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HY Emprical Duration Approximation

HY Emprical Duration Approximation

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Published by CreditTrader
Quick and dirty example of notable convexity changes in the duration hedge requirements for a HY bond as it tracks the index over the last few years.
The point is that as a bond becomes increasingly distressed, its risk/vol is allocated less to interest rate changes and more to equity (or asset valuation) changes. This means that using an analytical duration will tend to 'over' hedge interest rate risk as spreads decompress.
An understanding of this 'empirical duration' adjustment is critical to dynamically manage a portfolio of bonds through any cycle BUT even more so currently with spreads relatively low and rates 'potentially' going higher.
The chart shows the 'real' world duration to use to hedge (in 5Y TSYs here) for the HY bond index (BBG/TRACE).
Notice how rapidly empirical duration has risen (i.e. the need to sell more TSYs) as HY yields have dropped (the arrows try to point this out). Interestingly as HY bonds crashed in 2008, HY bond holders would have needed to be buying back TSY hedge positions in significant size - just as they have had to sell them (to hedge) as yields fell on HY corp debt.
The relationship is relatively static and can be described with a number of heuristics or multinomial regressions and is basically dependent on the Modified/Macaulay Duration (or any analytic duration) and the OAS (or spread) of the bond.
Don't take the numbers on the chart as gospel as to be truly accurate we would need a history of durations (I assumed Par for ease of use and example in the chart but it does not take away from the impact).
Bottom Line: Bonds are sensitive to IR changes and Equity changes; as risk rises the share of sensitivity shifts from IR to equity (a govt bond has 0 equity risk and 100% IR risk whereas a bond on the verge of default has 100% equity/asset value risk sensitivity and 0 IR risk); the relationship is highly convex and provides a double whammy on the convexity of analytic duration as yields fall; technicals (flows) might be better understood once the hedging requirements of more sophisticated managers are accounted for given this empirical duration hedge dynamic (exaggerates the non-spread aspect of a corp bond's yield in both directions).
Quick and dirty example of notable convexity changes in the duration hedge requirements for a HY bond as it tracks the index over the last few years.
The point is that as a bond becomes increasingly distressed, its risk/vol is allocated less to interest rate changes and more to equity (or asset valuation) changes. This means that using an analytical duration will tend to 'over' hedge interest rate risk as spreads decompress.
An understanding of this 'empirical duration' adjustment is critical to dynamically manage a portfolio of bonds through any cycle BUT even more so currently with spreads relatively low and rates 'potentially' going higher.
The chart shows the 'real' world duration to use to hedge (in 5Y TSYs here) for the HY bond index (BBG/TRACE).
Notice how rapidly empirical duration has risen (i.e. the need to sell more TSYs) as HY yields have dropped (the arrows try to point this out). Interestingly as HY bonds crashed in 2008, HY bond holders would have needed to be buying back TSY hedge positions in significant size - just as they have had to sell them (to hedge) as yields fell on HY corp debt.
The relationship is relatively static and can be described with a number of heuristics or multinomial regressions and is basically dependent on the Modified/Macaulay Duration (or any analytic duration) and the OAS (or spread) of the bond.
Don't take the numbers on the chart as gospel as to be truly accurate we would need a history of durations (I assumed Par for ease of use and example in the chart but it does not take away from the impact).
Bottom Line: Bonds are sensitive to IR changes and Equity changes; as risk rises the share of sensitivity shifts from IR to equity (a govt bond has 0 equity risk and 100% IR risk whereas a bond on the verge of default has 100% equity/asset value risk sensitivity and 0 IR risk); the relationship is highly convex and provides a double whammy on the convexity of analytic duration as yields fall; technicals (flows) might be better understood once the hedging requirements of more sophisticated managers are accounted for given this empirical duration hedge dynamic (exaggerates the non-spread aspect of a corp bond's yield in both directions).

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Categories:Business/Law
Published by: CreditTrader on Feb 18, 2011
Copyright:Attribution Non-commercial

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