be managed by applying dollar duration concepts to both the $18mm portfolio position and Bloomberg Credit futures. Matching the bond DV01 and the futures DV01 is the key to finding a hedge ratio between a cash and futures position. In this case, the portfolio manager is looking to manage interest rate risk, so the relevant metric is modified duration and the relevant futures contract is IQB because its underlying index includes an interest rate component. Note that DV01 measures the sensitivity of the instrument to a one basis point change in interest rates. Recall the bond DV01 formula:

Portfolio DV01 = Modified Duration × Price × 0.0001

Calculating the DV01 of the futures requires two additional inputs: the futures index value and the contract multiplier:  

Futures DV01 = Index OAD × Futures Index Value × Contract Multiplier × 0.0001

Since the bond portfolio position has an OAD of 6.50, its DV01 can be calculated:

Portfolio DV01 = $11,700 = 6.50 × $18,000,000 × 0.0001

The OAD of the futures position can be derived from its underlying index. On August 6, 2024, the OAD of the Bloomberg U.S. Corporate Investment Grade Index was 7.06 and its index value was 3,296.61. Its contract multiplier is a constant $30: 

IQB Futures DV01 = $69.82 = 7.06 × 3,296.61 × $30 × 0.0001

We can now say that for each change of 1 basis point in yield, the bond portfolio will change by $11,700 and IQB futures will change by $70.44. The final step is simply finding how many IQB contracts to purchase for the hedge ratio

Hedge Ratio = 167.57 IQB contracts = $11,700 / $69.82

The hedge ratio is 168 IQB contracts after rounding for this trade. This hedges the corporate bond portfolio from both interest rate risk and credit risk, regardless of whether the change in yields stems from a change in risk-free rates or credit spreads. This is because the IQB contract is exposed to both risks, as is the underlying corporate bond portfolio.

Now, suppose that the portfolio manager only wants to hedge the credit risk exposure in their portfolio, but not the interest rate risk exposure. Hedging credit risk uses similar logic, with two important distinctions: instead of using OAD to calculate the DV01 of the cash bond and futures positions, OASD is used to calculate the CR01 of these positions. In addition, DHB futures are used instead of IQB futures. Both inputs are used because we are looking for a credit-sensitive instrument to use to hedge credit risk. 

Assuming the bond portfolio position has an OASD of 6.00, its CR01 can be calculated:

Portfolio CR01 = $10,800 = 6.00 × $18,000,000 × 0.0001

The OASD of the futures position can be derived from its underlying index. On August 6, 2024, the OASD of the Bloomberg U.S. Corporate Investment Grade Duration Hedged Index was 7.07 and its index value was 197.7750. Its contract multiplier is a constant $500: 

DHB Futures CR01 = $69.91 = 7.07 × 197.7750 × $500 × 0.0001

We can now say that for each change of 1 basis point in credit spread, the bond portfolio will change by $10,800 and DHB futures will change by $67.24. The final step is simply finding how many DHB contracts to purchase for the hedge ratio

Hedge Ratio = 154.48 DHB contracts = $10,800 / $69.91

The hedge ratio is 154 DHB contracts after rounding for this trade. 

Bloomberg Credit futures offer market participants the ability to manage their exposure to both credit and interest rate risk. Full details on these products can be found via the CME Group website.