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(ProQuest: ... denotes formulae omitted.)
Many portfolio managers with investment-grade benchmarks are allowed out-of-benchmark (core-plus) allocations to high-yield debt. As with any other asset class, they need to understand the effect such allocations have on the overall duration of their portfolio. It is widely acknowledged that the interest rate sensitivity of high-yield securities is not necessarily what their stated cash flows imply, yet there is a wide range of opinion on this issue among portfolio managers. At one extreme, there are those who account for the full analytical duration of the high-yield component. At the other extreme are the managers who claim that high-yield debt exhibits rather equity-like behavior and ignore the duration contribution of high-yield entirely. The majority in-between usually have some heuristic rule of thumb - for example, to consider 25% of the analytical duration for highyield bonds.
Uncertainty about the interest rate sensitivity of high-yield bonds can severely affect the ability of portfolio managers to accurately express their views on rates. Assume, for example, that a portfoho and its benchmark both have durations of 5 and that the manager shifts 10% of the portfolio into high yield, also with (analytical) duration of 5. Depending on one's opinion, the "true" duration of the portfolio is anywhere between 4.5 and 5.0 - a tremendous range for many managers used to tweaking duration in much smaller increments when expressing their views on rates. If the portfoho target duration is 4.8 and the manager is prepared to adjust the Treasury component of the portfolio to hit this target, does he need to add duration or subtract it?
Similar inquiries by investors have prompted us to publish several studies since 2005 on the empirical duration of U.S. investment-grade and high-yield bonds.1 The studies confirmed that empirical durations decline as credit ratings deteriorate and established a relation between empirical duration and the level of spread based on both theoretical and empirical evidence. The findings indicated that the sensitivity to rates decreases as spreads widen, even across bonds with the same credit quality. Similar patterns were found for emerging markets bonds.
The main focus of the initial research was on high-yield bonds. The key concern was that high-yield managers tended to ignore the yield curve sensitivity of their...