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

Question

AcadiFi · Accepted Answer

Interest rate duration measures sensitivity to changes in the benchmark risk-free rate (typically Treasury yield at the bond's maturity). Spread duration measures sensitivity to changes in the credit spread — the excess yield over the benchmark — assuming the benchmark rate is held constant.

For an option-free corporate bond, the two are approximately equal because the bond's total yield = benchmark + spread, and a 1bp change in either rate produces the same price change. They diverge when:

1. **Floating rate notes (FRNs)**: Coupons reset with the benchmark, so interest rate duration is near zero (~0.25 until next reset), but spread duration equals the effective maturity (e.g., 5 years). Pure spread exposure.

2. **Step-up bonds**: Coupons change over time; sensitivities differ.

3. **Premium/discount bonds**: Cash flow weighting differs, shifting durations slightly.

4. **Option-adjusted contexts**: A callable corporate's effective interest rate duration may shrink from rate-driven call exercise, but spread duration doesn't incorporate the same dynamic.

For your BBB book: IR duration 6.2, spread duration 5.8. The ~0.4 gap suggests either some FRN content or convention differences. In risk terms:

- 25bp Treasury rally → price rises by ~6.2 × 0.25% = 1.55%
- 25bp spread tightening → price rises by ~5.8 × 0.25% = 1.45%
- 25bp rally in each → price rises by sum ≈ 3.00%

**Decomposing P&L**: %ΔP = −IR_Dur × ΔTsy_yield − Spread_Dur × ΔSpread

This lets you attribute performance: if credit spreads widened 15bps while Treasuries rallied 10bps, your P&L components are +6.2 × 0.10% = +0.62% from rates and −5.8 × 0.15% = −0.87% from spreads, net −0.25%.

**Portfolio-level spread duration** is the MV-weighted average:
SD_port = Σ w_i × SD_i

Credit managers think in 'spread duration contribution' (SDC): SDC_i = w_i × SD_i. An HY bond with 6% weight and SD 8 contributes SDC 0.48 — a relatively concentrated spread bet even if weight looks small.

**Practical importance**: In a credit selloff, spread duration drives most of the P&L — Treasury rates may even rally (flight to quality). An investor who thinks IR duration captures all risk will be blindsided. Always view credit portfolios through both lenses, and for HY/EM, spread duration is typically the dominant risk.

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

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