How do I build a duration-neutral fixed income portfolio while taking credit bets?

Question

AcadiFi · Accepted Answer

Duration-neutral construction: size long and short positions so their dollar durations cancel. Net portfolio DV01 = 0, isolating spread/credit exposure.

Formula: N_short = (DV01_long / DV01_short) × N_long, where DV01 is per $1 notional.

Example: Oravine Credit Fund wants a pair trade: long High-Yield Index ETF (HYG), short Investment-Grade Index ETF (LQD).

HYG: duration 3.2, price 78, so DV01 per $1M = $250. Target long $100M.
LQD: duration 8.4, price 105, DV01 per $1M = $840.

Long HYG position DV01: $100M × $250/$1M = $25,000.
To offset, short LQD: $25,000 / $840 × $1M = $29.76M short.

Portfolio characteristics:
- Net duration: 0 (duration-neutral)
- Net DTS (duration-times-spread): long 3.2 × 380bp = 1,216 bp-years; short 8.4 × 110bp = 924 bp-years. Net DTS +292 — still positive spread exposure.
- Credit beta: +0.8 to HY index, -0.4 to IG index. Spread-positive.
- Carry: HYG yields 7.2%, LQD yields 5.1%. Long carry 7.2% × $100M = $7.2M; short cost 5.1% × $29.76M = $1.52M. Net carry $5.68M/yr on ~$100M gross exposure = 5.7% carry.

When HY spreads tighten relative to IG (classic risk-on), HYG outperforms LQD with near-zero rate-exposure impact — trade profits.

Risks: (1) duration estimates change as rates move — rebalance monthly; (2) credit beta mismatch if HY rallies more than IG in normal regime; (3) convexity differences; (4) liquidity: LQD has tight spread but short requires stock borrow cost (~40bp in current market). Oravine manages these with monthly duration-neutral rebalancing.

How do I build a duration-neutral fixed income portfolio while taking credit bets?

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