The Risk Parity Principle Applied to a Corporate Bond Index

Abstract

This article applies the principle of risk parity to a corporate bond index, an asset class so far left behind in this literature. Specifically, the author relies on the Duration Times Spread (DTS), a coherent metric for bond credit risk. She constructs indexes based on sector, issuer, and bond level, using structured block correlation matrixes, weights being inversely proportional to DTS. The results provide evidence that applying an Equal Risk Contribution (ERC) principle using DTS in the index design significantly improves corporate bond index risk-adjusted returns. It appears that the higher the granularity, the higher the risk-adjusted performance enhancements will be. More generally, the ERC application presented here seems to be a valuable tradeoff between heuristic and more complex risk-modeling based weighting schemes.