CHAPTER 21

MEASURING CREDIT SPREAD

EXPOSURES OF CORPORATE BONDS

CHAPTER SUMMARY
In Chapter 4 our focus was on measuring the interest-rate sensitivity of a bond and a bond
portfolio to a change in the level of Treasury rates and to changes in the slope of the Treasury
yield curve. In this chapter, we focus on the interest-rate risk exposures of corporate bonds
resulting from changes to either Treasury rates or credit spreads.

MEASURING CHANGES IN CREDIT SPREADS

The credit spread of a credit-risky bond is the difference between the yield on that bond and the
yield of a comparable Treasury security. An important driver of the performance of a portfolio
containing credit-risky bonds is changes in the credit spread. There are two ways to measure
changes in the credit spread: absolute change in the credit spread and percentage change in the
credit spread. Letting si denote the credit spread of bond i and si the change in the credit spread
for the same bond, then the absolute change in the credit spread = si and the percentage change
si
in the credit spread = .
si

MEASURING CREDIT SPREAD SENSITIVITY

In Chapter 4, we explained how to measure the responsiveness of a bond to changes in the level
of Treasury yields using duration and changes in the shape of the Treasury yield curve. However,
when dealing with credit-risky bonds and a portfolio that includes such bonds, there is also
exposure to a change in credit spreads. Two measures have been proposed for such
measurement: spread duration and duration times spread.

Spread Duration

A portfolio typically includes bonds from the various sectors of the bond market. Looking at the
allocation to each of these sectors in terms of their market weight tells us little about the duration
of the portfolio. Two portfolios with identical allocations to the different sectors of the bond
market can have a very different portfolio duration. Contribution to portfolio duration is the
exposure of a bond or a sector to the duration of the portfolio resulting from a parallel shift in the
Treasury yield curve. Its computation begins with the calculation of duration for each bond in the
portfolio.

A corresponding measure is used for bonds, bond sectors, and bond portfolios that contain credit-
risky bonds: spread duration. Spread duration is the sensitivity of a bond, bond sector, or bond
portfolio to a parallel shift in credit spreads. Given the spread duration for a bond or bond
sectors, the contribution to portfolio spread duration can be determined.

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The calculation of the spread duration is the same as for the duration to measure the interest-rate
sensitivity due to a parallel shift in the Treasury yield curve where in Chapter 4 we used:
P P
approximate duration = . For spread duration, the corresponding formula is:
2 P0 y
P P
approximate spread duration = where P0 is the same as in the approximate duration
2 P0 s
equation; P_ and P+ now represent the bond prices resulting from a decrease or increase in the
credit spread with the Treasury yield held constant; and s is the change in the credit spread used
to calculate the new prices (in decimal form).

Consider the bond used in the previous chapter to calculate its approximate duration: a 25-year
6% coupon bond trading at 70.3570 to yield 9%. Lets assume this bond is a corporate bond and
that the yield for 25-year Treasury bonds is 7.5%. This means that the credit spread for this bond
is (9.0% 7.5%) = 1.5% or 150 basis points. The calculation of duration can be obtained by
decreasing and increasing the Treasury yield by, say, 10 basis points and calculating the
corresponding prices, P_ and P+. The new yield to calculate those two prices would be 8.9% and
9.1%, obtained by holding the credit spread constant at 150 basis points and changing the
Treasury yield of 7.5% by 10 basis points. By doing so, it can be shown that P_ = 71.1104 and
P P
P+ = 69.6164. Given that P0 = 70.3570 and y = 0.001, substituting these values into
2 P0 y
gives an approximate duration of 10.62.

P P
Now lets look at spread duration calculated using . With spread duration, the
2 P0 s
calculation involves changing the credit spread by a small amount, say 10 basis points, and
holding the Treasury yield constant. For our hypothetical bond, this means holding the Treasury
yield at 7.5% and changing the credit spread by 10 basis points so that the new credit spreads
used to determine P_ and P+ are 140 basis points and 160 basis points, respectively. This means
using 7.50% + 140 basis points (or 1.40%) = 8.90% and 7.50% + 160 basis points (or 1.60%) =
9.10% to get P_ and P+. However, these are exactly the same yields used to get the approximate
duration. Given that the shift in the credit spread of 10 basis point (s) used is the same as the
yield change for the Treasury yield of 10 basis points (y), all of the values that will be used in
P P P P
to calculate spread duration are the same as to calculate duration in , the
2 P0 s 2 P0 y
approximate duration and the approximate spread duration will be the same at 10.62.

Suppose for our hypothetical bond that the yield investors want for this bond changes by 50 basis
points. Regardless of whether the change is from the level of the Treasury yield or from a change
in the credit spread, the approximate change in the bonds price will be 5.31%. Suppose that the
change of 50 basis points is due to a 40 basis point change in the Treasury yield and a 10 basis
point change in the credit spread in the same direction. Then we know that the 5.31% change in
the bonds price is due to a 4.2% change in the Treasury yield and a 1.1% change in the credit
spread.

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Two points are worth noting. First, in the previous simplified analysis to demonstrate the
calculation of spread duration, all cash flows are assumed to be discounted by a single yield. This
is why there is no difference at all between the duration (sensitivity to yield changes), interest-
rate duration (sensitivity to rate changes), and spread duration (sensitivity to spread changes).
Second, there is empirical evidence that there is at times an inverse correlation between the
change in the level of Treasury yields and the change in credit spreads.

