Can government bonds plus index CDS replace a credit allocation?

Government bonds plus index CDS – this combination is sometimes marketed as a liquid alternative to corporate bond portfolios. We analyse how the two approaches differ and what risks investors need to be aware of.

Dr. Harald Henke
Head of Fixed Income Strategy

Concept and arguments

Recently, investment approaches have become more widespread that replace an allocation to investment grade (IG) corporate bonds with government bonds plus index CDS. In this case, the investor earns the base interest rate through government bonds and the credit spread through index CDS.

Proponents of this strategy argue that the high liquidity of the instruments makes it possible to change the credit allocation quickly. In particular in crisis phases index CDS and government bonds have more liquidity than corporate bonds. Thus, not only can the credit ratio be changed quickly and cost-effectively by reducing the CDS position, but the underlying government bond portfolio and the derivative overlay can be reduced if required.

While these arguments sound understandable, investors should be aware of disadvantages associated with the approach. These can be divided into several groups:

Disadvantage 1: Yield

Since the spread of the index CDS is measured over the swap curve and not over the government bond curve like corporate bonds, the yield of a government bond plus CDS portfolio with the same credit risk is lower than that of a corporate bond portfolio. This can be understood as a liquidity premium that an investor gives up for a more liquid investment. It can be significant, as in the current market environment.

This yield disadvantage can be reduced by investing in agency bonds instead of government bonds or in riskier government bonds with a spread over Treasuries or Bunds. The disadvantage, however, is a reduction in liquidity, especially when agency bonds are added. Riskier government bonds such as Italian bonds also have additional default risks. Moreover, in the event of rising spreads, investors must also provide collateral.

Because the issuer selection as well as company and sector weightings are predetermined by the CDS index provider, investors also forgo alpha achieved by active management. Positive effects achieved by the correct weighting of sectors or the investment in or avoidance of certain issuers are not possible in such a strategy when using liquid standard CDS. The only possibility to outperform the market lies in the correct timing of the credit quota. Empirical evidence from market timing strategies shows that such a strategy is more difficult to implement successfully due to the binary nature of the decision.

In addition, strategies that specifically focus on certain areas of the bond universe cannot be implemented. For example, short-dated bonds are empirically more interesting on a risk-adjusted basis than long-dated bonds. Strategies that rely on high Sharpe ratios often focus on this maturity range. Since index CDS have fixed maturities, such a strategy is difficult to implement derivatively, especially since the most liquid points are at five and ten years.

“Larger credit portfolios in particular are usually more diversified and spread the issuer-specific risk over significantly more names.”

Dr. Harald Henke
Head of Fixed Income Strategy

Disadvantage 2: Different risks between CDS and bonds

CDS spreads do not always behave identically to corporate bond spreads. The difference, the so-called basis, can be subject to considerable fluctuations. The realised performance of the synthetic credit exposure therefore does not always correspond to that of the physical bonds.

The sector distribution between a corporate bond index and a CDS index also differs significantly. The following chart shows the differences for European and US CDS indices and corporate bond indices according to their sector distribution:

Figure 1: Sector distribution of CDS and bond indices
Panel A: Sector distribution Euro IG corporate bonds
Panel B: Sector distribution Itrax Main index; Source: Bloomberg L.P., S&P IHS

An IG CDS index consists of 125 issuers, which represent the index in equal weights. Each issuer thus corresponds to 0.8% of the total index. While this already represents a certain diversification, larger credit portfolios in particular are usually more diversified and spread the issuer-specific risk over significantly more names. Also, the maximum weight in a bond portfolio is usually based on the rating and thus the risk of the respective issuer. Companies with a rating of BBB- have a different risk than companies with a rating of AA. Best practice portfolio construction techniques would differentiate for ratings.

The focus on 125 issuers usually excludes smaller, less liquid names that are often interesting from a risk-return perspective. An investor in index CDS focuses on the more reputable, liquid part of the universe, but misses out on opportunities.

Moreover, a CDS portfolio is concentrated by its maturities. The most liquid are 5-year and 10-year CDS with many investments at these maturity points. A bond portfolio invests across the entire maturity structure and can overweight points where the credit curve is particularly steep and thus the expected return is particularly high. These effects play only a minor role in a CDS portfolio.

“An investor in index CDS focuses on the more reputable, liquid part of the universe, but misses out on opportunities.”

Dr. Harald Henke
Head of Fixed Income Strategy

Disadvantage 3: ESG management

Active ESG management is becoming increasingly important in the bond market. Many investors apply exclusion lists or integrate sustainability targets into portfolio construction. There is also increasing regulatory pressure to invest more sustainably and report about it.

While this is easily possible with a corporate bond portfolio, the government bond cum CDS concept encounters difficulties. As the bond selection by sub-universe (IG, HY, Euro, USD) is given by the index composition, the sustainability characteristics of the index result purely by chance. Active ESG management is possible in the underlying government bond portfolio, but the key figures and options for influencing them are very limited in the case of government bonds. Each investor must check for himself whether he can fulfil his sustainability goals with such a construct.


An index CDS overlay over a government bond portfolio is sometimes presented as a more liquid alternative to a corporate bond portfolio. While this portfolio is indeed more liquid, it has a number of disadvantages that an investor should be aware of before investing:

  • The yield is somewhat lower if one wants to take advantage of the full liquidity benefit. Performance effects come mainly from the timing of the credit quota, while focusing on the most attractive part of the bond universe is not possible.
  • There are deviation risks to a physical corporate bond portfolio in various dimensions. Credit spreads of CDS and bonds do not always behave the same way, the sector distribution of the indices differs noticeably, a CDS index is less diversified and equally weighted, does not contain the smaller companies on the market and allows the overweighting and underweighting of interesting points on the credit curve only to a very limited extent.
  • Active ESG management is only applicable to the difficult-to-manage area of the government bond portfolio. Investor-specific exclusion lists or tilts cannot be implemented with CDS indices.

Investors should be aware of these disadvantages to make an informed decision about replicating corporate bond portfolios.