How to effectively develop credit options
The implementation of the desmoothing methodology increases portfolio risk. We already mentioned that there is a permanent and relatively stable component in bond (index) returns resulting from interest accrual, roll down and yield-curve effects. Therefore we apply the desmoothing technique only to the series of monthly changes in the price indices, and afterwards add the other three components to derive the adjusted return series.
It can be stated that the higher the degree of first-order serial correlation in monthly changes of the price indices the more portfolio risk surges. Our study shows that the high-yield sector is most exposed to this effect. Interestingly though, in mean–variance space the risk/return profile of government bonds is dominated by mortgage-backed securities and agencies before as well as after adjustment for serial correlation. That said, it is no surprise that government bonds do not receive a significant weighting in any of the optimal portfolios.
For the sample period the first-order serial correlation coefficient for the Merrill Lynch US High Yield Index is 0.26. Brown (1985) notes that 0.25 represents the upper bound for the serial correlation that may be introduced by a valuation process characterized by nonsynchronous trading. Even after considering the effect of relatively stable components in index returns such as interest accrual, roll down and yield-curve effects it can be claimed that the US high-yield market suffers seriously from illiquidity. The desmoothing process described above increases the volatility of the high-yield index by considerable 63 bp per month.
