What is credit spread duration and how does it differ from interest rate duration?

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AcadiFi · Accepted Answer

Credit spread duration measures a bond's price sensitivity to changes in its credit spread, while interest rate duration measures sensitivity to changes in the benchmark...

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**Key Definitions:**

- **Interest Rate Duration**: ΔP/P ≈ -D_IR × Δ(benchmark yield)
- **Credit Spread Duration**: ΔP/P ≈ -D_CS × Δ(credit spread)

For most option-free fixed-rate bonds, the two durations are approximately equal because a 1 bps change in spread has the same mathematical impact as a 1 bps change in the benchmark.

**When They Differ:**

| Situation | Interest Rate Duration | Credit Spread Duration | Why Different? |
|---|---|---|---|
| Callable bond (in-the-money call) | Low (call caps price) | Higher (spread widens → call less likely) | Spread widening extends effective life |
| FRN | ~0 (rate resets) | ~Maturity | Rate risk hedged, credit risk persists |
| Inflation-linked bond | Low (real rate sensitivity) | Higher | Nominal spread risk remains |

**Worked Example -- Beacon Industries Bond (fictional)**

Beacon 5.5% coupon, 10-year callable in 3 years. Currently trading at a credit spread of 200 bps.

| Scenario | Benchmark Yield | Credit Spread | Total Yield | Effective Duration |
|---|---|---|---|---|
| Base case | 4.00% | 2.00% | 6.00% | 5.8 (two-sided) |
| Benchmark +50 bps | 4.50% | 2.00% | 6.50% | Price falls, call less likely, duration extends |
| Spread +50 bps | 4.00% | 2.50% | 6.50% | Same total yield, same price impact? |

In practice, the credit spread duration for Beacon is slightly higher (~6.2) than the interest rate duration (~5.8) because spread widening reduces the probability of the bond being called, effectively extending the bond's life and its sensitivity to further spread changes.

**Portfolio Management Implication:**

A portfolio manager hedging with Treasury futures eliminates interest rate duration but retains credit spread duration. If corporate spreads widen during a recession, the hedged portfolio still loses money. The manager needs credit derivatives (CDS) to hedge spread duration separately.

Understanding this decomposition is essential for LDI (liability-driven investing) and credit portfolio construction where rate risk and spread risk must be managed independently.

What is credit spread duration and how does it differ from interest rate duration?

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