How do I isolate credit spread effect in fixed income attribution?

Question

AcadiFi · Accepted Answer

Spread effect captures return from active credit allocation — overweighting sectors where spreads tightened (or underweighting where they widened) relative to risk-free benchmarks.

Sapphire Credit Fund spread effect:
- Active weight in BBB corporates: +15%
- Spread duration of BBB sector: 6.5 years
- BBB spread change: -35 bps (tightened)
- Spread effect = Active Weight x Spread Duration x -(Spread Change)
- Spread effect = 15% x 6.5 x -(-0.35%) = 15% x 6.5 x 0.35% = +34.1 bps

Treasury underweight contributes zero spread effect (Treasury spread by definition is ~0), though it does contribute to duration effect if durations differ.

Spread duration vs modified duration distinction:
- Modified duration: sensitivity to overall yield change
- Spread duration: sensitivity to spread change only (treasury yield held constant)
- For investment-grade corporates, they're similar but not identical
- For floaters or very short-duration instruments, spread duration can be materially different

```mermaid
flowchart TD
    A[OW BBB +15%] --> B[Spread Dur 6.5]
    C[Spread -35bps] --> D[Tighten]
    B --> E[Spread Effect]
    D --> E
    E --> F[+34.1bps]
```

Sector-level attribution refinements:
- Break down BBB into industries (industrials, financials, utilities)
- Sub-divide by maturity buckets
- Separate CDX index hedges from cash positions
- Account for off-the-run Treasury spreads (swap spreads)

Caveats:
- Assumes spread duration stable through the attribution period (approximation)
- Ignores second-order effects from option-adjusted durations on callable bonds
- Default events cause discontinuous jumps not captured by spread duration
- Transition risk: BBB→BB migration shifts spread duration basis

Manager skill: consistent positive spread effect during tightening cycles signals credit expertise; negative effect during widening cycles (via underweights) also demonstrates skill. Random spread performance suggests lucky positioning.

Sapphire's +34bps spread alpha, combined with other attribution components, contributes to the total active return story — critical for institutional mandate reporting and performance fee calculations.

How do I isolate credit spread effect in fixed income attribution?

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