Adjusting for Risk Effects in Fixed Income Portfolios

Default and term structure risk are key drivers of fixed income performance. Ignoring this information when comparing investment strategies can be misleading. This study proposes an algorithm derived from mimicking factor portfolios to neutralize risk differences, thereby distinguishing selection from market timing. For a well-diversified portfolio, this method allows for simultaneous management of multiple risk dimensions, ensuring the final portfolio remains investable. The algorithm can be modified in such a way as to guarantee positive weights, thus offering greater flexibility compared with conventional methods. We apply it to credit sector portfolios to neutralize discrepancies in duration times spread (DTS) and find notable differences between risk-adjusted and unadjusted performance.