Credit and securitized strategies - Sector rotation and secu...

Learning Outcomes

This article explains sector rotation and security selection in credit and securitized strategies, including:

• How macroeconomic conditions, the business and credit cycles, and spread dynamics drive relative performance across credit sectors and securitized segments
• How to evaluate relative value across sectors using OAS, spread duration, expected loss, and fundamental and technical trends, and to recognize when valuations are misaligned with risk
• How top-down and bottom-up security selection frameworks are applied to corporate and securitized instruments to express macro views and capture idiosyncratic alpha
• How sector tilts and bond picks are integrated into benchmark‑relative portfolio construction, risk budgeting, and tracking‑error management while respecting mandate constraints
• How to distinguish justified sector rotation from backward‑looking performance chasing and to identify when security selection should be the dominant source of active return
• How to compare corporate and securitized opportunities using structural protections, collateral quality, liquidity, and prepayment or extension risk
• How to articulate exam-quality recommendations that link sector and security decisions explicitly to the stated economic outlook, client objectives, and risk tolerance

CFA Level 3 Syllabus

For the CFA Level 3 exam, you are required to understand sector rotation and security selection within credit and securitized strategies, with a focus on the following syllabus points:

• Analysis of sector rotation techniques in credit and securitized markets
• Identification of macro, fundamental, and technical factors influencing credit sector out- or underperformance
• Criteria and methods for security selection in corporate and securitized credit portfolios
• Use of relative value, credit quality, liquidity, and macro factors in allocation decisions
• Risk considerations and implementation pitfalls for sector rotation and security selection
• Practical application of sector and security allocation within benchmark-relative portfolio construction

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. A manager believes the economy is moving from late expansion into slowdown. Which sector rotation is most consistent with this view?
   1. Overweight high yield and EM hard-currency debt, underweight investment-grade financials
   2. Overweight investment-grade corporates and agency MBS, underweight high yield and EM
   3. Overweight subordinated bank capital and CLO equity, underweight Treasuries
   4. Overweight cyclical equities, underweight long-duration government bonds
2. In which situation is bottom-up security selection most likely to be the primary source of added value, rather than sector rotation?
   1. Large, macro-driven dislocations between corporate and securitized spreads
   2. Early in recovery when all spreads are near historical wides
   3. Within a single sector where valuations are broadly in line but fundamental dispersion across issuers is high
   4. At the start of a recession when all credit spreads are widening rapidly
3. A manager compares the option-adjusted spread (OAS) of BBB industrial bonds with BB high yield bonds and finds only a small spread differential, despite higher expected loss for BBs. Which conclusion is most appropriate?
   1. BB bonds are cheap and should be overweighted
   2. BBB bonds are rich and should be underweighted in all portfolios
   3. BB bonds may be overvalued relative to BBBs on a risk-adjusted basis
   4. OAS cannot be used to compare bonds across ratings categories
4. Which statement best distinguishes top-down and bottom-up approaches in credit security selection?
   1. Top-down focuses on issuer covenants; bottom-up focuses on macro factors
   2. Top-down starts from macro and sector themes; bottom-up starts from issuer and bond fundamentals
   3. Top-down is passive; bottom-up is always highly active
   4. Top-down is used only for securitized credit; bottom-up is used only for corporate bonds

Introduction

Sector rotation and security selection are central levers for adding value in credit and securitized strategies. Sector rotation adjusts portfolio weights across credit sectors—such as investment-grade corporates, high yield, emerging market debt, and securitized credit—based on expected relative performance. Security selection then determines which specific bonds or tranches to own within those sectors.

Key Term: sector rotation
The process of shifting portfolio allocations purposefully between different credit or securitized sectors based on anticipated relative performance, usually linked to the business and credit cycles.

Key Term: security selection
The process of evaluating and choosing individual bonds or securitized assets to purchase or hold, aiming to outperform a benchmark or meet investment goals on a risk-adjusted basis.

Effective managers integrate both tools. They use a top-down view of the macro environment and the credit cycle to determine sector tilts, and a bottom-up assessment of issuer fundamentals, structures, and collateral to implement those tilts with attractive securities. Level 3 questions often test whether you can distinguish when the main value comes from sector rotation versus security selection, and whether proposed tilts are justified by forward-looking analysis rather than past performance.