Duration Times Spread Measure

A measure that is used as an alternative to spread duration is referred to as duration times

spread, or DTS. There are two elements whose product is used in computing DTS: spread
duration and credit spread. The contribution of a bond or bond sector to a portfolio, referred to as
contribution to portfolio DTS, is the product of the DTS and the weight of that bond or bond
sector in the portfolio.

Lets illustrate the intuition behind the DTS measure using the notation of Dspread = spread
Pspread
duration, = percentage price change for a credit-risky bond or sector due to a change in
P
Pspread
the credit spread, and s = change in the credit spread. This implies = Dspread(s)
P
where the price changes in the opposite direction as the change in credit spreads. To get the price
sensitivity, the spread duration is multiplied by the absolute change in the credit spread.

Expressing the change in price due to a change in credit spread as the product of the spread
Pspread
duration, the credit spread, and the relative change in the credit spread gives: =
P
s
Dspread s where the first two terms on the right-hand side involve duration multiplied by the
s
credit spread.

The excess return volatility can be approximated in terms of absolute spread change and relative
spread change as follows:

return = Dspread abs and return = Dspread s rel

where return = excess return volatility, abs = volatility of absolute credit spreads and rel =
volatility of relative credit spreads.

Research has documented that DTS (based on relative credit spread) is superior to credit spread
(based on absolute credit spread) because of the stable relationship found in explaining excess
return volatility. More specifically, excess return volatility increases linearly with DTS. In
addition, research has found that portfolios that had different credit spreads and spread durations
but with a similar DTS were found to have the same excess return volatility.

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Empirical Duration for Corporate Bonds

Two risk factors impact the price performance of a corporate bond: sensitivity to interest rates
and exposure to equity risk. It is reasonable to expect that for investment-grade corporate bonds
the dominant risk factor is interest-rate risk. In contrast, the equity risk factor becomes
increasingly more important for high-yield corporate bonds, particularly the lower a bonds
credit rating. With respect to the interest-rate risk factor, a corporate bond is exposed to two risk
factors: Treasury yield risk factor and credit spread risk factor.

Given that modified duration does not take into account the equity risk factor and how changes
in the credit spread may change, the analytically derived modified duration may not be very
useful.

Portfolio managers have taken different approaches for estimating the duration of high-yield
bonds because they are less sensitive to changes in Treasury rates. The first is a heuristic rule-of-
thumb that involves reducing the analytically derived modified duration by some amount. The
second approach is to empirically estimate the sensitivity of a high-yield bond to changes in
interest rates using the technique of regression analysis. The estimated modified duration
obtained from the regression is referred to as empirical duration. One regression study
investigated the interest-rate sensitivity of corporate bonds of different credit ratings and found
that a lower-rated corporate bonds price movement was less sensitive to the change in the level
of interest rates. It was also found that bonds with higher spreads were found to have lower
empirical durations.

Importance of Properly Estimating the Duration for High-Yield Bonds

A common problem faced by portfolio managers is that they want properly estimate the duration
of high-yield bonds in a portfolio that contains investment-grade bonds. To do this, managers
must factor in the empirical finding that the high-yield corporate bonds will have a true duration
that is less than the analytical duration.

THEORETICAL DIFFERENCE BETWEEN ANALYTICAL DURATION

AND EMPIRICAL DURATION

In analyzing the theoretical difference between analytical duration and empirical duration, we
assume a simple two-factor model where the two risk factors are the interest-rate factors
consisting of (1) a parallel shift in the Treasury yield curve, denoted by y and (2) a change in
the credit spread, denoted by s. The approximate percentage price change due to these two
P PTrea Pspread
factors can be expressed as + where PTrea is the price change due to a
P P P
parallel change in the Treasury yield and Pspread is the price change due to a change in the credit
spread.

The approximate percentage change in price due to a parallel change in the Treasury yield is the
PTrea
modified duration multiplied by the change in the Treasury yield given as Dmod y
P

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where Dmod is modified duration and y is the change in the Treasury yield. The negative sign is
due to the inverse relationship between percentage price change and the yield change.

The approximate percentage change due to a change in the credit spread is

P s
Dmod y (Dspread s) .
P s

Noting that the modified duration is approximately equal to spread duration and the modified
P s
duration is simply D, we have D y (D s) . Denoting the relative change as
P s
s 1 P s
the credit spread, we have srel = and thus D (D s) rel .
s P y y

A simple approximation for change in relative credit spread divided by the change in the
srel s cov( y, srel )
Treasury yield is rel = where cov(y,srel) = covariance between the
y y var ( y )
change in parallel shifts in Treasury yields and the change in credit spreads and var(y) =
variance of the change in parallel shifts in Treasury yields.

Letting y = standard deviation of the change in Treasury yields, s = standard deviation of the
relative change in credit spreads, and y,s = correlation between the change in Treasury yields and
s
credit spreads, we have rel = y ,s s . Thus, there are three measures needed to determine the
y y
relationship given by the latter equation. They are the correlation between the parallel shift in
Treasury yields and the change in credit spreads, the standard deviation of the relative change in
credit spreads, and the standard deviation of the change in parallel shifts in Treasury yields.
There is no analytical solution to these three measures as they must be estimated empirically.

1 P
The equation of D 1 s y ,s s states the following about the analytical duration
P y y
for a corporate bond: The percentage change in the price of the bond when there is a parallel shift
in the Treasury yield depends on the modified duration of the corporate bond adjusted by the
impact of the change in the credit spread resulting from a change in the Treasury yield.

