Bridge over ocean
1 January 1997 Financial Analysts Journal Volume 53, Issue 1

Default Risk and the Effective Duration of Bonds

  1. David F. Babbel
  2. Craig Merrill
  3. William Panning

Default risk creates difficulties for fixed-income portfolio managers in measuring a portfolio's exposure to interest rate risk. It also heightens the anxiety of traders and arbitragers who are hedging their investments, and it compounds financial institutions' problem of matching assets and liabilities. The consensus among researchers is that credit risk shortens the effective duration of corporate bonds. This paper provides estimates of how much shorter durations become because of credit risk. These estimates are based on observable data and easily estimated bond pricing parameters. Because the duration measures are taken with respect to movements in a common reference rate of interest, they can be used with greater confidence than can other measures when attempting to compute the duration of a portfolio of bonds subject to varying degrees of credit risk.

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