“Street-Smart” Optimization: A Pragmatic Approach to Corporate Bond Position Weightings

Despite advances in quantitative optimization techniques, their application to corporate bonds continues to be hindered by intractable liquidity issues, particularly for the high yield sector. As a result, security selection and position weightings often reflect a more qualitative, and therefore <italic>idiosyncratic</italic>, process which may have implications for portfolio <italic>diversification</italic>. We develop a conceptual framework to evaluate the risk/return trade-off inherent with such “ad hoc overweights,” as a function of the number of additional positions required to replicate the volatility of an equally-weighted reference portfolio. We then apply various model-derived weightings patterns to historical returns to assess under what conditions the sizing dispersion observed in typical bond portfolios might be expected to enhance performance over a simpler 1/N approach.