When the economy weakens, Treasury rates decline; when the economy strengthens, Treasury
rates increase. Changes in corporate credit spreads tend to move in the opposite direction in
response to the state of the economy. That is, when the economy weakens, corporate credit
spreads tend to widen and when the economy strengthens, corporate credit spreads to tighten.
Hence, it is reasonable to assume that changes in Treasury rates are negatively correlated with
changes in corporate credit spreads.

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 1 P
The equation of D 1 s y ,s s provides theoretical support for expressing the
P y y
interest-rate sensitivity of a bond as a linear function of spread. That is, we see that the true
1 P
duration can be expressed as a multiple of analytical duration: DM where M takes the
P y
form M = a + bs.

Exhibit 21-2 shows values for a and b that were obtained based on a regression study of daily
price and yield changes on corporate bonds with various credit ratings from 1998 through 2009.
These results provide a simple linear rule for estimating the duration multiplier based on a
bonds spread and credit rating. For A rated bonds, for example, the exhibit would give an
approximation of M = 0.92 0.05 s such that a bond with a spread of 100 bps would get a
multiplier of 0.87, and a bond with a spread of 150 bps (the average A spread, as shown in the
exhibit) would get a multiplier of 0.85.

Duration Multipliers

Rather than employ ad hoc measures to adjust the duration of high-yield corporate bonds in a
portfolio, the adjustment can be made using the empirical duration or using the analytics whose
parameters must be estimated empirically. The true duration of a portfolio that includes corporate
1 P
bonds can also be expressed as follows: D M where M = 1 y ,s s .
P y y

Because the correlation y,s has historically been negative, M will be less than unity for a
corporate bond and therefore the modified duration will be reduced by M. The lower the credit
rating, the greater the reduction that must be made to the analytical duration, D.

KEY POINTS

The risk exposure of a credit-risky bond should be measured in terms of both changes in
Treasury rates and changes in credit spreads.
Changes in spreads can be expressed either as absolute (basis points) or percentage
(relative) changes in credit spread.
Empirical evidence indicates that credit spread risk for corporate bonds is best described
in terms of the relative change in credit spread.
The two measures that can be used to measure the responsiveness of a corporate bond to
changes in credit spreads are spread duration and duration times spread.
Spread duration is the sensitivity of a bond, bond sector, or bond portfolio to a parallel
shift in credit spreads. It can be interpreted as the approximate percentage change in the
price of a bond for a 100 basis-point change in the credit spread.
For a bond (or bond sector), the contribution to portfolio spread duration is computed by
multiplying spread duration by the weight of the bond (or bond sector) in a portfolio.
Duration times spread (DTS), an alternative to spread duration, is calculated as the
product of spread duration and the credit spread.

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 Contribution to portfolio DTS can be computed for a bond (or bond sector) by
multiplying DTS by the weight of the bond (or bond sector) in a portfolio.
Empirical evidence suggests that DTS is a better measure of credit spread risk than
spread duration.
Two risk factors that affect a corporate bonds price performance are its sensitivity to
interest rates and its exposure to equity risk.
The relative importance of the interest-rate risk and equity risk for a corporate bond
depends on the credit risk associated with the issuer of the bond.
The expectation, supported by empirical evidence, is that for investment-grade corporate
bonds the dominant risk factor is interest-rate risk; for high-yield bonds the equity risk
factor becomes increasingly more important.
An analytical-based (i.e., formula-based) duration can be computed for any corporate
bond, but that does not mean that the true interest-rate sensitivity of a corporate bond will
have the computed interest-rate sensitivity.
In practice, when assigning a duration to the high-yield bonds in a portfolio, managers
have used two approaches: (1) a heuristic rule-of-thumb that involves reducing the
analytically derived modified duration by some amount or (2) estimating duration
empirically.
Duration estimated using simple regression analysis of a corporate bonds price change
versus the Treasury yield change over some time period is called empirical duration.
Failing to properly account for the duration of lower-credit-rating corporate bonds in a
portfolio may result in unintentional interest-rate bets (i.e., a portfolios true duration may
differ from the calculated portfolio duration).
The theoretical difference between an analytical duration and an empirical duration can
be calculated.
The difference between analytical and empirical duration will depend on the following
three factors that must be estimated empirically: (1) the correlation between the parallel
shift in Treasury yields and the change in credit spreads, (2) the standard deviation of the
relative change in credit spreads, and (3) the standard deviation of the change in parallel
shifts in Treasury yields.
Empirical duration decreases as spreads widen. As a result, a simple linear function of
spread can be used to obtain an approximate value for the duration multiplier.
Empirical evidence suggests that there is an inverse correlation between parallel shifts in
Treasury yields and changes in credit spreads.
The duration multiplier is lower the lower the credit rating of a corporate bond.
Because of the negative correlation between the parallel shift in Treasury yields and the
change in credit spreads that have been observed in the corporate bond market, the
duration multiplier is less than one and therefore the true duration as found by adjusting
for the duration multiplier will be less the analytically derived duration.

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 ANSWERS TO QUESTIONS FOR CHAPTER 21
(Questions are in bold print followed by answers.)

1. When using the percentage change in the credit spread as a measure of the credit spread
change, what assumption is being made?

When using the percentage change in the credit spread as a measure of the credit spread change,
one is assuming that the change in the credit spread is proportional to the level of the credit
spread. This means that securities with wider spreads are likely to have larger spread changes
than those with tight spreads.