SECTOR ROTATION IN CREDIT PORTFOLIOS

Sector rotation in credit portfolios involves reallocating assets between credit market sectors based on predicted changes in spreads, default risks, and broader market drivers such as interest rates, liquidity, and policy.

Key Term: credit cycle
The recurring pattern in credit conditions—spreads, default rates, and lending standards—typically linked to the business cycle, moving from early recovery to expansion, slowdown, and contraction.

During different phases of the business and credit cycles, the trade-off between spread income and default risk varies. Risky sectors such as high yield, emerging markets, and subordinated financials often outperform during the initial recovery and early expansion when growth is improving and default risk is falling. Defensive sectors such as high-quality investment-grade corporates, agency MBS, and government-related debt generally perform better in slowdowns and contractions when risk aversion rises and spreads widen.

Key Term: sector allocation
The assignment of specific portfolio weights to various credit or securitized sectors (e.g., IG credit, HY, EM, ABS, MBS, CMBS) to optimize expected return for a given level of risk or tracking error.

Business and Credit Cycle Context

Linking sector rotation to the cycle is exam-relevant. A stylized mapping is:

• Initial recovery / early expansion

  • Macro: Growth rebounds, policy remains accommodative, output gap still negative.
  • Credit: Default rates peak then start falling, spreads materially above long-run averages.
  • Rotation bias: Increase allocation to high yield, EM, subordinated and mezzanine tranches (e.g., CLO mezzanine), cyclically exposed corporates.

• Late expansion

  • Macro: Output gap closes, inflation and wages rise, policy turns restrictive.
  • Credit: Leverage builds, underwriting standards loosen, spreads often near tights.
  • Rotation bias: Gradually upgrade quality within credit sectors; reduce exposure to weakest issuers, longest spread duration, and most junior tranches.

• Slowdown

  • Macro: Growth slows, yield curve flattens or inverts, policy is tight or in transition.
  • Credit: Early spread widening, funding costs rise, idiosyncratic defaults increase.
  • Rotation bias: Tilt from high yield and EM toward investment-grade and high-quality securitized (especially agency MBS).

• Contraction / recession

  • Macro: Output and profits fall, policy eases aggressively, yield curve steepens.
  • Credit: Spreads wide, default rates rising, liquidity stress.
  • Rotation bias: Maintain or add to high-quality credit; avoid forced selling of risk assets. Prepare to rotate back into HY/EM/securitized mezzanine as signs of trough emerge and spreads compensate for expected losses.

This mapping is not mechanical; markets anticipate turning points. Level 3 items often require you to judge whether a proposed rotation is too early, too late, or appropriately timed given the described macro indicators.

Drivers of Sector Rotation

Key drivers include:

• Credit cycle phase
  Default expectations, rating momentum, and lending standards signal which sectors’ spreads are likely to tighten (outperform) or widen (underperform).

• Interest rate and yield curve movements
  Long-duration, high-quality sectors (e.g., long IG corporates, agency MBS) benefit when rates fall and curves steepen in contractions. Shorter-duration or floating-rate sectors (e.g., bank loans, some ABS) may be preferred in rising-rate phases.

• Monetary and fiscal policy shifts
  Quantitative easing or targeted asset purchase programs can directly support certain sectors (e.g., agency MBS, investment-grade corporates). Fiscal expansion can favor cyclically sensitive sectors.

• Market liquidity and technical factors
  New issuance, dealer balance sheet constraints, index inclusions/exclusions, and ETF flows can all distort sector spreads relative to fundamentals.

• Relative valuations
  Spreads relative to historical ranges and to expected loss and volatility. Extremely tight spreads in high yield with rising defaults may trigger rotation to IG or securitized senior tranches.

• Regulatory or structural events
  Changes in capital requirements, risk-based capital charges, or housing finance policy can alter demand for particular sectors (e.g., bank demand for HQLA / government bonds; insurance demand for long-duration IG credit and securitized).

Key Term: relative value analysis
The comparison of expected risk-adjusted returns across sectors or securities, typically using spreads, expected losses, volatility, and correlations, to identify over- and undervalued opportunities.

Spread-Based Sector Views

Sector rotation is often framed in terms of spread and spread sensitivity.

Key Term: credit spread
The excess yield of a credit instrument over a risk-free or benchmark security of comparable maturity, reflecting compensation for credit and liquidity risk and embedded options.

