Hi guys,
Anyone have an intuitive way of explaining why (or if) credit spread duration and interest rate duration are negatively correlated? I keep seeing this phenomenon at work all the time but I can’t wrap my head around it why it’s happening.
If interest rates rise, that’s usually a sign of the fed trying to manage inflation (economy doing well) so if the economy is doing well then credit spreads are likely narrowing. In other words, there is a negative correlation between the economic growth and credit spreads (at least for most corporate issuers).
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This is true, but is says nothing about the respective durations.
I’m pretty sure that the correlation is positive (and near +1).
What evidence do you have that makes you think that it’s negative? Can you show us some numbers?
Thank you for your replies, sir. I’ll get back to you ASAP with numbers.
Interest rate often increase when credit spread narrow because of the cyclical nature of the former (during economic growth periods, interest rate tend to rise) and countercyclical nature of the latter (during economic growth periods, credit spread tend to narrow).
We can say that interest rates and credit spreads are, as a rule of thumb, negatively correlated.
What about their duration?
Duration is the sensitivity of price to both of those 2 variables.
Said differently this is the magnitude of price change when those 2 variables change also.
But why the respective sensitivity of bond price to interest rate an credit spread should be negatively correlated with each other?
Bond price is always (let’s get rid of exceptions) exposed to interest rate and credit spread change but the impact of each on bond price is driven by different systematic and idiosyncratic factors like maturity, sector, liquidity, inflation and so on in different proportion.
This is not because the interest rate duration of a bond increases that credit spread duration should decrease also and conversely.
But since credit risk has risk free rate imbedded in it, this would suggest that if a bond price is increasingly sensitive to interest rate risk it would be also increasingly sensitive to credit risk.
If conversely a bond price is increasingly sensitive to credit risk it can be increasingly be sensitive to other variable than interest risk, like liquidity, quality, maturity and so on. But it will be also be sensitive to interest risk.
A positive correlation of both durations is more likely than a negative one. Just my thought.
Spread duration should equal modified duration.
Hi Bill,
I understand that the spread duration of a corporate bond is its modified duration. Just trying to explain that interest rate duration and spread duration can hardly be negatively correlated. They are more prone to move in sync.
But I am surely missing what you mean.
I’m going to go to bed. These revisions are making my brain smoke.
If they’re equal, their correlation is +1.0.
Yes indeed.