2. What does the empirical evidence suggest about the behavior of corporate credit spreads
concerning whether credit spread changes should be measured on an absolute versus
relative basis?

The decision to use the absolute change or the percentage change to measure the change in credit
spreads is important in the management of credit-risky portfolios. Consequently, the empirical
question is which measure best describes the historical change in credit spreads. A
comprehensive study using an extensive corporate database that includes more than 560,000
observations found that credit spread changes are proportional to the level of the credit spread.
Thus, it appears (from empirical evidence about the behavior of corporate credit spreads) that
credit spread changes should be measured on a proportional (or relative) basis.

3. What is meant by spread duration and contribution to spread duration?

Spread duration is the sensitivity of a bond, bond sector, or bond portfolio to a parallel shift in
credit spreads. Its interpretation is the same as for duration, e.g., it is the approximate percentage
change in the price of a bond for a 100-basis-point change in the credit spread. Given the spread
duration for a bond or bond sectors, the contribution to portfolio spread duration can be
determined. A measure that is used as an alternative to spread duration for determining the
contribution of a bond sector to portfolio spread duration is one introduced by Barclays
Research. This measure is referred to as duration times spread, or DTS. More details are supplied
below.

The calculation of the spread duration is the same as for the duration to measure the interest-rate
sensitivity due to a parallel shift in the Treasury yield curve. The approximate duration formula
is
P P
approximate duration =
2 P0 y
where

P_ = price of the bond resulting from a decrease in the Treasury yield

P+ = price of the bond resulting from an increase in the Treasury yield
y = change in yield used to calculate the new prices (in decimal form) P_ and P+

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For spread duration, the corresponding formula is

P P
approximate spread duration =
2 P0 s

where P0 is the same as in the approximate duration equation; P_ and P+ now represent the bond
prices resulting from a decrease or increase in the credit spread with the Treasury yield held
constant; and s is the change in the credit spread used to calculate the new prices (in decimal
form).

As discussed in the text, the two equation generate the same answer. Thus, these two formulas
indicate that duration and spread duration are the same.

A measure that is used as an alternative to spread duration for determining the contribution of a
bond sector to portfolio spread duration is one introduced by Barclays Research. This measure is
referred to as duration times spread, or DTS. There are two elements whose product is used in
computing DTS: spread duration and credit spread. For example, suppose that a bond has a
spread duration of 4 and a credit spread of 90 basis points. Then

DTS = 4 0.009 = 0.036 = 3.6%

The contribution of a bond or bond sector to a portfolio, referred to as contribution to portfolio

DTS, is the product of the DTS and the weight of that bond or bond sector in the portfolio. For
example, suppose that the bond whose DTS is 3.6% has a 3% weight in a portfolio, then its
contribution to portfolio DTS is:

Contribution to portfolio DTS = 0.03 0.036 = 0.00108 = 10.8 bps

4. When all cash flows are assumed to be discounted by a single yield, why is there no
difference between the duration (sensitivity to yield), interest-rate duration (sensitivity to
rates), and spread duration (sensitivity to spreads)?

From our answer in the previous problem, we saw that formulas for duration and spread duration
generated the same value. Continuing with the bond problem described in our previous, let us
suppose the yield investors want for the bond changes by 50 basis points. Regardless of whether
the change is from the level of the Treasury yield or from a change in the credit spread, the
approximate change in the bonds price will be the same. Suppose that the change of 50 basis
points is due to a 40 basis point change in the Treasury yield and a 10 basis point change in the
credit spread in the same direction. Then we know that 0.4 / 0.5 = 0.8 or 80% of the total change
of 100% comes from the change in the Treasury yield and 0.1 / 0.5 = 0.2 or 20% comes from the
change in the credit spread.

Two points are worth noting. First, to demonstrate the calculation of spread duration, all cash
flows are assumed to be discounted by a single yield. This is why there is no difference at all
between the duration (sensitivity to yield changes), interest-rate duration (sensitivity to rate

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changes), and spread duration (sensitivity to spread changes). Although all three appear to be the
same, in practice, this sameness becomes blurred and so we need to distinguish between them. In
particular, the distinction becomes worth noting when considering discounting cash flows using
a constant spread over a Treasury curve. Furthermore, consider the spread duration for a floating-
rate bond. The difference between spread duration and Treasury duration becomes truly
important when considering floating-rate corporate bonds, which can have near-zero interest-rate
exposure but large spread durations.

The second point provides the motivation for other measures. The textbook provided an example
of where both the change in the Treasury yield and the change in the credit spread moved in the
same direction. However, there is empirical evidence that there is at times an inverse correlation
between the change in the level of Treasury yields and the change in credit spreads. This second-
order effect should be taken into account when measuring a portfolios exposure to changes in
interest rates.

5. Assume the following for corporate bond A: spread duration = 5, credit spread = 100
basis points, and weight in the portfolio = 6%.

Answer the below questions.

(a) What is bond As duration times spread?

A measure that is used for determining the contribution of a bond sector to portfolio spread
duration is one introduced by Barclays Research. This measure is referred to as duration times
spread, or DTS. There are two elements whose product is used in computing DTS: spread
duration and credit spread so that in equation form we have: DTS = spread duration + credit
spread.

In our problem, corporate bond A has a spread duration of 5 and a credit spread of 100 basis
points. Inserting our values into the above DTS formula and noting that 100 basis points is 0.01
in decimal form, we have:

DTS = spread duration + credit spread = 5 0.010 = 0.0500 or 5.00%

(b) What is bond As contribution to duration-times-spread?

