What process do skilled managers use for credit selection in corporate bonds?

Question

AcadiFi · Accepted Answer

Skilled credit selection combines fundamental analysis, relative value frameworks, and structural analysis to identify mispriced bonds within rating cohorts.

Systematic credit selection process:

1. Screening & Idea Generation
- Spread-to-fundamentals screens (bonds trading wide of fundamentals)
- Rating-adjusted spread rankings
- Event catalysts (M&A, divestitures, management changes)
- Technical triggers (indexed selling, rating-downgrade forced selling)

2. Fundamental Credit Analysis
- 3-statement financial modeling (5-year forecast)
- Cash flow quality (cash conversion, working capital discipline)
- Liquidity analysis (credit facilities, maturity schedule)
- Covenant review (financial maintenance covenants, incurrence tests)
- ESG integration (governance risks, transition exposure)

3. Structural Analysis
- Priority of claims (senior vs subordinated, secured vs unsecured)
- Call/make-whole features
- Change-of-control puts
- Negative covenants (restricted payments, debt incurrence limits)
- Cross-default and cross-acceleration

4. Relative Value
- Spread curve analysis (bond vs issuer curve)
- Peer-group comparisons
- CDS-cash basis (basis opportunities)
- Capital structure arbitrage (bonds vs loans vs equity)

```mermaid
flowchart TD
    A[Idea Generation] --> B[Fundamental Analysis]
    B --> C[Structural Review]
    C --> D[Relative Value]
    D --> E[Position Sizing]
    E --> F[Monitor & Exit]
    F --> A
```

5. Position Sizing & Risk Management
- Conviction-weighted sizing (high-conviction 2-3%, standard 0.5-1%)
- Diversification by issuer, sector, maturity
- Stress testing individual positions
- Correlation awareness (sector clustering risk)

6. Ongoing Monitoring
- Quarterly earnings reviews
- Rating agency actions
- News flow alerts
- Spread trigger alerts for exit

Institutional best practices:
- Analyst coverage: each analyst covers 30-50 names deeply
- Credit committee governance for large positions
- Documented investment theses with target/stop levels
- Post-trade reviews to learn from outcomes

Alpha sources that persist:
- Complex capital structures requiring deep legal analysis
- Smaller issuers under-covered by sell-side
- Sector specialization (pharma, energy requires expertise)
- Distressed and special situations
- Primary market allocations from strong dealer relationships

Alpha sources that erode:
- Pure ratings arbitrage (efficient)
- Simple duration timing
- Momentum strategies in liquid sectors

Information ratio benchmarks: top-quartile active corporate bond managers achieve IR 0.5-1.0; median achieves 0-0.3. Selection-driven alpha (as opposed to beta loadings) above 50bps with controlled TE demonstrates genuine skill. Consistency across market regimes (risk-on AND risk-off) separates skill from luck.

What process do skilled managers use for credit selection in corporate bonds?

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