Key Term: spread duration
The sensitivity of a bond’s price to a 100 bps change in its credit spread, holding the benchmark yield curve constant.

Sectors with high average spread duration (e.g., long-maturity IG corporates, mezzanine tranches) are more exposed to spread widening in downturns, but benefit more from spread compression in recoveries. A manager expecting spreads to tighten will tilt toward sectors and securities with higher spread duration, provided default risk is contained.

Key Term: option-adjusted spread (OAS)
The constant spread added to a benchmark yield curve that equates the present value of a bond’s expected cash flows (after modeling embedded options and prepayments) to its market price.

Using OAS rather than nominal spread is critical for sectors with embedded optionality (callable corporates, MBS, ABS, CMBS, CLOs). Sector rotation decisions between, say, corporate credit and non-agency MBS should be based on a comparison of OAS and the associated prepayment and extension risks.

Worked Example 1.1

A portfolio manager expects an economic recovery to accelerate over the next year. Current spreads on high yield bonds are historically wide, while investment-grade corporates have already rallied. How might sector rotation be used in this scenario?

Answer:
The manager may overweight high yield relative to investment-grade bonds, anticipating spread compression and outperformance from riskier sectors as credit improves. Given the recovery view, she might favor BB-rated and strong single-B issuers with relatively low expected losses, and callable issues with high spread duration. She might fund this by reducing exposure to tight-spread IG sectors and some agency MBS. This rotation deliberately increases the portfolio’s sensitivity to the credit cycle while remaining within the client’s risk and tracking error limits.

Relative Value Across Credit and Securitized Sectors

Relative value assessment across corporates and securitized sectors typically involves:

• Comparing OAS levels across sectors adjusted for expected loss and volatility.
• Assessing expected loss:

Key Term: expected loss
The probability-weighted average credit loss over a horizon, commonly approximated as:

$$\text{Expected loss} = PD \times LGD \times EAD$$

where $PD$ is probability of default, $LGD$ is loss given default, and $EAD$ is exposure at default.

• Considering structural protections in securitized products (subordination, excess spread, triggers) versus seniority, security, and covenants in corporate bonds.
• Evaluating liquidity—for example, on-the-run IG corporates versus off-the-run ABS or CMBS—especially under stress.

In practice, managers often find securitized senior tranches attractive late in expansions or early in slowdowns: they may offer comparable OAS to corporates with lower expected loss because of credit enhancement, though with more complex prepayment and extension risks.

Exam Warning

A common exam error is failing to distinguish between justified sector tilts driven by forward-looking macro and credit-cycle analysis and those that simply chase the most recent outperforming sector. In constructed-response questions, explicitly link recommended rotations to leading indicators (credit spreads, lending standards, yield curve shape, policy stance), not just trailing returns.

SECURITY SELECTION IN CREDIT STRATEGIES

Security selection is the process of choosing specific issues within sectors to achieve portfolio goals and implement sector views efficiently.

Key Term: top-down approach
A process that starts from macro, policy, and sector themes, then identifies issuers and securities that best express those themes.

Key Term: bottom-up approach
A process that focuses primarily on individual issuer fundamentals and bond structures, with sector weights being the residual outcome of aggregating attractive securities.

In practice, skilled managers combine both approaches: a top-down allocation framework to set sector and quality tilts and a bottom-up process to select bonds with attractive idiosyncratic risk–return profiles.

Key Security Selection Criteria

Within any sector, key criteria include:

• Relative value

  • OAS versus peers with similar rating, maturity, and liquidity
  • OAS versus the issuer’s own curve (on-the-run vs off-the-run issues)
  • OAS versus expected loss and volatility

• Credit quality and rating trajectory

  • Balance sheet strength, leverage, coverage, free cash flow, asset quality
  • Business model stability and industry structure
  • Likelihood of upgrades/downgrades or fallen-angel risk

• Capital structure and security seniority

  • Secured vs unsecured, senior vs subordinated, structural subordination
  • Recovery expectations in default scenario

• Structural protections

  • Covenants protecting bondholders (limitations on additional debt, restricted payments, collateral release)
  • Change-of-control or step-up features

• Liquidity and market conditions

  • Issue size, age, bid–ask spreads, trading frequency
  • Likelihood of forced selling by benchmark-driven investors (e.g., post-downgrade)

• Event catalysts

  • M&A (leverage step-up risk), asset sales, regulatory changes
  • Potential buybacks or tenders improving bondholder position

• Issuer diversification role

  • Correlation with existing holdings and sector exposures
  • Contribution to issuer, industry, and risk-factor concentration limits

Worked Example 1.2

Suppose a credit manager is concerned about the potential for increased defaults in retail but notes that several retail companies have recently improved their balance sheets substantially. How might this affect security selection?