The contribution of a bond or bond sector to a portfolio, referred to as contribution to portfolio

DTS, is the product of the DTS and the weight of that bond or bond sector in the portfolio. For
our problem, we have weight in a portfolio = 0.06 and DTS = 0.05, thus corporate bond As
contribution to portfolio is

Contribution to portfolio DTS = 0.06 0.05 = 0.003 = 30 bps

6. Why is the duration-times-spread approach superior to the spread duration approach in

estimating exposure to changes in corporate credit spreads?

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The duration-times-spread approach, or DTS approach, involves taking the product of the spread
duration and the credit spread. The contribution of a bond or bond sector to a portfolio, referred
to as contribution to portfolio DTS, is the product of the DTS and the weight of that bond or
bond sector in the portfolio. To show the superiority of the DTS approach to the spread duration
approach, let us begin by illustrating the intuition behind the DTS measure. We begin the
Pspread
illustration by using the following notation: Dspread = spread duration; = percentage price
P
change for a credit-risky bond or sector due to a change in the credit spread; and, s = change in
the credit spread. Since we know that the percentage change in price due to a change in the credit
spread is the product of the spread duration and the change in the credit spread, we have:
Pspread
= Dspread(s) where the negative sign indicates that the change in the credit spread
P
will result in a price change in the opposite direction to the change in credit spreads.

To get the price sensitivity due to a change in the credit spread using spread duration, the spread
duration is multiplied by the absolute change in the credit spread where the absolute change in
credit spread is one way to measure changes in the credit spread and this measure is not as good
as the relative change in credit spreads. We can use the relative change in credit spread in our
Pspread
analysis by multiplying the numerator and denominator of the right-hand side of =
P
Pspread s
Dspread(s) to obtain: = Dspread s . We can express the change in price due to a
P s
change in credit spreads as the product of the spread duration, the credit spread, and the relative
change in the credit spread. This give the same computed result for the price sensitivity due to
Pspread s
spread changes. The representation given by = Dspread s is preferred. The excess
P s
return volatility can be approximated in terms of absolute spread change and relative spread
change by first noting return = Dspread,abs and return = Dspread s rel where return = excess return
volatility, abs = volatility of absolute credit spreads, and rel = volatility of relative credit
spreads.

Historical excess return volatility can then be investigated to determine whether it is explained
better using absolute or relative spread volatility. The same study that investigated absolute
versus relative credit spread also documented that DTS (based on relative credit spread) is
superior to credit spread (based on absolute credit spread) because of the stable relationship
found in explaining excess return volatility. More specifically, excess return volatility increases
Pspread s
linearly with DTS, a finding that is consistent with the relation of = Dspread s . In
P s
addition, the study found that portfolios that had different credit spreads and spread durations but
with a similar DTS were found to have the same excess return volatility. In fact, this finding was
observed for not only U.S. corporate bonds (both investment-grade and high-yield bonds) but
also European corporate bonds.

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The key implication for corporate bond portfolio management and strategies is that DTS and
contribution to portfolio DTS provide a better measure for managing a portfolios credit spread
exposure to different sectors. That is, profiling a portfolio by its contributions to spread duration
is not as good as using contributions to DTS for estimating a portfolios exposure to changes in
credit spreads.

7. Answer the below questions.

(a) Corporate bond prices have interest-rate exposure and equity exposure. Why?

Corporate bond prices have interest-rate risk exposure because of an two risk factors: Treasury
yield risk factor and credit spread risk factors. They have equity risk exposure due to the extent it
can risks similar to equity as is particularly true when a bonds credit rating is low. More details
are provided below.

Two risk factors impact the price performance of a corporate bond: sensitivity to interest rates
and exposure to equity risk. How important each risk factor is depends on the credit risk
associated with the issuer of the bond. It is reasonable to expect that for investment-grade
corporate bonds the dominant risk factor is interest-rate risk. In contrast, the equity risk factor
becomes increasingly more important for high-yield corporate bonds, particularly the lower a
bonds credit rating. This is the reason investors refer to lower-grade high-yield corporate bonds
as being equity-like securities. Moreover, with respect to the interest-rate risk factor, a corporate
bond is exposed to two risk factors: Treasury yield risk factor and credit spread risk factor. One
would expect that the lower the credit risk of a corporate bond, the more important will be the
Treasury yield risk factor compared to the credit spread risk factor.

There are implication in computing the interest-rate sensitivity of a corporate bond based on
exposure to both equity risk and credit spread risk factors. Analytically we can use the standard
formula for duration where given the coupon rate, maturity, and yield, the modified duration can
be calculated. However, the resulting modified duration can fall short as a useful measure to
predict how the bonds price will change when interest rates change. Given that modified
duration does not take into account the equity risk factor and how changes in the credit spread
may change, the analytically derived modified duration may also not be very useful.

(b) What type of corporate bond is more likely to have greater equity exposure,
investment-grade bonds or high-yield bonds? Explain why.

From a legal standpoint, investment-grade bonds will share less in equity risk associated with
financial distress compared to high-yields bonds due to covenants that serve to offer better
protection by safe guarding their prior and senior claims on a firms assets and cash flows.

Per se equity risk refers to the risk involved in investing in equity. One major risk often cited is
the standard deviation of changes in prices. By this measure, the equity risk in investment-grade
bonds would be lower than that for high-yield bonds. In terms of a diversified investor that looks
at systematic risk, this type of risk would also be lower for investment-grade bonds compared to
high-yield bonds as it would have a higher sensitivity to changes in stock prices.

