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Separating Interest Rate Duration from Credit Spread Duration

Article Quant Q&A · Author: user33879
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Summary

The document explains why risky bonds are measured for both interest rate duration and spread duration. Interest rate duration captures price sensitivity to changes in the risk free curve, while spread duration captures sensitivity to changes in the bond’s credit spread over that curve. Though the two components contribute to the bond’s overall yield, separating them helps identify distinct sources of risk.

The answers describe hedging each exposure with different instruments: government bonds can hedge interest rate risk, while credit default swaps can hedge spread risk. They also note that the measures can differ substantially for floating rate bonds. Their interest rate sensitivity is limited until the next coupon reset, whereas spread exposure can remain significant. The explanation is conceptual and gives no calculations or broader treatment of how the measures are estimated.

Key ideas

  • Interest rate duration measures sensitivity to changes in the risk free yield curve.
  • Spread duration measures sensitivity to changes in credit spreads over that curve.
  • Separating the exposures helps traders choose different instruments to hedge each risk.
  • Floating rate bonds may have low interest rate duration between resets but meaningful spread duration.

Tags

Fixed incomeRisk management
Full text
# Why is 'duration' not the same as 'spread duration' for risky bonds


# Why is 'duration' not the same as 'spread duration' for risky bonds












For risky bonds, duration is defined as

> sensitivity of price due to change in underlying yield

while spread duration is

> sensitivity of price due to change in the 'spread in yields to the risk free curve'.

If we consider 'yield' to be yield of risk free curve + a spread. Then why do we care what contributed to a change to that yield? The price sensitivty should be the same regardless?

Any one can illustrate why that is NOT the case?

## Answer by Richi Wa (score 5)

https://quant.stackexchange.com/a/39370

Adding to the answer of Tim:

If you consider a fixed-rate bond then IR-duration and spread-duration have the same effect on the bond.

For a floating-rate bond, on the other side, you have IR-risk only until the next reset of the floating rate and thus very small IR-duration. The credit risk, however, is much higher than IR-risk and you can measure this using spread-duration.

## Answer by Tim Wilding (score 0)

https://quant.stackexchange.com/a/39367

Practitioners care about the difference between spread risk and sensitivity to the risk free curve because it enables them to hedge the risk for the bond separately. Those two elements combine to determine the risk of the bond, and can be hedged using different instruments in the marketplace.

So, for example, an investor can hedge the risk-free element of the bond using government bonds, or they can hedge the spread element using a Credit Default Swap (CDS). If the investor knows what the spread duration is, then it helps them to determine a CDS trade to hedge that component of risk.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.