Credit Risk Diversification

Abstract: We study the role of diversification in reducing the volatility of corporate bond returns induced by changes in credit spreads. Specifically, we look at how credit risk can be diminished when a portfolio is diversified across countries, industry sectors, maturities, seniority types and credit ratings. The role of national industrial structures on international diversification is also investigated. Our results show that geographical diversification is more effective in reducing portfolio risk than any alternative investment strategy we consider, and that industry effects are not material to this result. Finally, we explore the implications of our findings for credit risk capital regulation in banks.