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One important equity risk consideration is financial distress risk because investors in equity will
be the first to feel the fall-out when a firm has financial problems that can lead to bankruptcy.
Thus, equity has the greatest exposure to risks associated with financial distress. This risk of
default associated with financial distress is much higher for equity than bonds and especially
much higher for equity compared to investment-grade bonds. Investment-grade bonds will have
more legal senior claims on a firms assets and its cash flows compared not only to equity but
also to high-yield bonds. For high-yield bonds with very low credit ratings, their claims on cash
flows can come close to resembling the claims of equity albeit their cash flows should always be
more secure due to higher claims on assets.

8. What are the different approaches used to estimate the duration of high-yield corporate
bonds?

In practice, when assigning a duration to the high-yield bonds in a portfolio, managers have used
two approaches: (1) a heuristic rule-of-thumb that involves reducing the analytically derived
modified duration by some amount or (2) estimating duration empirically. Below we offer
details.

Given that high-yield bonds may have greater exposure to equity risk factors and credit spread
risk factor, it becomes more of a challenge to compute interest-rate sensitivity of a corporate
bond issue. Critically, we can use the standard formula for duration given by approximate
P P
duration = where (given the coupon rate, maturity, and yield) the modified duration
2 P0 y
can be calculated. However, there are major questions as to whether the modified duration is a
useful measure to predict how the bonds price will change when interest rates change. Given
that modified duration does not take into account the equity risk factor and how changes in the
credit spread may change, the analytically derived modified duration may not be very useful.

Consequently, portfolio managers have taken different approaches for estimating the duration of
high-yield bonds because they are less sensitive to changes in Treasury rates. One approach used
to estimate the duration of high-yield corporate bond is a heuristic rule-of-thumb that involves
reducing the analytically derived modified duration by some amount. For example, if the
analytically derived modified duration for a high-yield corporate bond is 5, a portfolio manager
may decide to reduce that value by 75% and use a modified duration of 5 0.25 = 1.25.

Another approach used to estimate the duration of high-yield corporate bond is to empirically
estimate the sensitivity of a high-yield bond to changes in interest rates using the technique of
regression analysis. The estimated modified duration obtained from the regression is referred to
as empirical duration. For any high-yield corporate bond, a simple regression of its price change
versus the Treasury yield change over the past 30 days (or 60 or 90) will give a bond-specific
estimate of empirical duration. Like any such numerical methods, direct calculation of empirical
durations can be very sensitive to irregularities in the pricing data. One could calculate these for
many bonds over many periods of time, and then compare results with estimates based on bond
characteristics such as spread or credit ratings. One study detected a clear dependence on
spreads: bonds with higher spreads were found to have lower empirical durations. This effect is

Copyright 2016 Pearson Education, Inc. 470

consistent with the DTS approach. However, the empirical durations of high-yield bonds were
found to be systematically lower than those of investment-grade bonds even after adjusting for
their higher spreads. One possible reason high-yield bonds are less interest-rate sensitive than
investment-grade bonds is that they sell in the marketplace primarily based on default/recovery
expectations.

9. Answer the below questions.

(a) What is meant by the empirical duration of a corporate bond?

Duration is the percentage change in a bond's price with a 100-basis-point change in yield.
Empirical duration of a corporate bond refers to calculation of a bond's duration based on
historical data. The calculation of empirical duration has some advantages and disadvantages
over other duration calculations, such as effective duration or modified duration. The advantages
of using empirical duration consist of the following. First, the estimate does not rely on
theoretical formulas and analytic assumptions. Second, the only inputs needed are a reliable
series of bond prices and a reliable series of Treasury yields. Some disadvantages consist of the
following. First, a dependable series of a bond's price may not be available. Second, the series of
prices that is obtainable might not be market based, but rather modeled or based on an analogous
security.

(b) How is the empirical duration of a corporate bond estimated?

Empirical duration is computed statistically using historical market-based bond prices and
historical market-based Treasury yields. When the historical yields change, the historical bond
prices will be modified accordingly. Regression analysis is the statistical method used to
calculate empirical duration. More details are below.

To empirically estimate the sensitivity of a high-yield bond to changes in interest rates, we use
the technique of regression analysis. The estimated modified duration obtained from the
regression is referred to as empirical duration. For any high-yield corporate bond, a simple
regression of its price change versus the Treasury yield change over the past 30 days (or 60 or
90) will give a bond-specific estimate of empirical duration. Like any such numerical methods,
direct calculation of empirical durations can be very sensitive to irregularities in the pricing data.
One could calculate these for many bonds over many periods of time, and then compare results
with estimates based on bond characteristics such as spread or credit ratings.

One study investigated, using regression analysis, the interest-rate sensitivity of corporate bonds
of different credit ratings. Daily data for the period August 1998 to November 2009 for six credit
rating categories of the Barclays Capital Corporate Investment Grade and High Yield Indices
(Aaa/Aa, A, Baa, Ba, B, and Caa) were used. The first three credit rating categories (Aaa/Aa, A,
and Baa) are investment-grade credit rating categories. The last three credit rating categories (Ba,
B, and Caa) are high-yield credit rating categories. For the change in Treasury yields, the 10-year
yield is used. The regression results indicated that for lower-rated corporate bonds, the bonds
price movement was less sensitive to the change in the level of interest rates (as measured by the
10-year Treasury rate).

