Sufficient Diversification in Credit Portfolios

How much diversification is required in an investment-grade credit portfolio to achieve a desired level of risk relative to a broad credit benchmark? Two approaches to optimal portfolio structuring address this fundamental question from different viewpoints. The first seeks to minimize the risk of underperforming a benchmark because of idiosyncratic credit events; the second explores the diversification levels that maximize the information ratio (risk-adjusted outperformance of the benchmark). This study focuses on the impact of rating downgrades on security returns relative to peer groups. Data on the Lehman Brothers Credit Index as well as transition probabilities published by the rating agencies underlie a methodology for estimating portfolio downgrade risk and the optimal diversification levels. Simple models of the value of credit research help the reader analyze the trade-off between increased diversification and diminished performance.