The effects of default and call risk on bond duration

Sovereign risk and its changing effects on bond duration during financial crisis

“…The sovereign risk-adjusted duration ranges from 64% of its Macaulay duration counterpart for AAA-rated bonds to 5% for B or lower rated bonds, respectively. The monotonic 'shortening' effect of sovereign risk on bond duration echoes the findings of Xie et al (2009) on the effect of default risk on noncallable US corporate bonds. Hull et al (2004) and Norden and Weber (2004) show that bond rating changes lag changes in CDS prices, while both ratings and CDS prices are driven by the credit quality of issuers.…”

“…To properly use the readily available Macaulay duration for managing interest rate risk, we must link the Macaulay duration to the effective duration appropriately. Xie et al (2009) derive a general relation between the risk-adjusted (i.e. default risk-, call risk-, and default and call risk-adjusted) effective duration and the Macaulay duration.…”

“…Since sovereign risk is similar to default risk in nature and our sample only includes US dollar denominated sovereign bonds, we can directly apply the relation derived by Xie et al (2009) to examine the relation between sovereign risk-adjusted effective duration and its Macaulay counterpart and show how sovereign risk affects bond duration. The sovereign bond literature has documented that the sovereign yield spread does reflect not only the risk premium for default risk, but also local and global macroeconomic risks, such as equity market risk, exchange rate risk and changes in sovereign CDS prices.…”

“…Table 2 reports the summary statistics of daily changes in sovereign yield spreads Δ(y S − y T ), changes in matching US Treasury yields (Δy T ), local stock returns (R), changes in foreign exchange rates (ΔFX), and sovereign CDS prices (CDS) and their changes (ΔCDS). We follow Xie et al's (2009) methodology to calculate the daily changes in sovereign yield spread Δ(y S − y T ). We first compute the daily yield of the matching US Treasury bond by applying the daily US Treasury spot rate curve to calculate the arbitrage-free price of each matching US Treasury bond.…”

“…Results from this study provide a standard for sovereign risk-adjusted duration for bond managers in managing the interest rate risk of sovereign bonds. Since the impact of sovereign risk on sovereign bonds is analogous to that of default risk on corporate bonds as both types of risk pertain to the ability of the issuer to meet its debt obligations, we follow Xie et al's (2009) methodology to analyse the sovereign risk effect on bond duration by examining the relation between changes in sovereign yield spreads and changes in the matching US Treasury yields. A precise matching procedure is used to control for the coupon and maturity effects in our examination of the impact of sovereign risk on bond duration.…”