Copyright 2016 Pearson Education, Inc. 471

10. A portfolio manager currently has a portfolio consisting solely of investment-grade
corporate bonds with an analytically computed duration of 6.6. The portfolio manager
wants to sell 20% of the portfolio holdings and invest the proceeds received in high-yield
corporate bonds. The client has granted the portfolio manager permission to do so. The
portfolio of the investment-grade corporate bonds after selling sufficient bonds to purchase
the bonds from the high-yield corporate bond sector is 6.2 (i.e., the portfolio ignoring the
high-yield corporate bond sector has a duration of 6.2). In addition, the portfolio manager
wants to reduce the portfolio duration from 6.6 to 6.0 (i.e., the target duration is 6.0). The
analytically computed duration for the high-yield corporate bonds to be purchased is 5.4.

(a) What is the portfolios analytical duration after the increase of 20% to the high-yield
corporate bond sector?

This question highlights the need to properly estimate the duration of high-yield bonds in a
portfolio and to also considers a common problem faced by portfolio managers who want to add
high-yield bonds to a portfolio that contains investment-grade bonds. For our problem, we
assume the following:

The current duration of a portfolio has an analytical duration of 6.6 and the portfolio manager
wants to reduce the duration to 6.0 (i.e., the target duration is 6.0).
The current portfolio has no exposure to the high-yield corporate bond sector.
In rebalancing the portfolio to achieve the target duration, the portfolio manager decides to
increase exposure to the high-yield corporate bond sector to 20% of the portfolio and the
analytical duration of the bonds from that sector that it acquires has an analytical duration of
5.4.
The portfolio of the bonds after selling sufficient bonds to purchase the bonds from the high-
yield corporate bond sector is 6.2 ignoring the high-yield corporate bond sector.

The portfolios analytical duration after the increase of 20% to the high-yield corporate bond
sector is given by

analytical duration after 20% increase to the high-yield bond sector = (1 a)(b) + a)(c)

where

a = percent increase in exposure to the high-yield corporate bond sector

b = portfolio of the bonds after selling sufficient bonds to purchase the bonds from the high-yield
corporate bond sector
c = the analytical duration of the bonds from that sector that it acquires

Inserting in our given values, we have: (1 a)b + a(c) = (1 0.20)6.2 + 0.20(5.4) = 6.04. Thus,
portfolios analytical duration after the increase of 20% to the high-yield corporate bond
sector is 6.04.

Copyright 2016 Pearson Education, Inc. 472

(b) Why for the high-yield corporate bonds in which the portfolio manager has invested
will the true duration be less than the analytical duration of 5.4?

The high-yield corporate bonds in which the portfolio manager has invested will have a true
duration that is less than the analytical duration of 5.4. The reason we know this is based on
empirical evidence. Factors can be given to explain differences in empirical and theoretical
duration. The difference between analytical and empirical duration will depend on the following
three factors that must be estimated empirically: (1) the correlation between the parallel shift in
Treasury yields and the change in credit spreads, (2) the standard deviation of the relative change
in credit spreads, and (3) the standard deviation of the change in parallel shifts in Treasury
yields.

Below we illustrate how the portfolio manager can attempt to reduce the duration to the target
without considering any adjustment based on empirical evidence.

Because the target duration is 6.0, this means that based on the analytical duration, the portfolio
manager must modify the portfolio to reduce the duration from 6.04 to 6.0. This would be done
by rebalancing the non-high-yield bond portfolio duration so that the portfolio duration is 6.0.
That is, (1 0.20)X + 0.20(5.4) = 6.0. Solving algebraically, we get X = 6.15. Thus, the duration
of the non-high-yield bonds in the portfolio must be decreased from 6.2 to 6.15.

However, we know empirically that the high-yield corporate bonds in which the portfolio
manager has invested will have a true duration that is less than the analytical duration of 5.4.

(c) Suppose that the portfolio manager believes that for high-yield corporate bonds, the
duration is 25% of the analytical duration. Based on that assumption, what is the true
duration for the portfolio consisting of the investment-grade and high-yield corporate
bonds?

In this problem, we assume the duration is 25% of the analytical duration. This means that the
duration of the high-yield corporate bonds is 0.25 of 5.4 = 1.35 so that the true duration for the
portfolio is (1 0.20)6.2 + 0.20(1.35) = 5.23.

(d) What action should the portfolio manager take to achieve the target duration?

The true duration is then less than the target duration of 6.0. Hence, the action that the portfolio
manager must take is to increase the duration of the non-high-yield bonds. We show this to be
7.19 by solving algebraically for this equation: (1 0.20)Y + 0.20(1.35) = 6.0. Doing this gives
Y = 7.19.

This indicates a significant difference in the action that must be taken by the portfolio manager
resulting from this change in the target duration and the allocation to 20% high-yield corporate
bonds, and it depends on the proper determination of the true duration for the high-yield
corporate bonds.