Answer:
The manager might underweight the retail sector at the sector level yet selectively buy bonds of specific retailers with strong cash flow, defensible brands, and conservative leverage. She may prefer senior secured or short-dated bonds of those issuers, while avoiding subordinated debt or long maturities that are more exposed to structural change and default risk. This is a bottom-up selection overlay on a cautious top-down sector stance, capturing idiosyncratic opportunities without reversing the overall defensive view on retail.

Expected Loss and Relative Value at the Bond Level

Using the expected loss framework:

• Two bonds with similar OAS but different expected losses are not equally attractive.
• A BBB bond with an OAS of 150 bps and low expected loss may be preferable to a BB bond with an OAS of 200 bps but materially higher expected loss, especially late in the cycle.
• Conversely, early in recovery, a BB bond offering 400 bps OAS with improving fundamentals may be superior if the extra spread more than compensates for expected loss and volatility.

This analysis often underpins exam answers where you must justify choosing one bond over another with similar yield or spread.

Security Selection in Securitized Credit

For securitized assets (MBS, ABS, CMBS, CLOs), security selection emphasizes:

• Collateral characteristics

  • Loan-to-value (LTV) ratios, borrower FICO scores or credit metrics
  • Debt-to-income ratios, documentation standards, and underwriting quality
  • Geographic and industry concentration, loan vintage, and seasoning

• Structure and credit enhancement

  • Subordination levels and tranche thickness
  • Excess spread, reserve accounts, and overcollateralization
  • Triggers that redirect cash flows when collateral performance deteriorates

Key Term: tranche
A specific slice or class of a structured security with its own credit enhancement level, cash flow priority, and risk–return profile (e.g., senior, mezzanine, equity).

• Prepayment and extension risk

  • For MBS and many ABS, borrower prepayments accelerate or decelerate with rates and housing/auto markets.
  • For CMBS and CLOs, extension risk may be more relevant: weaker collateral may refinance slowly, prolonging risk exposure.

• Option-adjusted analytics

  • OAS, option-adjusted duration, and convexity under various interest rate and prepayment scenarios.

• Servicer and manager quality

  • Track record in managing delinquencies, workouts, and recoveries.
  • For CLOs, quality of the collateral manager’s credit selection.

Careful tranche selection can provide exposure to a sector theme (e.g., housing recovery) while controlling tail risk. For example, a manager might prefer senior CMBS tranches with high credit enhancement over BBB industrial corporates when worried about corporate leverage but constructive on commercial real estate fundamentals.

Worked Example 1.3

A manager believes US housing fundamentals are stable, but the business cycle is in late expansion with rising rates and the potential for slowdown. She is comparing:

• A long-dated BBB corporate bond with 180 bps OAS, and
• A senior non-agency MBS tranche with 170 bps OAS, high credit enhancement, but meaningful extension risk.

Which is more appropriate?

Answer:
Late in the cycle, the manager should be cautious about corporate leverage and spread widening risk. The senior non-agency MBS tranche offers similar OAS with stronger structural protection and lower expected credit loss, though with prepayment/extension risk. Given stable housing fundamentals, the tranche may provide better downside protection in a slowdown. The manager may tilt towards the MBS tranche while shortening duration or pairing it with rate hedges to manage extension risk.

PORTFOLIO CONSTRUCTION AND RISK CONSIDERATIONS

Strategic decisions about how much to rely on sector rotation versus security selection depend on market structure, investor objectives, and benchmark constraints.

Key Term: tracking error
The standard deviation of active returns, i.e., the difference between portfolio and benchmark returns, measuring how much a portfolio’s performance is expected to deviate from its reference index.

A manager with a tight tracking-error budget (e.g., 50–75 bps) may:

• Keep sector weights close to benchmark, focusing on security selection within sectors.
• Use modest sector tilts expressed via liquid instruments (e.g., credit indices, CDX/iTraxx).

