When does empirical duration diverge from effective duration, and which should I use?

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AcadiFi · Accepted Answer

Effective duration and empirical duration measure different things and can diverge sharply for credit-sensitive or complex bonds. Effective duration is model-based: ED = (P- - P+) / (2 × P0 × Δy), computed by repricing the bond under ±25 bp parallel yield curve shifts using a term structure model (OAS framework for callables/MBS). It captures how the bond should move given rate changes, holding all else constant. Empirical duration is regression-based: regress observed bond price returns on Treasury yield changes over a rolling window (60-120 days). The slope coefficient is the empirical duration. For high-yield bonds, emerging market debt, or MBS in stressed markets, empirical duration often comes in 30-60% lower than effective duration. Why? Credit spreads move inversely with Treasury yields in risk-off episodes. When rates fall 50 bps in a risk-off move, HY spreads widen 80 bps, partially offsetting the Treasury rally. An investment-grade corporate with effective duration 6.0 may show empirical duration 4.5 if credit spread beta to rates is negative. For Oakfell Credit Fund's HY portfolio, effective duration 5.8 but empirical 4.1 reflects this spread offset. Hedging implication. If you hedge using effective duration, you over-hedge in stressed markets and give up returns in rate rallies when spreads tighten. If you hedge using empirical duration, you're exposed to the structural case where spreads move with rates (in normal times). Best practice: decompose into rates duration (effective) and spread duration separately. Hedge rates duration with Treasury futures, spread duration with CDX or single-name CDS. Monitor realized empirical duration quarterly; if it's persistently 40% below effective, your risk model is missing credit-rates correlation.

When does empirical duration diverge from effective duration, and which should I use?

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