Copyright 2016 Pearson Education, Inc. 473

11. Assuming the data in the following table for corporate bonds, compute the average
hedge ratio (duration multiplier) at the average spread level for the three credit ratings
(M1, M2, and M3):

AaaAa A Baa
Constant (a) 1.04 0.95 0.91
Spread coefficient (b) 0.08 0.08 0.04
Average spread (%) 1.15 1.70 1.80
Average Hedge Ratio (duration multiplier) M1 M2 M3

For Aaa-Aa rated bonds, we have: M1 = a + bs = 1.04 + 0.08(1.15) = 0.948

For A rated bonds, we have: M1 = a + bs = 0.95 + 0.08(1.70) = 0.814

For Baa rated bonds, we have: M1 = a + bs = 0.91 + 0.04(1.80) = 0.838

12. Assuming the data in the following table for corporate bonds, compute the theoretical
hedge ratio at the average spread level for the three credit ratings (X, Y, and Z):

AaaAa A Baa
Volatility of changes in Treasury yields (%/day) 0.074 0.074 0.074
Volatility of relative spread changes (%/day) 2.80% 2.00% 180%
Correlation between changes in yields and spreads 0.20 0.27 0.32
Average spread (%) 1.15 1.70 2.30
Theoretical hedge ratio at average spread level X Y Z

Below we compute the theoretical hedge ratio at the average spread level for the three credit
ratings of X, Y and Z.

0.028
For Aaa-Aa rated bonds, we have: X = 1 s y ,s s = 1 (1.15) ( 0.20) = 0.91
y 0.074

0.020
For A rated bonds, we have: Y = 1 s y ,s s = 1 (1.70) ( 0.27) = 0.88
y 0.074

0.018
For Baa rated bonds, we have: Z = 1 s y ,s s = 1 (2.30) ( 0.32) = 0.82
y 0.074

Below we compute M for the three credit ratings:

0.028
For Aaa-Aa rated bonds, we have: M = 1 y ,s s = 1 0.20 = 0.92
y 0.074

Copyright 2016 Pearson Education, Inc. 474

 0.074
For A rated bonds, we have: M = 1 y ,s s = 1 0.27 = 0.93
y 0.0200

0.074
For B rated bonds, we have: M = 1 y ,s s = 1 0.20 = 0.92
y 0.0280

13. Using the correlations for the corporate bonds shown in Exhibit 21-3, calculate the
duration multiplier for the three credit ratings shown in the exhibit.

Exhibit 21-3 Industry Portfolio Spread Correlations with Treasury Curve Shifts (June 2013)
AAA/AA A BBB
FINANCIALS
Banking and Brokerage 32% 33% 31%
Financial Companies, Insurance and REITS 26% 33% 38%
INDUSTRIALS
Basic Industries and Capital Goods 32% 35% 35%
Consumer Cyclicals 38% 34% 30%
Consumer Non-Cyclicals 35% 32% 30%
Communication and Technology 31% 34% 36%
Energy and Transportation 37% 37% 38%
UTILITIES 24% 35% 34%
NON-CORPORATE 32% 34% 36%
Source: Reproduced from Figure 3 in Antonio B. Silva, Insights from Point(R) Global Risk Model: Credit in a Turning Rates Environment,
Barclays Index, Portfolio and Risk Solutions Research/Portfolio Modeling, November 21, 2013. The results also appear in Arthur Berd, Elena
Ranguelova, and Antonio B. Silva, Credit Portfolio Management in a Turning Rates Environment, Journal of Investment Strategies, 3, 1
(December 2013). Courtesy of Barclays Capital.

The standard deviation for Treasury yields (i.e., y) according to the Barclays Risk Model is 24
bps per month. The standard deviation for the credit spread according to Barclays Risk Models is
10.1 bps per month for AAA/A rated corporates, 18.2 bps per month for A rated corporates, and
29.6 per month for BBB rated corporates. We will use these values in our computations. Exhibit
21-3 shows the correlations (y,s) for AAA/A, A, and BBB rated bonds in that industry.

Substituting these values into the equation of M = 1 y ,s s , we can compute the duration
y
multipliers.

0.00101
M for AAA/A for Banking and Brokerage = 1 y ,s s = 1 ( 0.32) = 0.84
y 0.00240

0.00182
M for A for Banking and Brokerage = 1 y ,s s = 1 ( 0.33) = 0.75
y 0.00240

Copyright 2016 Pearson Education, Inc. 475

 0.00296
M for BBB for Banking and Brokerage = 1 ( 0.31) = 0.62
0.00240

Similarly, we can get the following values for the other corporate bonds in Exhibit 21.3. The
answers are given below.

M for AAA/A, A and BBB for Financial Companies, Insurance and REITS: 0.89, 0.75, 0.53
M for AAA/A, A and BBB for Basic Industries and Capital Goods: 0.87, 0.73, 0.57
M for AAA/A, A and BBB for Consumer Cyclicals: 0.84, 1.26, 0.63
M for AAA/A, A and BBB for Consumer Non-Cyclicals: 0.85, 0.76, 0.63
M for AAA/A, A and BBB for Communication and Technology: 0.87, 0.74, 0.56
M for AAA/A, A and BBB for Energy and Transportation: 0.84, 0.72, 0.53
M for AAA/A, A and BBB for UTILITIES: 0.90, 0.73, 0.58
M for AAA/A, A and BBB for NON-CORPORATE: 0.87, 0.74, 0.56

14. Answer the below questions.

(a) If the correlation between changes in Treasury rates and changes in the credit spread is
zero, what is the duration multiplier?

As seen below, the duration multiplier is one.

s s
1 y ,s = 1 0 = 1 + 0 = 1
y y

(b) If during a time period the correlation between changes in Treasury rates and changes
in the credit spread is positive, what happens to the duration multiplier?

Instead of the duration multiplier being less than one when the correlation is negative, it will now
be greater than one as demonstrated below.

s
Let = y ,s . Since correlation is greater than zero and also both standard deviations are
y
s
greater than zero by definition, we have = y ,s > 0. This implies that 1 y ,s s > 1.
y y

Copyright 2016 Pearson Education, Inc. 476