High Yield Corporate Bond Portfolio Optimization

Abstract: The fixed maturity, cash flow and risk characteristics of high-yield corporate bonds distinguish them from equities and complicate a direct application of well established optimization techniques such as Markowitz's mean-variance model and Sharpe ratio maximization. This can partly explain why qualitative methods constitute the dominant design in the portfolio selection process of high-yield corporate bonds. This thesis attempts to employ elements from Markowitz's theories and combine them with optimization- as well as financial theory in order to develop a quantitative optimization model. In addition, we examine the possibilities for a shift in the existing dominant design. A risk-neutral pricing model were used to estimate default probabilities of high yield corporate bonds. To approximate the covariance matrix, a new application of the single-index method were proposed. The derived optimization models produced results that coincide with financial theory regarding risk, return and diversification. Furthermore, an examination of a potential shift in the current dominant design suggests that a shift is not likely to occur in the near future. A reoccurring remark in this thesis is the importance to understand the underlying assumptions behind any quantitative model, suggesting that quantitative models can merely be used as a tool in combination with a human judgement.