A manager with a larger risk budget can:

• Take more aggressive sector bets (over/underweight HY, EM, securitized vs corporate).
• Use security selection to control idiosyncratic risk within those sectors.

Key portfolio construction and risk issues include:

• Diversification and concentration limits

  • Set limits by sector, industry, rating bucket, region, and issuer to avoid concentration in correlated risk factors.
  • Within securitized, diversify by collateral type, vintage, servicer, and tranche level.

• Liquidity management

  • Recognize that many corporate issues and securitized tranches are illiquid and trade infrequently.
  • Avoid building large positions in thinly traded securities unless holding period and client liquidity needs allow.
  • Under stress, liquidity often evaporates first in subordinated tranches and high yield; sector rotation that increases illiquidity must be explicitly justified.

• Interest rate and spread risk

  • Align overall duration with benchmark or liability profile while expressing spread views via sector rotation and security selection.
  • Manage key rate durations and spread duration so that active credit views do not unintentionally introduce large unhedged rate bets.

• Alignment with mandate and stakeholders

  • Pension and insurance mandates often restrict below-investment-grade exposure or certain securitized types; sector rotation must respect these constraints.
  • Liability-driven investors may prioritize cash flow matching and surplus volatility over aggressive sector tilts.

• Ongoing monitoring and risk decomposition

  • Decompose active return into contributions from sector allocation, quality/yield-curve positioning, and security selection.
  • Monitor whether the portfolio is actually being rewarded for risks taken; if most active risk comes from sector bets that are not delivering, reallocate risk budget to security selection or vice versa.

Worked Example 1.4

A benchmark-aware manager with a 1.5% tracking error limit is considering:

• Overweighting high yield by 5% vs benchmark, funded from investment-grade corporates
• Remaining neutral on security selection within each sector (buying the index)

Given the tracking error constraint, is this an efficient use of risk?

Answer:
A 5% HY overweight is a large sector bet that could consume much of the 1.5% tracking error budget, especially in stressed markets. Because the manager is not exploiting idiosyncratic issuer mispricing, the expected information ratio from this bet alone may be modest. A more efficient approach might be a smaller HY overweight combined with active security selection (e.g., favoring higher-quality HY, avoiding downgrade candidates), spreading active risk across both sector and security selection. This aligns better with the constraint and improves diversification of active risk sources.

Revision Tip

Practice distinguishing whether outperformance in a case vignette is driven mainly by sector rotation (e.g., large HY/EM overweights timed around the cycle) or by security selection (e.g., avoiding downgrades, choosing better-structured tranches). In your answers, tie recommended actions back to client objectives, risk tolerance, and benchmark constraints.

Summary

Sector rotation and security selection are key tools in credit and securitized strategies. Sector rotation uses business- and credit-cycle analysis, spread and OAS measures, and technical factors to tilt between sectors such as IG corporates, high yield, EM debt, and securitized bonds. Security selection then identifies specific bonds and tranches with attractive risk-adjusted returns based on issuer fundamentals, structure, collateral quality, and expected loss.

In benchmark-relative portfolios, tracking error and risk budgets determine how aggressively managers can pursue sector tilts versus bond-level alpha. Effective portfolio construction diversifies active risk across sectors and securities, manages liquidity and spread duration, and ensures that active bets are consistent with client mandates and liability profiles. For Level 3, the emphasis is on synthesizing macro views with bond-level analysis, justifying tilts with forward-looking reasoning, and avoiding performance-chasing behavior.

Key Point Checklist

This article has covered the following key knowledge points:

• Define and differentiate sector rotation and security selection in credit and securitized strategies
• Link sector rotation decisions to the business and credit cycles and to spread and OAS dynamics
• Apply relative value and expected loss analysis when comparing credit sectors and specific bonds
• Distinguish top-down and bottom-up approaches and understand how they interact in practice
• Identify key security selection criteria for corporate and securitized instruments, including structures and collateral
• Integrate sector and security decisions into benchmark-relative portfolio construction and tracking error management
• Recognize liquidity, concentration, and implementation risks associated with active credit strategies
• Avoid exam traps of performance chasing and misattributing returns between sector rotation and security selection

Key Terms and Concepts

• sector rotation
• security selection
• credit cycle
• sector allocation
• relative value analysis
• credit spread
• spread duration
• option-adjusted spread (OAS)
• expected loss
• top-down approach
• bottom-up approach
• tranche
• tracking error